FinPod

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Imagine a single company spending more than $700 billion over a decade. Which is just a staggering amount of money. Right. And, you know, we aren't talking about spending that money to build, like, massive new factories. Or to acquire their biggest rivals. Exactly. Or even to fund some crazy moonshot research project. No, they spent $700 billion just to buy back their own stock. Yeah. That is more than the entire market value of almost any company on Earth. It really puts it into perspective, doesn't it? It really does. So welcome to the Deep Dive. Today, you and I are going to explore a really fascinating stack of corporate finance analyses and market strategy notes on capital allocation. It's a great batch of sources. Yeah. And our mission for this Deep Dive is to understand how a brand new 1% federal excise tax on stock buybacks is, well, quietly shifting the math of corporate America. Right. But more importantly, we are going to uncover the real secret behind why companies buyback stock in first place and why they so often get it just spectacularly wrong. It is a phenomenal topic because, I mean, we really have to look at this calmly, analytically, and objectively. Right. Buybacks have actually become the dominant form of capital return in the S&P 500. Wow. Really the dominant form. Oh, absolutely. Companies are returning far more cash to their shareholders through these repurchases than they are through traditional dividends now. Okay. So when this new 1% tax went into effect recently, it touched the single largest channel of capital return in the entire market. That's a huge deal. It is. But it's important to understand right up front, this tax isn't about blowing up the economy or completely destroying the buyback. Right. It's really about testing a company's financial discipline. Okay. Let's unpack this. Because to understand how a mere 1% tax can actually change the behavior of multinational corporations, we first have to understand the strange loophole buried inside how it's calculated. Yes. The netting rule. Right. So I was reading through the notes on section 4501 of the tax code, which is where this new rule lives, and it imposes a 1% non-deductible excise tax on the gross fair market value of the repurchase stock. Exactly. And since it's an excise tax, companies can't just shield it with other deductions. I see. Yeah. It is a true 1% cash leakage out the door. Got it. But there is this crucial netting rule that the sources highlight. Right. The tax base isn't just the stock they buy back. It's the value of shares repurchased minus the value of new shares, the company issues during that same year. Yes. And crucially, and this is the wild part to me, that includes shares issued to employees as stock-based compensation. Exactly. The issue inside of the equation is just as important as the repurchase side. Really? Oh, yeah. If not more so for certain sectors. I mean, if you are issuing equity to your executives and your engineers, you get to net that total value against the shares you were buying back in the open market before you apply the 1% tax. Wait, wait. So let me get this straight. Sure. If a company is basically running like a dilution treadmill. Dilution treadmill, right. Where they are constantly printing new stock to hand to their employees as compensation, and then turning around and spending company cash to buy back stock just to offset that dilution and break even, they get a tax discount. They do. I mean, it almost sounds like a perverse reward for diluting the stock in the first place. What's fascinating here is that you've hit on the exact quirk of the policy that analysts are obsessing over right now. It's just so counterintuitive. It is. Think about two different companies. Let's say company A is a mature industrial firm that pays its employees entirely in cash. Okay. When they buy back stock, they were genuinely returning excess cash to reduce their overall share count. They pay the full 1% on every single dollar. Right, because they have no new shares to subtract. Exactly. Now look at company B. They're a massive tech firm that pays out billions in stock units to its engineers. Okay. When company B buys back stock, they're often just mopping up the shares they just handed out to prevent their share count from ballooning. But because of this netting rule, company B pays significantly less tax or sometimes literally no tax at all on large portions of their buy back program. That feels entirely backwards. The company actually returning capital gets penalized more than the company just treading water. It does feel backwards if you look at it in isolation, for sure. Yeah. But to understand the underlying logic, you kind of have to look at the historical tax that we've enjoyed over dividends for decades. Right. The whole double taxation debate. Exactly. Because if a company pays a dividend out of its profits, the shareholder receives cash, but immediately owes income tax on that money in that exact same year. Right. It's a taxable event. But if a company takes that same pile of profits and buys back stock, the shareholders who just hold onto their shares owe absolutely nothing right then. Precisely. For the shareholder who doesn't sell, the gain is completely unrealized. Right. The value of their remaining shares theoretically goes up because there are fewer shares in circulation, but that gain is deferred. It's locked away. Yes. Locked away until they eventually decide to sell, at which point it's usually taxed at much more favorable long-term capital gains rates. Ah. Okay. That massive structural tax efficiency is the underlying reason why buybacks came to dominate dividends over the last 30 years. Makes sense. So the policymakers introduced this 1% excise tax to claw just a little bit of that advantage back. It was meant to put a tiny 1% thumb on the scale toward dividends. Which brings us to the mathematical hurdle of accretion. Yes. And this is where I need you to translate something for me. Go for it. Because if the tax advantage of buybacks over dividends is still vastly larger than a measly 1% penalty for a shareholder, why does this tiny new tax matter at all? It's a great question. To see why it matters, we have to look past the tax code for a second and return to the absolute first principles of why a buyback creates value on a spreadsheet. Okay. Think of a company's total earnings like a giant pizza. I like pizza. Who doesn't? Yeah. A buyback works by buying out some of your friends who are sharing that pizza and basically asking them to leave the table. Okay. If the size of the pizza, the company's earnings, stays exactly the same, but you spread those slices among fewer people, every remaining person gets a bigger slice. Right. In finance, we call that being accretive to earnings per share. Your slice got bigger. Okay. I track with the pizza. Fewer friends, bigger slices for me. But here's the catch. It is only mathematically accretive if the premium you pay to get your friend to leave the table makes sense. What do you mean? Well, in financial terms, the earnings yield of the stock must exceed the after-tax return on the cash you use to buy them out. Right. Okay. If your cash is sitting in a bank account earning 5% interest and your stock is trading at a sky high valuation where its earnings yield is only 3%, buying back stock actually makes you poor. Oh, wow. Yeah. You gave up a 5% return to capture a 3% return. So you paid way too much for that extra pizza slice. Exactly. And this is where the 1% tax comes in. It effectively raises your purchase price. If you spend $100 on stock, you are actually spending $100 plus the $1 non-deductible tax. Because your effective purchase price is now higher, that relative earnings yield you are capturing is mathematically lower. The window for the buyback to be accretive shrinks. But I have to push back here. Please do. Honestly, it is 1%. Yeah. If a CEO is just determined to prop up their stock price to make their quarterly earnings look good, maybe because their own bonus is tied to those numbers. There is. Yeah. Is a 1% penalty actually going to stop them? I mean, it feels like throwing a pebble at a freight train. You're completely right to be skeptical and the analysts in our sources highlight exactly this point. Yeah. For the biggest, most cash flush players, this tax won't stop them at all. It is a pebble. Right. But at the margins for the average Fortune 500 company, it acts as a very necessary discipline forcing device. How so? Well, that's because the dirty secret of corporate buybacks is that they are systematically, almost comically missed time. Oh, I see. They buy high. They buy high over and over again. Companies historically authorize and execute the largest buyback programs when they are flush with cash. Right. And when our companies flush with cash at the very top of the economic cycle when times are booming. Which means the stock is expensive. Exactly. At that exact moment, their stock is usually trading at peak, highly expensive Wow. So a buyback that a CFO thought was barely accretive before this tax suddenly crosses the line and becomes neutral or even dilutive once you factor in that extra 1% cost. Ah, that makes sense. It forces the finance team to pause, look at the math, and ask the hardest question in corporate finance. Is our stock actually cheap enough to justify this? To see what that discipline actually looks like in the real world, I think we need to look at the giants who are actually pulling the trigger on these massive sums. Definitely. And there is no bigger giant than Apple. The sources hold Apple up as the ultimate scale benchmark here. Oh, yeah. We mentioned a single company spending $700 billion at the top of the deep dive. That is Apple. It's unbelievable scale. Over roughly a decade, they spent over $700 billion on buybacks. In one recent year alone, they spent close to $100 billion buying their own stock. And you have to look at the staggering result of deploying capital at that scale. Right. By doing that systematically, year after year, Apple shrank its total share count by about a third over a decade. A third? That's insane. Yeah. That means a continuous shareholder. Someone who just bought Apple stock 10 years ago, sat on their hands and did nothing, saw their ownership stake in the entire company grow by roughly 50% without spending a single dime to buy new shares. Wow. It is the buyback in its absolute purest value-freeing form. But here is what I find wild when looking at the impact of this excise tax. Like that. Because Apple has relatively modest stock-based compensation compared to the sheer astronomical size of their buyback program, they don't get a huge netting benefit. Right. The loophole doesn't save them. Exactly. So that 1% tax costs Apple on the order of $1 billion a year in hard cash handed over to the IRS. But reading through the strategic analysis, the consensus is that for Apple, this tax is basically a treasury levy. It's a cost of doing business. Yeah. Pretty much. But is it really just noise? I mean, a billion dollars is a billion dollars. Surely a corporate board flinches at writing a 10-figure check to the government for nothing in return. I mean, a billion dollars is certainly a massive number to anyone else. But you have to view it through the lens of Apple's free cash flow. Okay. When you are generating well over $100 billion in cash a year, and your business is inherently asset light, meaning you don't need to build 50 new steel mills every year to keep growing, the cash just piles up faster than you can legally deploy it. That's a good problem to have. A great problem. A billion dollar tax on a $100 billion program isn't going to deter you because the alternative is letting that cash rot in a low-yield bond portfolio while inflation eats it. So for a Titan like Apple, the real debate in the boardroom isn't buybacks versus dividends. Right. And it certainly isn't buybacks versus the 1% tax. Right. It's buybacks versus investing more aggressively in R&D and growth. Exactly. And they basically concluded that there just aren't enough viable moonshot projects on Earth to absorb $100 billion a year efficiently. That is the ultimate luxury of scale. They literally have more money than ideas. Yeah. But if you want to see what tactical cutthroat financial discipline really looks like, we have to look outside of tech and look at the banking sector. Who are we looking at? Specifically, JP Morgan. Their CEO, Jamie Dimon, has offered a multi-decade masterclass in capital discipline. Oh, definitely. He has explicitly and publicly refused to buy back his own stock when it is trading well above a sensible multiple of tangible book value. Which is a phrase we hear a lot in finance. Let's ground that for a second for everyone. Good idea. Tangible book value essentially means if you took JP Morgan, sold off all its raw assets, paid off all its debts, and ignored all the fuzzy stuff like brand value or goodwill, this is the hard cash leftover. Exactly. Dimon is saying he absolutely refuses to pay a massive premium over what the bank's raw assets are actually worth just to shrink the share count. Precisely. Because buying overpriced stock destroys shareholder value, even if you have a mountain of cash sitting in the vault. Right. If we connect this to the bigger picture, it is about treating the buyback as a price-sensitive residual. A residual. In Dimon's view, a buyback should be your absolute last priority. First, you fund the daily maintenance of your business. Make sure the lights stay on. Second, you fund high return growth investments and higher talent. Third, you pay a sustainable dividend that your investors can rely on in good times and bad. And then. Only after all of those buckets are full, if you still have excess cash, and this is the critical part, if your stock is genuinely cheap, do you execute a buyback? Got it. Treating a buyback like finding a great deal at a store, rather than an obligation you have to fulfill every quarter? Exactly. Yeah. JP Morgan actually paused their buybacks entirely during the 2020 COVID shock to preserve capital when the world was uncertain. Wow. And they throttled them way back again in 2022 to build up their capital reserves ahead of tougher regulatory requirements. They literally turned the spigot off the moment the math stops making sense. That extreme caution perfectly highlights the devastation that happens when companies do the exact opposite. Oh, absolutely. Like when they treat buybacks as a first line obligation to Wall Street rather than a residual afterthought. Yes. Here's where it gets really interesting. And honestly, reading the source material on this made me incredibly frustrated. Let's look at the major US airlines from about 2014 to 2019, right before COVID hit. It was the longest and most profitable aviation boom in commercial history. Right. Fares were up. Fuel was relatively cheap. Times were incredibly good. And during those boom years, these airlines collectively took about $45 billion in free cash flow and spent it on share buybacks. They were buying their own stock at absolute peak prices. They were rewarding shareholders, but they built virtually zero cash cushion for a rainy day. None. Then March 2020 arrives, the pandemic hits. Global demand for travel vanishes literally overnight. Revenues drop essentially to zero. It was unprecedented. And those exact same airlines suddenly required roughly $54 billion in federal aid to survive, which by the way, came with strict bans on any future buybacks. The symmetry of those numbers is just brutal. $45 billion out, $54 billion needed to plug the hole. It's insane. Let's put this in everyday terms for you listening. It's like someone taking their entire emergency fund, the money they should be saving for a crisis, and dumping it into the stock market at the absolute peak just because they feel rich. And then the very next day, their roof caves in, they have no cash, and they have to beg their neighbors to hand them the exact amount of money they just gambled away on stocks. It's a perfect analogy. The taxpayer had to step in and refill the exact buffer the airlines had just handed out to their shareholders. And that perfectly highlights the fundamental error in their capital allocation strategy. Aviation is a highly cyclical fixed cost industry. Planes cost money sitting on the tarmac, whether people are flying or not. Exactly. If you are in a cyclical industry, you have to assume that severe, violent downturns will happen. Treating buybacks as your top priority in good times and treating your cash reserves as an afterthought is exactly backwards. That's totally backwards. And unfortunately, the airlines aren't the only ones who learned this the hard way. The major banks before the 2008 financial crisis ran the exact same tragic playbook. Really, it is the exact same pattern just with different assets. The same pattern, but with arguably much worse systemic consequences because banks are quite literally in the business of managing risk and capital. Oh, man. In 2006 and 2007, heading right into the teeth of the subprime mortgage crisis, major banks were repurchasing massive amounts of their own stock at peak prices. Unbelievable. They were trying to keep their EPS growing to satisfy Wall Street, completely ignoring the toxic assets piling up on their balance sheets. They were systematically depleting the exact capital reserves they were about to desperately need. We call this pro-cyclical capital depletion. You are destroying your own safety net just as the storm clouds are gathering. And then 2008 hits, the housing market collapses, the losses mount. And because they had spent all their cash buying back stock at peak prices, they had absolutely no buffer left. Wow. To avoid bankruptcy, they had to raise capital by issuing new equity at deeply, deeply depressed prices. Many of them were forced to take government TARP funds. Right, the bailouts. So think about the math here. They spend billions buying their own shares at record highs, and a year later, they were forced to issue new shares at record lows just to survive. That is just- It is the single most value destructive move a management team can possibly make. It's the definition of buy high, sell low, executed with billions of shareholder dollars. Yeah. And it is exactly why post-crisis regulations put bank buybacks under strict Federal Reserve stress test controls. The regulators basically said, "We do not trust you to restrain yourselves." Okay. So knowing this history of catastrophic existential failures on one hand, and masterclass successes like JP Morgan on the other, how does a finance team actually execute a buyback today without falling into the trap? Good question. Because there's a big difference between wanting to buy back stock and actually doing it efficiently. Very true. The sources outline two primary methods of execution, and understanding how they work behind the scenes is really fascinating. The first is an ASR, or Accelerated Share Repurchase. Right. And ASR is all about speed and sending a massive signal of confidence to the market. Okay. Let's say a company wants to buy back a billion dollars of stock immediately. They don't just log into a brokerage account and click buy. No. No. They go to a major investment bank, say Goldman Sachs, and hand them a billion dollars in cash upfront. Just hand it over. Yep. The investment bank then turns around and delivers the bulk of those shares to the company immediately, often within days. But wait, how does the bank do that? The bank doesn't just have a billion dollars of that specific stock sitting in a vault somewhere. No, they don't. The bank goes out and borrows those shares from large institutional investors, like pension funds or index funds. Oh, wow. They borrow the shares, hand them to the company, retire them, and shrink their share count. Got it. Then over the next several months, the investment bank slowly buys shares in the open market to replace the ones they borrowed. That's wild. It's essentially a massive short position executed by the bank on behalf of the company. Okay. I see. The advantage for the company is immediate EPS accretion.

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But the massive downside is that it is incredibly rigid. Yeah. You have committed that billion dollars regardless of what happens to your business or the broader economy over the next six months. You lose all flexibility to be opportunistic. Right, because if the stock market crashes the week after you sign the ASR, you are locked in at the old pricing mechanics. You look foolish. Exactly. So the alternative to that rigidity is the open market repurchase, which is often executed through what's called a preset 10B51 plan. This is much more gradual. The company essentially puts the buyback on a stripped set of autopilot rules. They instruct their broker to just buy shares out in the open market over time, but only under certain conditions. Right. It allows for price sensitivity. You can instruct the broker to buy aggressively when the stock dips below a certain valuation and completely halt buying when it gets expensive. Exactly. It's slower. It doesn't give you that immediate sugar high of a suddenly lower share count. Yeah. But it gives you that crucial flexibility and price discipline. Yeah. And it's worth noting that for this new 1% excise tax, the execution method actually doesn't matter. Really? Yeah. The IRS doesn't care if you used an ASR or an open market plan. The tax only looks at the total fair market value of the shares repurchased by the end of the year, net of whatever issuance is you made. So bringing all these threads together, the tax loopholes, the catastrophic airline bus, the quiet discipline of Jamie Dimon, the sources synthesize this into an ultimate boardroom checklist for capital allocation. I love this checklist. I want you to put yourself in the CFO's chair. You have excess cash. Your CEO is telling you to buy back stock. Before you sign off, there are five questions you have to answer. Question one, is this genuinely excess cash? Meaning, have we fully funded the maintenance of our existing factories? Have we funded growth? And is our dividend secure? And if the answer is yes, you move to question two. Is the stock actually cheap? This is the Jamie Dimon test. Right. Are you buying well below intrinsic tangible value or are you just blindly buying on autopilot in the high and ultimate because Wall Street expects you to? Question three, have we modeled the 1% tax net of our employees' stock issuances? So we actually know what the real after-tax mathematical accretion is. And question four, and given everything we discussed about the airlines and the 2008 banks, this might be the most critical. Do we have a cash cushion for a severe 12-month downturn? If the economic cycle turns tomorrow, will we look back and regret having spent this cash on our own stock? Absolutely crucial. And finally, question five, is the structure rate? Do we need the immediate signaling power of an ASR or do we need the price discipline and flexibility of an open market plan? Right. So what does this all mean? When you strip away the tax code jargon, the complex netting rules, and the advanced financial engineering of investment banks shorting shares, it really comes down to an ultimate meta question. What's that? Are you returning capital because there is literally nothing better or safer to do with it and the price is an absolute steal? Wait, I mean, is the price an absolute steal or are you doing it just because you feel pressured to prop up your stock price for the next earnings call? That is the definitive dividing line between the value creators and the value destroyers in corporate America. Yeah. And that's what makes this new 1% tax so interesting to analyze. A 1% penalty isn't going to break the financial system. It isn't going to stop Apple. Definitely not. But it acts as a subtle nudge, a tiny mathematical speed bump that makes the poorly timed autopilot buyback just a little bit harder to justify in the boardroom. It really is a fascinating shift in the landscape. For you listening, the real takeaway from all these corporate finance notes isn't just about a 1% change in the tax code. It's about treating capital allocation with cold, hard discipline. Exactly. We've seen that buybacks are brilliant wealth compounding tools when used strategically by cash rich fortresses like Apple or highly disciplined operators like JP Morgan.

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But they are incredibly toxic when used as a blind reflex by cyclical companies that should be building an emergency fund. This raises an important question, one that every investor should keep in mind when evaluating a company's leadership. Never buy your own stock at a price you wouldn't pay for anyone else's. That is the golden rule of capital allocation. I want to leave you with a final provocative thought to mull over. We established early on that the structural tax advantage of buybacks over dividends for a long term shareholder, that deferral of capital gains, is still far larger than this new 1% penalty. Right. The math still heavily favors the buyback. Exactly. So play this out in your head. Put yourself in the shoes of a future policy maker. How high would that excise tax percentage actually have to go before the math finally breaks? Companies are forced to abandon the buyback altogether and we return to the golden age of the traditional cash dividend. That's a great question. Something to think about next time you see a headline about a massive billion dollar stock