Inside the DuPont Buyback

Goldman Sachs won't go hungry in the $3 billion accelerated share repurchase.
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DuPont

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gave its shareholders some instant gratification last week, setting a $3 billion buyback whose impact was juiced up by a semi-exotic trading arrangement with

Goldman Sachs

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.

Shares of the chemical manufacturing giant are up 6% since the news, a gain that also reflects investment upgrades at banks including Goldman and the adoption of a more conventional $2 billion repurchase program over two years. They closed Tuesday at $41.73.

But what really lit the fire was DuPont's $3 billion "accelerated share repurchase" plan, in which Goldman was hired to help retire 8% of DuPont's outstanding stock over nine months. Unlike typical buybacks, which might never be consummated, DuPont's deal created an immediate improvement in the supply/demand profile of its stock while lowering the denominator in the company's earnings-per-share calculation.

While the agreement helped revive a flagging stock, Goldman Sachs hardly goes hungry in the deal. Not only does the powerhouse investment bank rake in a fee for structuring the transaction, it also gets a chance do some trading arbitrage in shares of DuPont.

In the deal, DuPont pays Goldman Sachs for 75.7 million shares at their price the day before the agreement was announced: $39.62 apiece. Over the next nine months, the investment bank will make open-market purchases of DuPont shares to close out the position. The transaction is similar to a short sale in which a trader sells borrowed shares and must replace them later.

On the surface, the deal might seem risky for Goldman Sachs -- couldn't it lose money if it's forced to repurchase the DuPont shares at inflated prices? The answer is no. The way accelerated buybacks -- which have been around for a little over a decade -- are structured, Goldman has an insurance policy against any such swing.

Roughly speaking, if DuPont's stock rises, the company will pay Goldman Sachs the difference between the initial buyback price and the "volume-weighted average price" of the stock over the period when Goldman does its buying. Conversely, if the stock declines in price over time, Goldman Sachs will credit the difference back to DuPont.

Michael Mauboussin, chief investment strategist for Legg Mason Capital, says there "really is not any risk'' for the investment bank in an accelerated buyback. Several years ago, when Mauboussin was an analyst with Credit Suisse First Boston, he commented favorably on accelerated buybacks, saying both the company and investment bank win in such a deal.

Still, the unspoken fringe benefit for Goldman Sachs in this arrangement is that it gets to be a major market participant in DuPont's stock for the next nine months, say people familiar with accelerated buybacks. And a savvy trading firm like Goldman Sachs can use that unique position to its advantage. Among other things, Goldman is likely to cover its short position in DuPont at prices that beat the volume-weighted-average quote. So, whether the stock rises or falls, when the bank settles up with DuPont, it will probably walk away with a profit.

A Goldman Sachs representative wasn't available to comment.

Of course, Goldman Sachs isn't the only Wall Street securities firm making money on corporate America's demand to provide its shareholders with instant results. In recent years, the number of accelerated buybacks has picked up, as companies find themselves flush with cash and looking for ways to bolster their stock prices.

A year ago,

Hewlett-Packard

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tapped

Merrill Lynch

(MER)

to structure an almost equally as large accelerated buyback, which retired $1.3 billion of the computer manufacturer's stock. Other more recent accelerated buybacks include a $562 million deal handled by

Citigroup

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for

Sara Lee

(SLE)

and a $175 million fast-track buyback arranged by

J.P. Morgan Chase

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for

Manor Care

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.

"Perhaps some banks are marketing it as a quick way to bolster a company's share price," says Sean Egan, managing director of Egan-Jones Rating Co., an independent credit ratings firm. "The biggest beneficiaries are the investment banks taking the fees out.''

To be sure, accelerated buybacks have their detractors. Bondholders and credit rating agencies tend to hate the practice, viewing it as a waste of corporate assets, since most accelerated buybacks are paid for with new debt. Any corporate move that adds leverage or reduces a company's cash flow is often seen as a negative for existing bondholders.

Sure enough, all the major ratings agencies downgraded DuPont's bonds in the wake of the buyback announcement.

One thing critics dislike about accelerated buybacks is the lack of flexibility it affords a company. Unlike an ordinary buyback, in which a company controls how much it spends on occasional stock repurchases, there is no such control over the corporate purse strings in an accelerated buyback. Once a company enters into one, the cash is gone, leaving no room for second guesses.

"The cash for an ASR is out the door immediately,'' says Carol Levenson, director of research for Gimme Credit, an independent corporate bond research firm. "There may even have to be more cash out the door at the end of the repurchase period ... if the stock price has risen in the meantime.''

Levenson says a company that enters into an accelerated buyback "is sacrificing some financial flexibility, which ought to matter to stockholders as well as to bondholders.''

A DuPont representative wasn't available to comment.