June 10, 2013 - Merck: Share Buyback Program Warrants Confidence
Traditionally, companies use their profits to expand their operations, thus generating more revenue and, hence, more profits. They also invest in their own infrastructure to increase their efficiency and their margins, which likewise increases profits. Depending on their sector, companies must spend on logistics, licences, fuel, R&D, advertising, insurance, legal defense? there would seem to be almost no end to the ways in which a company can or must use money to improve itself, and when there are no clear options for doing so, companies can expand through acquisition or return money to their shareholders in the form of dividends.
After all these needs have been considered and either embraced or discarded, some companies find themselves with the extraordinarily fortunate problem of having more money than they can find anything to do with. Rather than let the cash simply pile up higher and higher, a company in this position will often embark on a share buy-back program.
As with many market terms, "share buy-back" may be a slight misnomer. At the very least, it might be confusing from the perspective of the individual investor, who, even when buying shares in an Initial Public Offering (or IPO), never buys stock in a company directly from the company itself, and who, even during a share buyback program, is never approached by the company with any offer to buy stock.
Before a company begins a share buyback program, it must register and make public its intention to do so. It then buys shares from the market just as any institution would, but with one critical difference. Once the shares have been purchased they become treasury stock, which means they are no longer considered outstanding shares. In terms of calculations such as earnings per share, such shares effectively no longer exist, thus, by buying back shares, a company can cause its earnings per share to rise, even when its actual earnings are not. For each share bought back in this way, each outstanding share represents a larger percentage of ownership in the company. Another way to think of this is as a buyout in which investors who hold the stock are, in effect, using the profits of their company to buy out those investors who sell.
Share buyback programs are sometimes criticized as a tool by which a company can manipulate its stock price. Whether that is true or not depends largely on one's definition of manipulate; a share buyback will likely increase the price of a share, but it does so by changing the actual value of a share, legally and publically. Whether a share buyback program is in the best interest of shareholders, however, depends entirely on the situation.
Consider the consumer and pharma super-giant, Merck (MRK). As is the case with many pharma companies, Merck is in an adjustment period as some of its most profitable drugs have recently reached the end of their patent-life and are therefore beset by competition from lower priced generics. For Merck, the biggest heartbreak has been the 2012 expiration of the patent on its immensely profitable respiratory therapy, Singulair. Nevertheless, Merck's diversification has allowed them to mostly replace the lost revenue?sales are expected to be only 3% lower in 2013.
Merck's robust pipeline, which includes promising drugs for hepititus C, osteoporosis, type 2 diabetes and melanoma, is likely to push revenues and EPS even higher in 2014 and beyond. The stock has a PE of 24, but this is expected to fall all the way to 13 by the end of 2014, and the company pays a steady and rising dividend, all of which suggests that it could support a higher share-price in the future. In the near-term, Merck has registered its intention to repurchase $5 billion worth of its own stock. The potential danger in doing this for a pharma company is that they may be using money that could potentially have a greater value to future shareholders if it were spent on R&D. In the short term, however, investors can take heart, knowing that there is one more factor buoying the stock.
Chart courtesy of stockcharts.com
Our analysts conclude that the chance of any significant decline in MRK's share price in the near-term is remote and seek to profit from the strength with a bull-put credit spread. Look at the August 41/44 bull-put spread for at least a $0.24 credit. This trade has a target return of 8.7% over 68 days, which is an annualized return of 46.7%, (for comparison purposes only) and the stock has to fall 9.9% to cause a problem. Be aware that this is an aggressive trade, best undertaken by investors with diverse portfolios and high tolerance for risk.