Hewlett-Packard Company (HPQ), Weight Watchers International, Inc. (WTW), Alliance Data Systems Corporation (ADS): Don’t Be Fooled by These Destructive Buybacks

Returning capital to shareholders is usually interpreted as a shareholder-friendly action — and it often deserves this interpretation. However, the tendency of investors to view all returns of capital as positive events has emboldened the boards of struggling companies to initiate share repurchases as a show of confidence — even when such repurchases destroy shareholder value.

Such value destruction occurs at companies with good and bad prospects alike. For instance, Hewlett-Packard Company (NYSE:HPQ) spent $17.6 billion on share repurchases in 2010 and 2011 just as the PC market started to show serious signs of stumbling. Although the repurchases boosted earnings per share, shareholders would have been much better off had the company paid out the money in a dividend. Instead, Hewlett-Packard Company (NYSE:HPQ) paid only $1.5 billion in dividends during the period and bought back stock at much higher prices than it trades for today, now that reality is priced into the stock.

But even good businesses with bright prospects can destroy shareholder value by repurchasing stock that is selling well above intrinsic value. Weight Watchers International, Inc. (NYSE:WTW) provides a good example of this. Weight Watchers International, Inc. (NYSE:WTW) has a strong brand and effective program that enable it to earn outsized profits year after year.

In 2007, the company borrowed money to repurchase $1 billion in stock at $54 per share. It increased its leverage once again in 2012 with a $1.5 billion repurchase at $82 per share. The stock currently trades around $45 per share due to uncertainty regarding near-term earnings.

Destruction not just obvious in hindsight

The vast destruction of shareholder wealth brought on by repurchases of Hewlett-Packard Company (NYSE:HPQ) and Weight Watchers International, Inc. (NYSE:WTW) stock is not only obvious in hindsight, it also should have been obvious at the time of repurchase.

Hewlett-Packard Company (NYSE:HPQ) traded at a decade-high $50 per share in early 2010, but fell to the low $40s as cracks began to appear in the PC market. Partial substitutes in the form of tablets and smartphones were clearly hurting PC sales, and it was clear that Hewlett-Packard Company (NYSE:HPQ) would at least not have any tailwinds if not headwinds. The last thing shareholders should want in a declining business is for management to reinvest cash, which is essentially what repurchases are doing.

In Weight Watchers International, Inc. (NYSE:WTW)’s case, reinvesting cash in the business is a good idea — but only at the right price. The company has demonstrated significant pricing power over the last two decades, and it is unlikely that even free Internet applications will derail the company’s profitability.

But Weight Watchers International, Inc. (NYSE:WTW) repurchased shares for $82 apiece in a year when the company earned a record $4.23 per share; it paid 19 times record earnings for a business that will grow at a slow-to-moderate pace over the next decade.

One company that did it right

Hewlett-Packard Company (NYSE:HPQ) and Weight Watchers International, Inc. (NYSE:WTW) destroyed value with their pricey share repurchases, but Alliance Data Systems Corporation (NYSE:ADS) created enormous value with its opportunistic buyback. The company spent nearly $900 million on repurchases in 2008 and another $400 million in 2009 when the stock traded at absurdly low multiples of normal earnings. Management eased off repurchases as the stock price recovered. Today, the stock trades at around $190 per share.

Alliance Data Systems Corporation (NYSE:ADS) is not a great business, but it’s a good one. It does not have the same earnings protection that a wide-moat company like Weight Watchers enjoys, but it arguably created more value for shareholders over the last five years than many companies of much higher quality. This is because management took the opportunity to invest cash on the balance sheet at a high rate of return in its current operations by repurchasing stock.

Bottom line

Share repurchases are neither universally good nor bad; it comes down to what the repurchase price is in relation to the value of the stock. Hewlett-Packard Company (NYSE:HPQ) and Weight Watchers repurchased shares at wildly overvalued prices, while Alliance Data Systems Corporation (NYSE:ADS) repurchased at absurdly low prices. The latter created enormous value for shareholders, while the former two destroyed value. Keep these companies’ respective capital allocation records in mind when deciding whether or not to buy them.

The article Don’t Be Fooled by These Destructive Buybacks originally appeared on Fool.com.

Ted Cooper has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Ted is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.

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