When prompted for commentary on their current stock price, management teams will almost always tell you that their shares are undervalued, perhaps even desperately so. Even companies that have been awarded with the frothiest of valuations will typically only concede that they have been fairly valued by the market. Talk is cheap, as the saying goes. As a result, investors will often carefully monitor what management is doing with either their own money (are they purchasing or selling shares in the open market?) or the company’s money (are they raising capital through share issuances or repurchasing stock?). These actions potentially have signalling value that can inform investors as to what management really thinks about the investment prospects of their company’s shares.
The title here is a little misleading, however, as the announcement — and even the follow through — of a share repurchase program usually has very little, if any, signalling value.
Firstly, when companies announce that they have received board authorization for a share repurchase program, they often have no intentions of ever acting upon it. Management announces the share buyback purely to create the perception that they think the stock is undervalued.
Secondly, the companies that follow through with share repurchases aren’t even necessarily doing it because they think their shares are undervalued. Some of the most common reasons are:
- Because it is “accretive to EPS.” Of course, when interest rates are as low as they are today, it’s pretty hard for share repurchases not to be accretive, regardless of the price paid. This is often the rationale given when the company has more cash than they require, yet feel the need to do something with it.
- To appease the demands of large shareholders, who could seek to replace the board of directors and, in turn, the CEO.
- To “support the stock.” Always cringe-worthy, but embarrassingly common.
- To compensate for stock option dilution.
Even when management claims to be repurchasing shares because they think the shares are undervalued, they don’t necessarily really believe that. The size of share repurchase programs are often so small that the CEO views it as a small price to pay to change investors’ perception of the stock price. In other words, they view it as a small price to pay to make their stock price go up immediately.
As a result, share repurchase programs very rarely contain any signalling value for investors. One notable exception, however, can be seen with Arbor Realty Trust (ABR). Here, the confluence of three rare factors indicate management legitimately believes that shares are undervalued and is now acting to take advantage of the opportunity.
Arbor Realty is an externally-managed real estate investment trust (REIT) that announced in June their board had authorized a share repurchase program for 1.5 M shares, around 6% of the company’s shares outstanding. When the company held a conference call to discuss Q2 results less than two months later, management disclosed that they had already repurchased 125k shares, clearly suggesting that their share repurchase plans were not an empty promise.
What makes the situation at Arbor Realty unique is as follows:
- The CEO owns a significant equity stake in Arbor Realty, with roughly 20% of the common shares. More specifically, Arbor Commercial Mortgage, the external manager of the REIT, owns about 22% of the common. Arbor Realty’s CEO, Ivan Kaufman, however, owns 91% of ACM. With such a large stake in the business — over $20 M at current market prices — the CEO is significantly more likely to only repurchase shares if they truly are trading at a meaningful discount to their intrinsic value.
- Arbor Realty is an investment company with an abundance of opportunities to pursue. They are generally in the business of making real estate bridge and mezzanine loans, but also invest in real estate equity and mortgage-backed securities. This is a very important distinction. As alluded to above, most companies that repurchase shares only do so when they’ve exhausted all possible internal uses; they repurchase shares simply because they figure it is better than letting the cash pile up on the balance sheet, where it earns a negligible return. Arbor’s CEO, however, has weighed the possibility of deploying this unrestricted cash into additional real estate loans — in which he explicitly targets a 15% total return — and has seemingly determined that his own stock should yield a greater return than this going forward.
- While the CEO has a $20 M equity stake in ABR, he has an even greater financial interest in the company through the base management and incentive fees he receives at Arbor Commercial Mortgage for managing ABR’s portfolio. In 2010, for example, ACM received over $26 M in total management fees from Arbor Realty. What’s interesting here is that the CEO actually has a disincentive to repurchase shares due to this lucrative management agreement. By repurchasing shares he is shrinking the company’s capital base, which has the impact of reducing the potential fee income he is able to receive for managing it at ACM.
Now just because there is substantial evidence that the CEO really does believe his company’s shares are meaningfully undervalued does not make Arbor Realty Trust a compelling investment. Arbor’s CEO could certainly be wrong. While I believe the shares are in fact undervalued at current prices, a discussion of ABR’s investment merits is not the purpose of this post. I wanted to highlight the very rare example of an active share repurchase program with significant signalling value because similar situations present fertile ground for investors seeking outsized returns.
Disclosure: Long ABR
