US Corp Share Buyback - Double Edged Sword

From The Economist Sept 13th - 19th 2014. My thoughts are in blue.
http://www.economist.com/news/leaders/21616950-companies-are-spending-record-amounts-buying-back-their-own-shares-investors-should-be

Companies are spending record amounts on buying back their own shares. Investors should be worried

FINANCIAL excess is more commonly associated with banks than with blue-chip companies. While the rich world’s finance industry—supposedly the brain of the economy—went berserk in the run-up to the 2007-08 crash, other big firms behaved sensibly, avoiding too much debt, keeping their costs under control and their eyes on long-term opportunities in emerging markets. But in the era of weak growth and low interest rates that has characterised the aftermath of that crash, there is growing evidence that the blue chips are engaged in their own kind of financial excess: a dangerous addiction to share buy-backs.

Over the past 12 months American firms have bought more than $500 billion of their own shares, close to a record amount. From Apple to Walmart, the most profitable and prominent companies have big buy-back schemes (see article). IBM spends twice as much on share repurchases as on research and development. Exxon has spent over $200 billion buying back its shares, enough to buy its arch-rival BP. The phenomenon is less extreme in other countries, but is becoming popular even in conservative corporate cultures. Led by firms such as Toyota and Mitsubishi, Japanese companies are buying back record amounts of their own shares.

Intel also does buyback in the tune of $20 billion announced back in July 2014 (before the spike in share price) and expects to repurchase about $4 billion in shares in the current quarter. This amount is similar to IBM. Intel spent $10 billion in 2013 for research and development. 

Buy-backs are not necessarily a bad idea. When firms buy their own stock in the open market they return surplus cash to their shareholders, in much the same way as if they were paying out dividends. And if firms can’t find opportunities for profitable investment, handing cash back to investors is the right thing to do. In many ways the surge in buy-backs is a symptom of the rich world’s feeble growth prospects.

But it could also be a source of trouble, for two main reasons. First, both short-term investors and managers have incentives that could lead them to overdo buy-backs and neglect long-term investment projects. The announcement of a buy-back scheme can prompt a sudden spike in share prices and a quick buck for the short-term investor. By reducing the number of shares outstanding, buy-back schemes can also artificially boost a firm’s earnings per share. This helps explain why managers whose pay depends on reaching specific earnings-per-share targets like to buy back shares. We will never know as it is only disclosed privately.

Second, some firms may be borrowing too much to pay for their buy-back habit. American companies, if one includes their global operations as a whole, are only moderately indebted; record buy-backs are being paid out of record profits. But the overall figures are skewed by a few cash-rich giants, such as Google. In 2013, 38% of firms paid more in buy-backs than their cashflows could support, an unsustainable position. Some American multinationals with apparently healthy global balance sheets are, in fact, dangerously lopsided. They are borrowing heavily at home to pay for buy-backs while keeping cash abroad to avoid America’s high corporate tax rate. Intel borrowed $6 billion for the sole purpose of buying back shares. Though the DE ratio is at a 'not to worry' ratio of 0.227 as of writing, the intent borrowing to do this for the first time is worrisome.

Intel's 5 Year Per Quarter DE ratio: It will continue to grow as long as profits do NOT compensate for growing debt

Let's examine IBM's case where profits are not lowering down the debt ratio.

IBM's 5 Year Per Quarter DE Ratio: Ever growing. 2014 saw massive borrowings for buy back scheme.

IBM's 5 Year Per Quarter Gross Profit: Not affected by crisis but also NOT growing 

The difference between a growing business and not.

Intel's 5 Year Per Quarter Gross Profit: Grew when demand needed to replenish inventory during global recovery but relatively flat since peak of 2011

Costco's 5 Year Per Quarter Gross Profit: Ever growing PER quarter

Drawing a line
If firms are overdoing buy-backs and starving themselves of investment, artificially propped-up share prices will eventually tumble. That is why investors need to pay close attention. In the long term they need to ensure that bosses’ pay schemes are designed in a way that does not create a perverse incentive to repurchase stock. In the short term, they must give willing firms a licence to invest. There are some signs that this is beginning to happen. According to a poll by Bank of America Merrill Lynch, a record majority of fund managers now think firms are investing too little; only a minority want higher cash returns. That is welcome: shareholder capitalism is about growth and creation, not just dividing the spoils.