Why Buying Back Stock Isn't Always the Best Use of Capital

A year of so ago, we analyzed Reader's Digest post reorg equity, which trades on the distressed desks. At that time, the equity traded at 20 dollars a share. Today the equity trades for 9 dollars a share. Reason: Poor management capital allocation skills and weaker than expected results.

In January 2011, Reader's Digest, under the leadership of Mary Berner, announced a tender to repurchase up to $50M of stock via a Dutch Auction tender between $22 and $25/share (representing 8.3% of outstanding shares). This tender was later amended to increase the purchase price to $27 - $29/share. In the end, $43M worth of capital was used to repurchase shares at $29/share, retiring 5.4% of the outstanding shares (1,494,134 shares tendered).

We will never know if Berner thought it would be a good idea to tender for the share herself, or if she was pushed by her stockholders or board to buy back stock. Given the lack of liquidity of the stock, I'd guess the latter. We do know that in April, the company put out a press release: "RDA Holding Co. today announced that a majority of its shareholders have appointed a new Board of Directors, effective April 18, 2011. Mary Berner, President and Chief Executive Officer will continue to hold a Board seat." - You do not often here about an entire new board of directors. Soon after (i.e. a week after), this new board of directors appointed a new CEO.

Net / Net, the company deployed $43M of capital in the first quarter. Then, last week, the company put out its press release for its fiscal results for the 2nd quarter ended June 30th, 2011. In that press release, the company announced a new capital raise (my emphasis added):
"On August 12, 2011, the Company entered into and borrowed the full amount under a term loan and guarantee agreement, providing the Company with a $45.0 million secured term loan, and an unsecured term loan and guarantee agreement, providing the Company with a $10.0 million unsecured term loan, each with Luxor Capital Group, as administrative agent; the Guarantors (defined in each agreement); and the lenders thereunder (who are affiliates of RDA shareholders). The secured term loan matures in November 2013 and bears interest at the rate of 7.00% per annum. The unsecured term loan matures in May 2014 and bears interest at the rate of 11.00% per annum. The new credit facilities contain substantially the same covenants and limitations as our existing senior revolving credit facility, although in certain cases they are more restrictive. The proceeds of the new credit facilities will be used for seasonal working capital and general corporate purposes. In addition, in connection with the unsecured term loan, the Company issued two tranches of warrants to the lenders under the agreement. The first tranche of warrants provides the holders with the right to purchase up to 1.125 million shares of the Company’s common stock at an exercise price of $17.50 per share. The second tranche of warrants provides the holders with the right to purchase up to 1.25 million shares of the Company’s common stock at an exercise price of $15.00 per share. Both tranches of warrants expire two years after the issue date. Previously, the Company had drawn down the balance of its senior revolving credit facility."
Wait. Let's get this straight. 4 months ago, you spent $43M to buy back ~1.5 millions shares at $29/share and now you issue warrants at $15 and $17/share for 1.25 million and 1.125 million shares respectively? Hold on; and you drew down the balance of your revolver? Let's go to the conference call and see if we can find some answers.
Tom Williams, New CEO: "This past week, we entered into two term loan agreements that provided $55 million of incremental cash. The new $45 million secured facility was originally contemplated under the structure of the debt agreement that we put in place at the time we emerged from Chapter 11. Recognizing the need for additional seasonal working capital, given the peaks and troughs of our business, the company conducted a thorough process to raise new capital. After speaking with multiple potential lenders, we entered into serious negotiations with several parties and we are very pleased that we're able to close the financing last week, in light of the challenging capital markets environment.

In the end, we entered into a transaction with lenders that are affiliates of two of our shareholders. The agreements call for $45 million of secured loans with a term of 2-1/4 years and an interest rate of 7% and $10 million of unsecured loans with the term of 2-3/4 years and an interest rate of 11%, which also provides for warrants to be purchased of 2.375 million shares of Class A common stock.

The primary use of this new cash is for seasonal working capital needs."
Two things I take away from this:
  • Someone forgot to carry the 1 when they were projecting working capital draws apparently. That $43M you spent for shares at $29/share looks pretty precious right now if you ask me. (Especially considering they also drew down on their revolver!)
  • Luxor is getting an extremely attractive deal. This is essentially 2.5 year paper, senior secured, with a healthy rate, AND warrants.
I am only singling out Reader's Digest as it is topical to the site. Hundreds of management teams bought back excessive stock in 2006 only to see their stock price drop 50% in the ensuing 2 years. Unfortunately, management teams rarely think like owners and instead listen to their shareholder base on when it makes sense to buy back stock. Many times this has to do with incentives: I.E. Keep the shareholder base happy so the board doesn't kick me out. And because a buy back may increase short term potential of equity valuation, management teams benefit if they have options or if they themselves want to sell shares on the open market at a higher valuation.

Management teams should think like value investors: Buying back stock only when there is a substantial margin of safety in the purchase using prudent assumptions. If management thinks the stock is worth $20-30/share, they should buy back stock in the mid teens, not if its trading in the fair value range. I always love it when management teams are buying back stock significantly less than intrinsic value: Not only is it good for me as a shareholder, but it also shows me that management gets it. Henry Singleton, arguably one of the greatest capital allocating CEOs ever, tendered for 90% of Teledyne's stock over a 15 year period. He waited until blood was in the streets, and bought back loads and loads of stock and shareholders were dutifully rewarded over time.

In the future, when contemplating an equity investment, take a look at the company's history of buying back stock (and frankly issuing debt - a good capital allocator at the helm will be issuing bonds when rates fall ... see Warren Buffett last week). Were they buying back stock at peak multiples of earning and cash flow? Were they then issuing stock at the lows? While that might not preclude me from buying a certain security, it will require me to have a larger margin of safety in the purchase price to counter the off chance management makes a capital allocating mistake in the future.


Offshore,  8/22/2011  

Keep up the good work.


hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.