A Real Share Buyback -- or a Smoke Screen?

Insider-trading clues can often tell you the difference between real buybacks and those used to satisfy executive stock-option plans. Discuss it on our message board.
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Investors have long placed faith in the seminal 1995 study by Rice University Finance Professor David Ikenberry, which found that you could beat the market by investing in companies that were repurchasing their own shares.

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Increasingly, however, corporate buybacks are raising investor eyebrows more than investor confidence. The reason? Many companies never buy back the full number of shares indicated in the initial announcement. Others appear to be buying back shares expressly to turn them over to company insiders exercising incentive stock options. So, how do you know when to put your trust into a corporate repurchase plan? Insider info can help sort out the situation.

Consider

Pep Boys

(PBY) - Get Report

. Here's a stock that last saw 35 in mid-1997, and it has headed south ever since. Even so, the company's Dutch tender offer to repurchase 11.3 million shares at $16 per share was oversubscribed, and since the offer's February expiration, the shares managed to rally on two occasions to above 20. But each time, they promptly fell back below 15.

And if you believe that actions speak louder than words, that may not be the bottom: From Aug. 19 through Sept. 2, two insiders sold a combined 365,000 shares. But they didn't take advantage of the tender offer, nor did they sell shares during either of the two ensuing periods when the stock traded above 20.

Instead, they sold when the shares fell back to the 14-to-16 range. True, the shares were acquired through the exercise of incentive stock options -- in fact, both insiders exercised options to acquire slightly more shares than they subsequently sold. Still, no matter how you slice it, the sales -- the largest at the company since '86 -- trimmed each insider's actionable position considerably. And that's hardly a good sign. Logic dictates that if your stock is weak and you think it's headed higher, you hold on for the ride -- at least for a little while.

A similar divergence between public assurance and private divestiture occurred at

Seagate Technology

(SEG)

. Shortly after company insiders had unloaded more than 500,000 shares in the 41-to-44 range last January, the company extended its ongoing share-buyback program. Since then, the shares have drifted to a low of 25.

What all this means is that, strangely enough, the announcement of a corporate share buyback may actually be a signal that insiders are getting ready to cash out. The number of options issued has virtually exploded in the 1990s, and many of the companies with the most aggressive options programs face the challenge of coming up with the stock to satisfy their insiders' option exercises. The increasingly common solution? Companies often find themselves scrambling to buy back shares to satisfy this demand.

The pressure is on the rise: The number of options granted to

S&P 500

companies jumped from 1.6 billion in 1994 to as high as 4.3 billion in 1998, increasing dramatically each year. And the only way to avoid dilution is to buy the necessary shares from the public -- using either cash on hand or borrowed funds.

The latter is becoming more common than anyone realizes. Pep Boys, for example, funded its buyback using $110.4 million in cash and $70 million in senior notes. On the surface, the debt placement might not look overly serious. After all, it only represents a 14% increase in the company's long-term debt. But the deal changed the company's long-term debt-to-equity ratio from 65% to 95%.

Nor is Pep Boys the exception: In 1998, nonfinancial businesses increased their debt by more than $400 billion -- with over half of this sum being used to finance share buybacks. Which raises the question -- how much of this represents legitimate share-buyback interest and how much is an attempt to ensure insiders' abilities to cash in their options? And is increased leverage what shareholders really want at this stage of the economic cycle?

Certainly, some buybacks are motivated by a desire to increase shareholder value. Again, we are particularly impressed when we see insider buying in support of a company buyback.

Tricon Global Restaurants

(YUM) - Get Report

,

Carmike Cinemas

(CKE)

and

Walter Industries

(WLT)

are companies that currently fit this bill.

Insider selling directly in the face of a company repurchase is something altogether different. If not downright suspicious, such behavior, at the very least, undermines the implied spirit of any share-repurchase program.

Bob Gabele has been tracking and analyzing insider trading since 1978, most recently for First Call/Thomson Financial. This column is not meant as investment advice; it is instead meant to provide insight into the methods of insider trading. At time of publication, Gabele held no position in any of the companies discussed in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Gabele appreciates your feedback at

rgabele@thestreet.com.