One way I find undervalued stock is to research companies that show large reductions in shares of stock outstanding over a period of several years. Most of the time, this happy situation is caused by something known as a stock repurchase plan, where a company uses cash to buy shares of its own stock and then destroys those shares so that the profit and assets have to be split among fewer "pieces".

This was how I originally found AutoZone, which went from $25 per share to $150 per share, and provided the down payment on my house. I've explained why the math of stock repurchases can be attractive in How Share Repurchases Can Increase EPS for Investors.

Potential Dangers of Stock Repurchases

There are some real dangers with stock repurchase programs. These include:

• If management spends too much cash as part of the stock repurchase, liquidity could be hurt. When the economy goes off a cliff, it's possible the firm would have to declare bankruptcy because they didn't have enough current assets to make it through the crisis.
• If the price paid for each share as part of the stock repurchase is too high, a stock repurchase can literally destroy value. It would be like purchasing $1 bills for $2. Despite owning more of the company, long-term shareholders would be poorer following the transaction.
• If an acquisition comes along that management really wants, it may do stupid things to close the deal, such as issuing new shares at a lower price than it paid as part of the stock repurchase plan. Just look at Kraft Foods at the fight the CEO is having with Warren Buffett!

• No dividend tax owed, even though share repurchases are effectively backdoor dividends.

Sonic Restaurant and It's Massive Stock Repurchase Plan

Last week, I had one of my companies, Mount Olympus Awards, LLC (the largest letterman jacket retailer on the Internet), pick up a couple hundred shares of Sonic restaurant so I could watch it. Sonic is a franchiser of drive-in restaurants throughout the United States, but mostly in the South and Midwest. Although it does operate some of its own locations, a good deal of profit comes from franchise fees, royalties, and other income from entrepreneurs who have franchised the concept from the company and pay to operate under the Sonic brand name.

Several years ago, the management of Sonic decided that it wanted to reward shareholders with a massive stock repurchase program. Through this program, the company spent more than $600 million to repurchase roughly 30 million shares of stock, with much of the bill being paid by issuing long-term debt. This took shares outstanding from 91 million shares to 61 million shares.

Here's how new investors should think of this transaction: Before the stock repurchase program, Sonic was cut up into 91 million pieces, or "shares". This meant that all of the company's profit had to be divided by 91 million and each share was entitled to 1/91,000,000th of the earnings. By borrowing more than $600 million and using the money to pay for the stock repurchases, Sonic was able to go to the stock market, buy 30,000,000 of its own shares, and destroy them. Now, as a result of the stock repurchase, total shares outstanding are 61,000,000. That means that the company's assets and profits are divided into only 61 million pieces and each piece, or "share", is entitled to 1/61,000,000th.

The net effect of the stock repurchase was that each share of Sonic stock now represents more ownership in the business. In other words, even if a stockholder didn't buy a single new share, their ownership of Sonic increased after the stock repurchase transactions because there were fewer shares outstanding.

The downside is that Sonic now has to pay interest expense on the money it borrowed, which will lower profit. Given that interest rates were at a near all-time low, and that interest expense is tax-deductible for corporations, Sonic decided this was a good use of the money. As earnings are generated from the restaurants and franchise royalties over the next few years, management believes it can meet the debt obligations.

In effect, imagine Sonic had been owned by only 3 shareholders. You, me, and a third guy named Mr. Market. You and I went to the bank and borrowed a bunch of money to buy out Mr. Market. We gave him the check, signed the loan documents, and then destroyed his share. Now, our company has only two shares outstanding. Although there is more debt, and interest expense, you and I now own the whole company, so profits and assets only have to be split 2 ways instead of 3 ways. We plan on using the earnings from the business to pay back the loan over the next few years. This is, on a larger scale, what Sonic did with its stock repurchase plan.

Analyzing the Sonic Restaurant Stock Repurchase Plan

Was this a good deal for investors? Are they better, or worse, off because of the stock repurchase plan? The answer comes down to how management conducts itself over the coming 3-10 year period.

You see, after adjusting for all of the accounting and some other factors (which are beyond the scope of this article), it seems that Sonic paid $22.69 on average for each share of stock it bought and destroyed as part of the stock repurchase. Today, Sonic shares are trading at $8.35 each, or only 37 cents on the dollar. Part of this is due to the huge debt load and jittery investors scared of anything that isn't the bluest of blue chip stocks.

In the short-run, it may appear that the stock repurchase plan caused massive wealth destruction because the entire company is now valued less than the shares that were bought back at far higher prices! It's not that simple.

If Sonic management can continue to generate earnings and reduce the debt, interest expense should continue to fall. At some point, between modest economic recovery, new location growth, and natural debt reduction, profits should reach the same level they were before the stock repurchase program happened. When that occurs, that same profit will be divided 61 million times instead of 91 million times, meaning the earnings per share should be far higher. At a decent valuation, this would put the stock at a much higher level than the current $8.35 at which it trades.