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Buyback Mania Inflates 2Q Earnings Growth

By Wall and MainFOXBusiness

With more than 80% of the companies that comprise the S&P 500 having reported their June quarter earnings, it’s time to take stock – no pun intended – in how they did. On the surface, it would appear that this earnings season held up far better than expected.

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Per data from FactSet Research Systems, nearly three quarters of the S&P 500 companies that have thus far reported their second-quarter earnings have issued profits above the mean estimate. As I always say, a data point without reference or context is nothing more than a dot in the sand, on the chalkboard or on a piece of paper. Moreover even a grade school student knows you need at least two data points to draw a straight line. That 73% figure is ahead of the trailing average and in aggregate, and at 8.4%, the earnings growth rate for the S&P 500 is well ahead of the 4.9% earnings growth expectation that was marked on June 30. Other figures from S&P Capital IQ put the year-over-year earnings growth rate for the S&P 500 just north of 10% for the June 2014 quarter.

Now, you have to ask yourself if the economy has gotten that much better than Wall Street thought over the last several weeks to deliver such a robust earnings beat. Pockets of it have, but not enough for companies across the board to deliver such a swift rate of earnings growth.

What you have to remember is that when a company reports the “earnings” that it and Wall Street are talking about, it’s earnings per share or EPS. Now that we’ve cleared that up, there are a few ways companies can improve their EPS comparisons on a year-on-year and quarter-over-quarter basis. After all, earnings per share equates to earnings or net income divided by the outstanding share count (with certain adjustments).

To deliver better-than-expected EPS a company can grow its net income, which can either reflect a robust core business or something funky beneath the operating line such as a lower-than-expected quarterly tax rate. The company can also shrink its outstanding share count via a share buyback program, or some combination of the two.

Stock buybacks have soared to more than $670 billion in 2013 alone with more than $230 billion announced so far in 2014, according to data from Trim Tabs. While that sounds like a steep fall off, a quarterly analysis shows that corporate America set a record during 1Q 2014 of $138.5 billion for the second highest amount ever spent in any quarter. It also shows a dramatic drop to $92.7 billion in the second quarter, which marks the lowest levels in seven quarters. During the first half of 2014, 15 S&P 500 companies including Apple (NASDAQ:AAPL), Intel (NASDAQ:INTC), Caterpillar (NYSE:CAT), Wells Fargo (NYSE:WFC), Qualcomm (NASDAQ:QCOM) unveiled significant buyback plans.

But just because a company announces a buyback plan doesn’t necessarily mean it was actively buying back shares. FactSet, however, found that “dollar-value share repurchases amounted to $154.5 billion over the first quarter and $535.2 billion for the trailing twelve months.” Among the big buyback spenders FactSet found Apple, IBM (NYSE:IBM), FedEx (NYSE:FDX), Boeing (NYSE:BA), Abbott Laboratories (NYSE:ABT), Corning (NYSE:GLW) and eBay (NASDAQ:EBAY). Other notables included Pfizer (NYSE:PFE) and Home Depot (NYSE:HD). Sifting through those respective quarterly earnings statements we find those nine companies on average shrank their June quarter outstanding share count by 6.5% year over year.

Simple calculations show a 6.5% drop in a company’s share count year over year can deliver a 7% increase in its earnings per share even if its net income is the same. Following a record year of buybacks in 2013 and the second best buyback quarter ever in 1Q 2014, it stands to reason the aggregate net income growth across the S&P 500 companies was far slower than the 8.4% earnings growth rate from FactSet or the 10% figure offered by S&P Capital IQ. Remember, the stock market rewards true growth, not simulated growth.

Some observations: First, given the impact of buyback activity across the S&P 500, the actual year-over-year profit growth at the aggregate operating line in all likelihood far slower than EPS growth would suggest. Second, in order to fund these buyback programs, companies, like Apple, have piled on debt. Just this week AOL (NYSE:AOL) announced it would tap the convertible bond market to the tune of $300 million, with $50 million earmarked to repurchase AOL shares.

According to Andrew Lapthorne of Société Générale, net debt in the US corporate sector is at a record $2.3 trillion, up 14% over the past year. Not only is this not a good picture for when the eventual next recession hits, but it begs the question as to how much longer buyback mania can continue. When it finally sputters, be prepared for it to weigh on forward earnings growth expectations, especially if we continue to dwell in a sub-par economy.  Borrowing from the future to artificially pump up earnings today is not a recipe for long-term growth and makes for a riskier corporate balance sheet.

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