Share buy-backs return…….NOOOO!

Share buy-backs return…….NOOOO!

5 Mar 2013

After the shock of the credit crunch, many companies are beginning to feel flush with cash again. Sadly, an unwelcome old habit is also making a re-appearance – buying back shares in an exercise falsely described as “returning cash (or value) to shareholders”.

Here is an extract from the last annual report of an otherwise very sensible company, Morrison Supermarkets:

We expect capital expenditure to be higher in 2012/13 as we continue to invest for future growth. £368m was invested into our equity retirement programme, and we are on track to meet our objective of returning £1bn to shareholders over the two years to March 2013, in addition to normal dividends.

In 2012/13, Morrison generated £1209m of cash flow after tax. It invested £796m in capital expenditure and paid £301m in dividends for a total of £1097m which is just over 90% of cash flow: result, as Mr Micawber would say, happiness? Not quite. As the extract points out, the company also spent (or as it would say, “invested”) £368m buying back its own shares meaning, obviously, that it had to borrow to do so and total net indebtedness increased.

So why do they do that? There are a number of possible reasons, most of which are negative for ordinary shareholders and some of which are outrageous.

Managers of companies sometimes dislike building up excessive cash on their balance sheets. If they have run out of ideas to enhance the business by reinvesting that cash, they should presumably pay it back to the owners (aka the shareholders). The trouble with this is that many managers appear to think that a) paying a high dividend is an implicit admission that the company is ex-growth and b) the obligation to keep paying the dividend will become an inconvenience if the business performs less well in the future – executives know that dividend cuts often cost their own jobs, so why tempt fate?

Yet, businesses that just sit on piles of cash can become takeover targets, particularly from private equity buyers who can effectively use the target’s cash to fund its own takeover. Once again, executives of acquired firms tend to lose their jobs. So, despite the fact that shareholders would probably like a higher dividend or a takeover, the managers are often keen to obstruct both.

The token excuse for share buybacks is that, by reducing the number of shares outstanding, EPS (earnings per share) rises – indeed, everything rises, including SPS (stupidity per share). EPS became popular as a way of measuring a company’s return in the 1980s and swiftly fell prey to Goodhart’s Law: “When a measure becomes a target, it ceases to be a good measure.” EPS is a very flexible friend to executives whose reward is partly based upon its growth. It might seem hard to believe but some managers use share buybacks in order to enhance EPS to, in turn, enhance their own rewards. Morrison itself makes a point of saying in its 2012/13 report that it has ceased to do this. Good for Morrison but this presumably means that in the past, it used to do exactly that.

It can be much, much worse. Some companies buy back shares but do not cancel them. Instead, they hold them as “Treasury” shares which they exclude for the purposes of EPS calculations but which lurk waiting to be reissued to -guess who?- senior executives when they choose to exercise the stock options that were awarded as a reward for achieving their EPS growth targets. How they must laugh.

I have not done exhaustive research here but I will be very surprised to hear of any company with a share buy-back programme that does not in some way reward its executives on the basis of EPS growth. With companies less financially strong than Morrison, this is more disturbing. As I write Debenhams has just warned on its profits and its shares have fallen by 15% today. It suffered badly from the recent snow in the UK, apparently: but fear not: at the end of the statement it says: “Full year guidance on costs, capex, dividends and the share buyback programme are unchanged.” Hurrah! The share buy-backs are safe!

Let us turn to Debenhams’ last annual report. And there it is. An executive share plan that is 75% based on EPS growth. And get this.

Reported EPS in the 2008/09 base year for the PSP performance period ended 1 September 2012 was impacted by the firm placing and placing and open offer of new share capital that took place in June 2009, prior to the grant in November 2009 of PSP share awards for this performance period. In accordance with the PSP rules the Remuneration Committee has determined that it would be appropriate for this purpose for base year EPS to be calculated as if the firm placing and placing and open offer took place at the start of the year with a corresponding increase to profit after tax to reflect the interest benefit from the additional capital.

Allow me to translate. The base year of 2008/9, against which future EPS growth will be measured, is being artificially depressed by the use not of the average number of shares in issue (ubiquitous practice in EPS calculations) but by using the greater number of shares that were issued by the end of the financial year. How very generous.

Believe it or not, I haven’t finished explaining why share buy-backs are usually hostile to shareholders. There’s more yet.

There is at every moment a market price for a share that is unaffected by insider buying. Sometimes people (usually stockbrokers or financial journalists) speak approvingly of share buy-backs as if they are supportive to the share price – and certainly sellers will tend to hold out for higher prices if they know that The Stupid Group is proposing to purchase its own stock. This obviously benefits sellers (otherwise known as ex-shareholders) rather than those who continue to own the stock (otherwise known as shareholders). You might then say that remaining shareholders should still benefit in a residual way from the fact that the shares have traded higher – but you would be wrong.  In fact, the higher the price that the company pays for its own stock, the worse it is for the holders who do not sell.

The enterprise value of a company consists of its market capitalisation plus its debt minus its cash. No one (I hope) has ever argued that the intrinsic value of a healthy business can be improved by simply swapping equity for debt. (In the case of a financially unsound company, injecting new equity and retiring debt can be the difference between life and death, but that is a different subject). The enterprise value should be unaltered by a share buy-back at the market price.

Here is a simple theoretical exercise.

The Stupid Group (TSG) has 100 million shares in issue. They trade at £1 each giving it a market capitalisation of £100m. It has £10m long-term debt and £30m cash. Its enterprise value is therefore £100m (mkt cap) plus £10m (debt) minus £30m (cash) = £80m. The company’s brokers persuade TSG that it would be a great, EPS-boosting idea to spend £20m of its cash on its own stock.

As it happens, the stock market is going through a bad time and sellers are happy to accept £1 a share (fearing, probably correctly, that without TSG’s purchases, the share price would be falling). The result is that TSG’s £20m scoops up 20m shares at £1 each. The enterprise value of the group is unaltered at £80 but it now consists of 80 million shares at £1 = £80m market cap +£10m debt minus £10m cash = £80m.

So far, so dull, so unlikely. A much more likely scenario is that TSG has to pay up for its shares. With brokers and financial journalists cheering from the sides, it pays 110p a share. The shares have gone up by 10%! Everyone is better off!

Let’s go back to our enterprise value calculation to check. As the share purchases should not change the intrinsic value of the business, we know that the enterprise value must stay at £80m which in the case of TSG means that its market cap must be £80m (because post-buyback, the £10m debt and £10m cash cancel each other out).

This time TSG’s £20m bought 18.2m shares at 110p each meaning that there are 81.8m shares left. That means that the resting share price will be £80m divided by 81.8m which gives us…..just under 98p. How can this be? The answer is that by overpaying for its own stock, TSG has actually reduced the value of the business. If you don’t believe me, listen to Warren Buffet (in 1999).

Now repurchases are all the rage, but are too often made for an unstated and, in our view, ignoble reason, to pump up or support the stock price. The shareholder who chooses to sell today, of course, is benefitted by any buyer, whatever his origin or motives. But the continuing shareholder is penalised by repurchases above intrinsic value. Buying dollar bills for $1.10 is not good business for those who stick around.

There is one time and one time only when a company should repurchase its own stock. This is when a stock market rout produces a great deal of panic and effectively forced selling. Were TSG able to spend £20m at 80p a share, it would buy 25m shares, leaving just 75m outstanding meaning that the share price ought to rise to nearly 107p to maintain the £80m enterprise value. In this case, the company would be benefitting continuing shareholders at the expense of sellers. If you ever read an annual report citing that as the motive for a share buy-back scheme, you have my permission to fall off your chair.

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