C-Suite Financial Engineering Binge——Goosing Stocks And Options, Gutting Balance Sheets And Growth

GE, in order to paper over a net loss of $13.6 billion and declining revenues in the first quarter, said on April 10 that it would buy back $50 billion of its own shares. That’s on top of the $10.8 billion in actual buybacks last year. The announcement was beat only by Apple’s $90 billion announcement last year, to which it added another $50 billion on Monday.

It’s going to be a great year, not for revenues and earnings, but for share buybacks. Hence for share prices and executive bonuses, despite crummy revenues and earnings. Goldman Sachs says so.

In a note to clients, Goldman predicted that companies would goose share buybacks by 18% over 2014 and dividends by 7%. That would be a $1-trillion banner year.

The year has started out on the right foot. Repurchase plans, including GE’s mega-dose, have already reached $337 billion through April 24, Reuters reported, based on data from Birinyi Associates. That’s a 34% jump over the same period last year.

The next party of actual repurchases will commence in a week or so, Goldman’s chief U.S. equity strategist David Kostin wrote in the note. Turns out, that’s when about 80% of the S&P 500 companies will have exited their blackout period for share repurchases, which stretches from about five weeks before they report earnings to two days afterwards.

So be it if actual earnings, as reported under GAAP, are in the doldrums. By reducing the number of shares outstanding, companies automatically increase their earnings per share. And EPS is the magic metric, particularly “adjusted” ex-bad items EPS. It performs outright miracles.

Look at Twitter. It just reported a zinger of a net loss of $162 million for Q1, up 22.7% from a year ago, on the somewhat iffy theory that rising revenues should create bigger losses. Its lifetime “accumulated deficit” and “accumulated other comprehensive loss” now amount to $1.78 billion. A truly fascinating business model.

But its “Non-GAAP net income” wasn’t a loss at all; it was a miraculous profit of $46.5 million. That stroke of genius converted an actual loss of $0.25 per share to an adjusted “profit” of $0.07 per share. That is the most fundamental principle of the art of financial engineering.

But Twitter won’t buy back shares anytime soon. That privilege is reserved for companies that have been around for a while, such as McDonald’s, whose revenues dropped 11% in Q1 and whose net profit plunged 33%. So it announced a share buyback and dividend program of $18 billion spread over two years. These companies are going on a veritable buyback binge.

Goldman reminded its clients what this is all about: Buybacks tend to boost share prices. That too is a fundamental principle of financial engineering – getting share prices to rise while bad stuff is happening at the company. And as these shares rise, they will goose the entire market, the note added. Buy, buy, buy.

It has worked perfectly so far, pushing the stock market from one new high to the next. By now, companies are the biggest buyers of their shares. The entire stock market valuation is based on the premise that companies will forever buy their own shares. And most companies have to go out and borrow this money.

So they issue bonds – nearly free money these crazy days – and they use this cash to become the relentless bid in the market. They buy when shares hit highs because it drives them even higher, and they buy when shares sag because it puts a floor under them. In the process, they load up their balance sheet with debt, and they hollow out stockholder equity. They’re becoming a precarious structure that balances an enormous amount of debt on an ever shakier foundation.

The hope is that there will always be enough nearly free money around to roll over this ever growing mountain of debt endlessly. Because if the money gets more expensive or dries up, that precarious structure is going to topple (unless the Fed steps in again, as during the Financial Crisis, to bail them out).

Nevertheless, Goldman manages to squeeze in a word of caution: “Given current historically high equity valuation and a strong U.S. dollar, for many firms a superior strategic allocation of cash could be overseas M&A rather than share repurchases,” the report said.

Of course! M&A is where Goldman extracts its extra-special fees coming and going.

So GE has suddenly decided to dump most of its financial assets, including its vast commercial property assets. With impeccable market timing: it rides up the boom and now tries to get out while it still can. But it’s doing a lot more. Read… Moody’s Has a Cow, Slams GE’s Masterful Financial Engineering