Question

By April 2009, Henri Termeer had been the Chairman and CEO of Genzyme for more than 20 years. Under his watch, Genzyme had grown to be one of the top-five U.S biotechnology firms. It first established its footprint in the treatment of rare genetic disorders, but its subsequent growth was the result of acquiring nascent biotechnology companies. Genzyme reached record revenues of $4.6 billion in 2008 and was expected to generate an increasing level of free cash flow in coming years. However operational problems in one manufacturing plant had led to a warning letter in late February 2009 from the U.S. Food and Drug Administration (FDA), which, combined with news on impending health care reform, had pushed Genzyme’s stock price from a high of $70.42 down to a low of $56.38.

Genzyme was being targeted by Relational Investors (RI), an “activist” investment fund that had a 2.6% stake in the company at the end of March 2009. RI had a history of engagements with the boards of numerous companies that, in several instances, resulted in the CEO’s forced resignation. Ralph Whitworth, RI cofounder and principal, met with Termeer and delivered a presentation, arguing that Genzyme was trading at a discount. He offered recommendations on how Genzyme could address this: (1) improve capital allocation decisions; (2) implement a share-buyback or dividend program; (3) improve board composition by adding more members with financial expertise; and (4) focus executive compensation on performance metrics.

(i) Why is Mr. Whitworth arguing that Genzyme needs to implement a share repurchase program?

(ii) What problem would a share repurchase solve?

(iii) Wouldn’t it be easier for Genzyme to simply announce a dividend to achieve the same objective of returning cash flow to the shareholders?

Answer 1

1) In a share repurchase program, a company buys back its own shares from the public in return for cash at current stock price, $56.38 in this case.We are told Genzyme's future is bright. The free cash flow will increase in the coming years. The problem with FDA is only a minor setback. Even though market is reacting badly to FDA letter, but in the long term we can expect the stock price to regain it previous high of $70.42, or even beat it. The problem is, what is Genzyme going to do with the extra cash that it is generating and will generate in future? It can use this cash to buy nascent biotechnical firms, like it did in the past, or it can reward the shareholders by giving them dividends or via share repurchase program. It will bring back faith in the stock as a share repurchase program sends a signal to the market that the firm strongly believes in its future.

2) The stock repurchase program will solve many problems-

-> It will send a good signal to the market that company believes that the stock is underpriced at $56.38

-> By bringing back the confidence, retail investors might start buying the stock, which would increase the demand of the stock, which will ultimately increase the stock price.

-> It will also put the current cash of the company to good use

-> Share buyback will reduce the outstanding shares in the market. So, future earnings will be shared by fewer people. In other words, earnings per share (EPS) will increase in future, so will the stock price.

To summarise, a share repurchase program will increase the stock price of the company

3) Dividend is also a good option to return idle cash back to shareholders and instill confidence back into the stock. However, the tax rate on dividends is usually higher than the tax on share repurchase. If you give an investor $100 in dividend, it will be taxed by the government at the investor's current tax bracket. IT is treated as the part of the income. At highest bracket, it could be close to 37%

However, the share repurchases are treated long term capital gains and the tax rate could vary anywhere between 0% to 20%. Hence, it is more tax friendly for the investors to get money via share repurchase program.

The share repurchase program also gives additional benefit of boosting the stock price.

Please rate my answer if it helped you. Thank you.