BT: BUYBACKS SHOULD NOT PENALISE THE LOYAL

BUYBACKS SHOULD NOT PENALISE THE LOYAL

Friday • May 26, 2006

Adrian Tan
news@newstoday.com.sg

OPEN market share buybacks are becoming a fashionable way of returning cash to shareholders. So far this year, Armstrong Industrial Corp, Datacraft Asia, Oversea-Chinese Banking Corp and United Overseas Bank have done it.

There is also market speculation that StarHub may be planning to borrow $700 million for a share buyback, though there is the possibility that the money may be used for a special dividend or a capital reduction or a combination of some of these methods of returning cash to shareholders.

Investors can expect more listed companies to do market buybacks because there are advantages in companies doing them as opposed to paying one-off dividends or reducing capital.

But if they don't do their homework, they could be damaging their prospects while penalising loyal retail shareholders while rewarding less faithful ones.

Companies with stock option programmes for employees have three problems. Stock options must be reflected in a company's financial statement as an expense. This reduces profits. In addition, they are an expense that is not tax deductible.

Finally, as options are exercised, they add to the number of shares on issue, diluting existing shareholders (who may not be pleased), and dilute earnings per share (EPS) and lower return on equity (ROE) because all things being equal, the number of shares on issue (the denominator in ROE and EPS calculations) has increased.

However, companies that buy back shares from the market and hold them as "treasury" shares that are then given to employees when options are exercised, will get a tax deduction. And using "treasury" shares (and not new shares) avoids share dilution.

So it is not surprising that company managers, investment managers, analysts and investment bankers like share buybacks. There are tax and accounting and financial engineering benefits, when cash is returned to shareholders.

Returning cash via dividends (ordinary or one-off) or via a reduction in capital do not offer such a tax benefit. And dividends are paid out of taxed earnings.

As for reducing capital, shareholders may be annoyed that they are getting less than the market price back in cash, and that they end up with odd lots.

But dividends and reducing capital have one advantage over buybacks — all shareholders benefit equally, not just those selling their shares. And it is usually the more active and larger investors (usually the institutions) who participate in buybacks, not the small retail shareholder.

Another advantage is that they do not require a company to judge whether its share price represents good value for the company. What happens when a company is too optimistic about the value of its shares?

In a recent article, a New York Times columnist chronicled the share buyback activities of Sun Microsystems, a major US computer maker.

"With the share price down to US$20 ($32), a third of the peak reached less than six months earlier, the company announced plans to buy up to US$1.5 billion of stock — not to offset dilution, but because the shares were cheap ... The stock kept falling as Sun spent US$1 billion buying back shares ... Now the stock is around US$5 ... "

At US$5, Sun didn't buy back shares because it said it had better uses for the money.

Sun lost because there are better ways of spending US$1 billion than buying back shares at US$20. Loyal shareholders lost because US$1 billion flowed out of Sun and they didn't benefit.

The only winners were those shareholders who sold their shares.

According to legendary investor Warren Buffett, a company can add value to its shares by buying some of them when it has surplus funds; and can buy them back at a price below intrinsic value.

The latter is the problem.

There are very few people who are good at calculating the value of businesses. Even professional fund managers have great difficulty in assessing the worth of listed companies. The vast majority of them consistently fail to beat their benchmarks, one reason why Mr Buffett is so honoured as an investor.

Let Mr Buffett have the last word.

In 1999, he said: "Repurchases are all the rage, but are all 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 benefited 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."

The writer is a freelance financial journalist.

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