Value Creation through Share Repurchases: Juniper Networks
An activist investor, Elliott Management, recently acquired a 6% stake in Juniper Networks, Inc. (JNPR), one of our holdings, and published a presentation proposing that management take certain actions including the initiation of an accelerated share repurchase program.1 Management teams, investors, and market observers talk a lot about creating value through share repurchases; the JNPR situation provides a good opportunity to discuss the extent to which, and the mechanism by which, this is the case. I will also relate this topic back to an observation made by my colleague, Nate Palmer, regarding the extent to which net cash on company balance sheets is currently valued by the market.
We agree with Elliott that an accelerated share repurchase would create value for JNPR shareholders; however, we come at it from a different direction and differ on the magnitude of the benefit. Elliott’s analysis is based on earnings accretion; ours focuses on the impact to JNPR’s per share intrinsic value.
Elliott’s presentation suggested that utilizing $3.5B, slightly more than JNPR’s current net cash and investments,2 to repurchase shares would create 24% earnings per share (EPS) accretion.3 Elliott also assumed that the price-to-earnings multiple would stay constant, implying that the stock price would appreciate by the same 24%.4
At Diamond Hill, we seek to create value for our clients by investing in businesses at discounts to what we think they are really worth – the companies’ intrinsic values. Likewise, corporate management teams have a similar opportunity to create value by repurchasing company shares when they are available at a discount to intrinsic value.5 Two factors affect the amount of value created: the size of the discount and the percentage of total shares repurchased. Bigger discounts represent bigger opportunities for value creation, so we like to see management teams increase share repurchases when discounts widen.
Algebraically, the percentage increase in per share intrinsic value can be calculated as follows:
V = (S * D) / (1 – S)
S = the percentage of shares repurchased
D = the discount to intrinsic value (in % terms) at which the shares are repurchased
V = the percentage increase in value per share for remaining shareholders
In the case of JNPR, Elliott also proposes that management create additional value by initiating some fairly significant cost cutting and product line rationalization, both of which we support. To simplify comparison of the two approaches to calculating the prospective value created by the proposed JNPR share repurchase, I will use Elliott’s assumptions about 1) the value created through cost cutting and 2) the number of shares to be repurchased.6 Doing so yields the following assumptions and outcome for the formula above:
- (S) Percentage of shares repurchased: 29%
- (D) Discount to intrinsic value (in % terms): 15%
- (V) Percentage increase in value per share: (0.29 * 0.15) / (1 - 0.29) = 6%
The difference in impact calculated by the two approaches is fairly significant: 24% per share for the accretion approach and 6% for the intrinsic value approach.
This disparity arises from the differing treatment, between the two approaches, of the cost of the share repurchase. In the intrinsic value approach, the cost of the share repurchase is the reduction of a balance sheet item – the $3.5B used to repurchase shares. In the accretion approach, however, the cost consists only of income statement items – interest and financing adjustments to earnings resulting from the proposed use of JNPR’s domestic cash and new debt to finance the repurchase. Due to the current low interest rate environment, the interest and financing items are significantly less impactful than reducing the intrinsic value calculation by the $3.5B outlay.
The accretion / income statement approach seems consistent with something Nate Palmer observed while writing about our technology holdings in August 2013 (i.e. that the market does not seem to be applying full, if any, value to cash).7 It is also worth noting that this ambivalence toward cash does not appear limited to that of technology companies. As an example, Forest Laboratories, Inc. (FRX), a branded pharmaceutical holding of ours, recently announced its intention to spend roughly its full net cash balance ($3B) to make an acquisition. The purchase price was ~16 times expected earnings and synergies, a reasonable sounding price, but no steal. Surprisingly, the initial market reaction was to add almost $3B more in market capitalization to FRX – essentially the entire purchase price. It seems the market might have been expressing that while sitting on the balance sheet, the net cash was worthless, but once it was earmarked to be put to work (i.e. increasing EPS to which a multiple can be applied), this cash was suddenly worth approximately face value. Said another way, in the case of FRX, a future cash flow stream with a net present value of $3B was deemed by the market to be worth $3B, but $3B in balance sheet cash was valued at zero.
At Diamond Hill, we are focused on estimating intrinsic value, and cash is one component of that estimate. We are in favor of share repurchases when they are both value creating and represent management’s best use of cash, and the bigger the discount to intrinsic value, the more we like them. With regard to JNPR, we are in favor of the share repurchase, even though much of the discount to intrinsic value appears to have been removed since the time of Elliott’s presentation. If the stock price were to move above our estimate of intrinsic value, we would no longer support the share repurchase; however, at that point we would have become disinterested observers, as our sell discipline is to exit a position when the stock price exceeds our estimate of intrinsic value.
The views expressed are those of the analyst as of February 2014, are subject to change, and may differ from the views of other portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.
1 Elliott Management presentation: http://www.new-juniper.com/
2 As of 12/31/13 JNPR had roughly $4.2B in gross cash and investments (~ 50% non U.S.) and ~ $1B in debt. Elliott proposes using a combination of U.S. cash, cash flow, and new debt to repurchase $3.5B in stock.
3 The 24% EPS accretion contemplates decreased interest income, increased interest expense, and new financing costs, all of which would be incurred to finance the proposed repurchase.
4 Relative to the closing price on 1/9/14 of $22.83 per share.
5 Management should weigh this decision against alternate uses for the cash, including re-investment in the business.
6 The Elliott presentation offered a range of scenarios regarding the price at which the full repurchase might be completed. The middle scenario assumed a $24 per share stock price (up 5% from $22.83). Since Elliott’s presentation, the stock has risen well above this price; however, for the purposes of this note, the $24 price will be used in order to fairly compare the two approaches to calculating value created. At $24 per share, $3.5B could repurchase ~29% of shares outstanding.
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