A couple of entries ago, I went on a rant about my favorite stock bugaboo: the share buyback. Today I came across a particularly fatuous discussion of this very topic in Barron's Weekday Trader column of September 16, 2013. Entitled "Seagate: The Shareholder's Friend", the article describes a very aggressive share buyback program that is designed to reduce the company's outstanding shares by 30%, to 250 million shares. An earlier program has already reduced the share count by 26% to 371 million from 500 million over the last three years. Seagate's president is quoted as saying "We don't believe in holding excess cash on our books."
Notably, the article proceeds to draw a comparison with Seagate's main rival in the disk drive business, Western Digital. It says that Seagate's share price is up 30% this year, while Western Digital's is up 50%. The difference is that Western Digital has been investing its "excess cash" in flash memory acquisitions, a strategy Seagate dismisses as premature. The company president is confident that he'll be able to buy mature technology later on.
Now, I am no expert in this business, but I do know that flash drives are vastly quicker than disk drives. For example, the very sexy Ultrabook I'm using to compose this blog boots up in seventeen seconds, due to its advanced flash memory. I also know that flash is upending memory technology across the board. The very biggest players (EMC and IBM) are investing huge sums in this area. So, what I see here is a classic face off between a company committed to financial engineering and one committed to reinvesting in the business.
While both companies have risen sharply over the last three years, that rise is from very low levels following a long period of distress: too much capacity and falling volumes. Seagate bottomed at $3.80, Western Digital at $11.45. Neither, therefore, has been a particularly great investment over a 15 year span. Still, economic recovery coupled with careful capacity management has caused both stocks to soar in the last couple of years.
With its "shareholder friendliness" and 26% buyback, why has Seagate's recovery lagged its rival's? Well, folks, follow the money! As opposed to dividends, which clearly end up in the shareholders' pockets, and are therefore, clearly shareholder friendly, the funds allocated to buybacks have ended up in the pockets of ... the sellers! People who no longer own Seagate (or who own fewer shares) have received the dough. For the rest, it's gone! If that makes you feel like a sucker for loyally staying the course, well ...
Cash comparisons between the companies are eye-opening. Seagate's 2012 ending cash position was nearly identical with the start of the year; Western Digital was up by $1.1 billion. Seagate spent $1.4 billion on stock buybacks, while WD spent $.66 billion. Seagate also spent $518 million on dividends, compared to WD's $181 million. Making the comparison extreme is the fact that Western Digital is 1.55 times the size of Seagate. So, which do you think is the grasshopper, and which the ant?
Why is Seagate up at all? Don't forget about the law of supply and demand. A constant flow of buyback dollars has an effect on the share price. It rises temporarily when there are more buyers than sellers. What I find compelling is that Western Digital is up quite a bit more, with far less tinkering. Clearly, I think, its more sophisticated investors find the pursuit of technology a superior path to shareholder rewards.
So, which company is right? Well, again, I'm no expert. What I do know is that Seagate now has much less cash on hand to buy flash drive technology, or do anything else, for that matter. And once it's retired another 30% of the shares, it will have even less money when the time comes to buy a "mature" flash drive company at sharply higher prices. Hmm, what sounds like the better way to reward shareholders: invest in technology that is clearly the future of the business, or get rid of excess cash while waiting for a better entry point?
What is the likely outcome? Well, if history repeats (or rhymes), Seagate will eventually face a huge financing nut relating to its tardy effort to acquire flash technology. One way to free up cash will be to cut the dividend. Then it will then borrow a ton of money, at much higher rates than today's, or perhaps raise funds in a massive issuance of "new" stock. None of these things will be good for the stock price.
At present, Seagate's per share price is about $40, Western Digital's 65. I see this as a perfect test case for my abhorrence of buybacks. I hereby go on the record with a prediction: five years from now, Western Digital will have significantly outperformed Seagate (not by a few percentage points, but by factors: two, three, four times). Will I actually make the bet (perhaps by shorting Seagate, or establishing option spreads in Western Digital's favor? Probably not. I'm a Bondsman, after all.
Update: Over a year later. The trends I discussed above continue. Seagate's revenue has fallen 4.7% in 2014, while net income has declined even faster, 14.58%. Yet the stock is up 40% for the year (to $56). Why would that be? Well, while the market is rising as a whole, such a sharp rise against a backdrop of dreary financial results can only be understood in the context of stock buybacks. As for Western Digital, its revenue fell much less (1.44%), while its net income has exploded 65%. And Western Digital's price is up even more than Seagate, even though its buyback program is dwarfed by Seagate's. What do you think will happen to Seagate's price when the company stops blowing its cash on buybacks? Western Digital, using far less cash for buybacks and dividends, is investing in the core business. Down the line, I continue to predict that it will outperform Seagate by large margins.
Update: January 2015. Well, I did take a flyer in Western Digital, purchasing out of the money calls and selling at the money calls. The stock flew up, and I ultimately cashed out for a $5,000 profit. No big deal, but a nice confirmation of my read on WDC. As to Seagate, it just announced that it's halting stock buy-backs, now indicating that they only make sense below a stock price of $60. Guess what? The stock immediately dropped 7%. Why? Because folks were counting on further buybacks! Guess what's going to happen going forward? Gravity, folks!
Update: May 2016. Well ... Both stocks have hit hard times. Today Seagate is trading at $18.64, Western Digital at $35.74. Both have been rocked by a slump in sales of personal computers, and both are down roughly 70% from year ago highs. Now, however, Western trades nearly double Seagate. So, even in tough times, its price relative to Seagate has improved sharply. And, despite sharp controversy relating to Western's purchase of flash drive maker Sandisk, the company has solidified its technology going forward. So, it has spent its money on the company's future. And Seagate? It announced ANOTHER $2.5 billion buyback a year ago. The result? The stock has PLUNGED, and now has a preposterous dividend of 13% (200% of net income, while Western's dividend yield is a far more sustainable 5%). All that money, tossed overboard in the name of enhancing shareholder value! Once Seagate cuts its dividend, the stock will face more downward pressure. The company will still have its core technology issue and the prospect of further income erosion. So, I'm fairly sure the gap between the two companies will widen further ... much further. Does that make Western a good buy? Hell if I know. This article is, after all, about the follies of stock buybacks. I think that point is strongly substantiated by this ongoing thread. An arbitrage strategy, shorting Seagate and going long Western might be attractive, but that's no longer my game.
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