Share Buybacks – Good, Bad?
By Genghis Research
The Capital Markets Authority has published for public comments . The guidelines are meant to detail and give effect to the Companies Act 2015 that provides for general directions for share buybacks.
The guidelines come at an interesting time, stock prices at discounted levels – good for buyback and buybacks facing global backlash amidst pandemic ravaging the economy – bad environment for buybacks.
Similar to dividends, a stock buyback is also a way to return capital to shareholders. A dividend is mostly a cash bonus while a stock buyback requires the shareholder to surrender the stock to the company to receive cash. The shares surrendered are ‘cancelled’ and taken off the market. The market price of the remaining shares re-adjusts upwards to maintain parity rewarding shareholders who did not surrender their shares.
LESSONS FROM THE UNITED STATES
Share Buybacks are prominent (or were, before the pandemic) in the United States and other advanced markets. In 2018, share buybacks hit a record level of USD 1.1 trillion in what is termed as a ‘buyback binge’. However, the pandemic exposed ‘who has been swimming naked before the tide went out’ with wide public criticism of stock buybacks after numerous companies requiring bailout a few short months after spending billions of dollars in stock buybacks, exposing poorly thought buyback programmes from otherwise weak companies. Data from Financial Intelligence indicates that companies that retained their buyback programmes had a combined USD 910 billion in cash on their balance sheets in May 2020 while companies that suspended buybacks had a combined minuscule USD 494 million cash in their balance sheets.
A classic case of a poorly thought-out Share Buyback programme is McDonald’s and its franchisees (needing federal government bailout after laying off 135,000 employees out of its 200,000 workforce). In 2019, the business posted revenues of USD 21.1 billion, a great USD 5.7 billion in free cash flow BUT a closing cash balance of USD 899 million. Where did the free cash flow of 5.7 billion go? Stock buyback of USD 4.9 billion, plus USD 3.6 billion for cash dividend (USD 3.2 billion borrowed to pay dividend). The buyback, good for shareholders and executives, now an existential threat to the business.
A well-thought-out stock buyback programme. Apple Inc holds the record of biggest cash pile in a balance sheet (USD 193 billion in 1Q20, record USD 285 billion in 1Q18). As the pandemic ravaged business and companies shelved their buybacks programmes, Apple expanded its existing buyout programme by an additional USD 50 billion! Apple spent USD 67 billion in stock buybacks in 2019 and estimated by end of this year to have executed a stock buyback to the tune of USD 460 billion since the start of the programme in 2012. Not that Apple does not have debt, (about USD 108 billion) which can easily be paid off its cash pile. However, paying off the debt is not prudent given that Apple borrows cheaply than what it earns from its cash pile. Its stock price has rewarded shareholders richly, hitting all-time highs as most buyback peers desperately wait for government bailouts.
How does Apple do it? First, a large rainy day fund (for organic growth, Research & Development spend, Mergers & Acquisitions activities and Capex and some buffers to cover entire debt), THEN execute stock buyback from free cash flow generation.
CONSIDERATIONS FOR BUYBACK
- Company’s business model – cash-intensive businesses (Airlines?) hardly suitable
- Company’s ability to access capital in adverse market conditions
- Difference between market price and intrinsic value where the intrinsic value should reflect the sustainability of future cash flow stream
- Economic cycles, buybacks in economic downturns could be catastrophic.
ARGUMENTS FOR BUYBACKS
Reward for shareholders by enhancing stock prices. Mathematically, a company executing a 10% share buyback should see the market price of remaining shares tick up by 10%. Better key performance indicators for the company/management – Increases company per share metrics (earnings per share – EPS, dividends per share – DPS, return on equity – ROE, book value per share) due to the fewer shares It is another way of returning profit to shareholders.
CRITICS OF BUYBACKS
Larry Fink, CEO of BlackRock Inc., world’s largest asset manager (USD 7.4 trillion) has warned of seeking to “deliver immediate returns to shareholders…while underinvesting in innovation, skilled workforces or essential capital expenditures necessary to sustain long-term growth.”
- Companies deprive themselves liquidity that would help them cope in economic downturns. The pandemic is
classic example with widespread criticism of giant corporations in the US (American Airlines for one) that
utilized billions of dollars for buybacks but now require a federal government bailout.
- Poorly planned buyback will require the company in the future to re-issue new shares (likely at discounts) for
- Unethical management can use stock buybacks for near-term stock manipulation through improper signalling to
the market due to the better post-buyback per share metrics (ROE, EPS etc)
- Indicates management has run out of ideas for growth of the business
- For the economy generally, it leads to a reduction in business investment, skewing the rewards to ‘financial
investors’ rather than supporting economic growth and employment.
BUYBACKS AT THE NSE
It is unlikely we will see buybacks in the immediate term under the current economic environment where cash preservation is key. However, it is important to keep an eye on companies that are highly cash generative with low cash burn and have liquid balance sheets, the most likely to consider stock buybacks.
KENYA COMPANIES THAT HAVE CONSIDERED BUYBACKS.
Centum Investments. Management has been vocal about executing buyback transaction to boost the stock price which they consider unfairly priced by the market trading at a discount to book value (0.4x)
Crown Berger had in 2017 sought shareholder approval for a buyback before ditching this plan later in 2018
Safaricom Plc. Back in 2011 Safaricom had indicated an interest in buying back its shares to prop up its share price that was then badly trailing the IPO price. However, we do not expect this to be under any consideration (unless from the 2 anchor shareholders – GoK and Vodacom with a combined 75% stake) despite its rock-solid (debt-free) balance sheet and admirable free cash generation (KES 70Bn last financial year).