There has been a lot of talk in recent weeks about financial engineering and the fact that earnings appear to have grown nicely while revenues have lagged behind. Much of the earnings growth the past five years has been driven by buybacks and cost cuts, and I really do not think that's sustainable.
Stanley Druckenmiller talked about this at the Sohn Conference earlier this year when he pointed out that more companies are interested in buying back stock and financial engineering than investing in their business. He cited IBM (IBM) as an example of the practice, but that's not even the worst case of using financial engineering to grow earnings without really growing the business.
Harley-Davidson (HOG) is a great example of financial engineering. If you look at reported earnings growth, business is wonderful. Earnings have grown by 59% a year for the past five years at the iconic motorcycle manufacturer. Revenues, however, have grown by only 7% on average per year. The company has bought back a lot of stock during that time, with shares outstanding falling from 234 million in 2011 to 184 million today. Most of the buybacks appear to have been done with borrowed money, as debt has gone from $3.8 billion to $5.4 billion. Sales are slowing in the U.S. and the company has increasingly turned to foreign markets for revenue growth. The stock appears expensive to me, with a price to book value ratio over 4 and an EV/EBIT ratio of 12.
Merck (MRK) is a great company, but when you look at top-line revenues, business has been flat for the last five years. In fact, total revenues have declined slightly over that time and analysts don't see any improvement this year. They have done a great job of buying back stock as the share count has dropped from 3 billion shares outstanding to 2.7 billion. Long-term debt has risen from $15.5 billion to $23.6 billion over that time frame. What makes this remarkable is that Merck has actually purchased several companies over the past five years to expand its drug portfolio. The pharmaceutical giant is focusing its R&D efforts on higher-growth markets including diabetes, oncology, vaccines, hepatitis C and acute care, but it is way too soon for that effort to grow the top line. It is a great company, but at 34x earnings and 3.5x book value with no revenue growth, I am not so sure it is a great investment at this level.
At first glance, it looks like boom times at Allison Transmission (ALSN). Earnings for the company have grown by an average of 44% over the past five years. However, revenues are pretty much flat over that time period. The company makes transmissions for medium- to heavy-duty trucks, buses, motor homes and fire trucks as well as for heavy-duty military vehicles. Sales strength in Europe and Asia was more than offset by very weak demand in the much larger domestic markets and a flat market for defense vehicle transmissions. Management is projecting a sales decrease of about 6.5% for 2016.
Mining, engineering and construction vehicles are major markets for Allison and it doesn't show signs of meaningful improvement any time soon. The company has been buying back stock as the share count has dropped from 183 million to 171 million over the five-year period. The bright spot here is that unlike many other companies buying back significant amounts of stock, Allison isn't buying back shares with borrowed money as long-term debt levels have fallen as well. At 29x earnings and almost 4x book value, I see no reason to invest in a company with no revenue growth and little chance of that improving any time soon.
According to a recent research report from Barclays, $2.5 trillion of stocks has been repurchased since 2010. That has created growth in earnings per share but it hasn't really improved business conditions as revenue growth has been hard to find in a slow-growth global economy. Much of the buyback cash has been borrowed rather than generated internally, and I just don't see how that can ultimately have a happy ending. In their report, Barclays analysts warned, "If volatility is high enough, financing markets can close, imperiling shareholder-friendly activities such as buybacks. So far, this has not happened, but it is an ongoing risk."
Buying back stock at high multiples of EBIT and book value to grow earnings is a horrible practice, and companies that practice this approach should be avoided as the bull market ages.