The S&P 500 is close to its record high as earnings season heats up, but one of the major drivers of the market’s advance - stock buybacks - looks to be sagging.
US companies announced about $182bn in buybacks in the first quarter, according to Birinyi Associates research, putting buybacks on pace for their weakest year since 2012. Strategists link this, in part, to falling cash flow, a trend that is expected to worsen in coming quarters.
First-quarter earnings per share are expected to fall 7.8%, but more importantly for the outlook for buybacks, revenues are set for a fifth consecutive quarter of decline. Thomson Reuters data forecasts a 1.1% revenue drop.
Cash flow is a better indicator of buybacks prospects than earnings, as per-share earnings can be managed through cost-cutting such as asset sales and cutbacks. Weak free cash flow, on the other hand, cannot be papered over. The expectation is that buybacks, which have become part of the corporate finance routine in recent years, could slip in coming quarters as a result.
“More companies are decreasing their cash flow from operations, which does not really lend itself to repurchases,” said Abhra Banerji, director of quantitative research at Evercore ISI. “They may honor existing commitments that they have made - but it is unlikely they will issue new ones.”
Banerji notes that the share of S&P 500 companies increasing cash flow has slipped from about 55% in mid-2014 to about 49% now.
Aggregate cash flow for S&P 500 companies is estimated to have increased by almost 16% in the first quarter compared to a year earlier, but is seen flat in the second quarter and falling markedly in the second half of the year according to a data analysis by David Aurelio, research analyst for Thomson Reuters I/B/E/S.
Even with the increase in the first quarter, the number of buyback announcements fell to 58, compared with an average of 76 in the first quarter of the past three years, according to Evercore.
For example, ExxonMobil Corp, which has spent more than $200bn in buybacks in the last decade, more than any other company, chose to refrain from buybacks altogether in the first quarter.
The largest US energy company said then that it would “evaluate” the buyback program each quarter. It reports results on April 29.
Industries expected to feel the biggest free cash flow squeeze in the second quarter include energy, consumer services companies, such as McDonald’s ; the capital goods sector with big share repurchasers like Caterpillar and Boeing , and diversified financial companies such as Goldman Sachs, according to Thomson Reuters data.
Those companies rank in the top 20% of share repurchasers in the last decade. In the last two years, spending on buybacks and dividends surpassed overall companies’ net income for the first time outside of a recession, according to a Thomson Reuters analysis.
Now, companies mostly associated with buybacks, particularly those with high ratios of buybacks to their market value, could struggle as they see cash flow sink.
Four of the top 10 members of the S&P Buyback Index – Michael Kors, Emerson Electric, Parker-Hannifin and Scripps Networks are expected to report falling per-share cash flow in the first quarter of 2016, according to Thomson Reuters I/B/E/S data.
This buyback index, long an outperformer against the S&P, has lagged the broader average since early last year. The index is down 4.7% from the beginning of 2015 until April 14 of this year while the S&P is up 1.4% in that time.
Michael Kors, an apparel company, is among the worst performers, down 30% in that time.
Buybacks also help company earnings look better than the weakened revenue figures suggest, as the lowered share count boosts earnings per share. If repurchases fail to keep up with the recent pace, the effect of declining earnings on valuations could be magnified.
“It makes a declining fundamentals picture perhaps a little bit worse that it would be,” said Michael Arone, chief investment strategist at State Street Global Advisors in Boston.
Cash has, however, not been the only fuel for the buyback frenzy over the past six years. Many companies have taken advantage of historic low interest rates to borrow and use the proceeds to purchase their own stock.
There has been nearly $7bn in US corporate bond issuance in the last five years, according to Securities Industry and Financial Markets Association (SIFMA) data.
“The pace of net buybacks accelerated in the last two quarters of last year even as earnings declined,” said Brian Reynolds, chief market strategist at New Albion Partners in New York.
He added that the ongoing boom in bond sales means more companies will “start leveraging their balance sheets for more buybacks,” that is, selling more debt to pay for their shares.
What might affect this calculus is an upward drift in interest rates. If the Federal Reserve continues to raise interest rates in response to jobs growth and a perceived stronger economy, long-dated bond yields will also rise, increasing the cost for companies who want to buy back shares.
That, in addition to weak cash flow figures, could prove a double-whammy for the stock market.
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