Btw Happy 11.11 11-11-11! I’m amused to see the media highlighting all the weddings today, more romantic than induced labor I guess…! Yes, lots of babies being born today – and if you’re born in Korea today your SS number begins with 111111… It’s also Nigel Tufnel Day – c’mon turn up your stereo/ipod to 11!!
valuestockinquisition highlighted his distaste for share buybacks here and here. Ideally, I’m a supporter of share buybacks, but in reality I have very mixed feelings about them… The quality of stock/share buyback analysis in most companies is atrocious – throw away your corporate finance textbooks! I don’t think I’ve ever met anybody in a corporate environment who could come up with (or discuss coherently) a fundamental Intrinsic Value for their company stock. This is a tremendous handicap for any strategic decision making, and of course for share buybacks. In most companies, the analysis goes something like this: Do we have spare Cash/Debt for a buyback? Are we feeling good about the company, the share price, ourselves? What’s the EPS impact? This is the final trigger for any share buyback, let’s take a look at the math:
Assume a company with a Net Income of USD 1,300 million, and 1 billion shares outstanding. EPS will be USD 1.30 per share, and let’s say the share price is USD 15.60. Now presume the company borrows a USD 1 billion, at a 4.5% interest rate, and spends these funds on a share buyback. All other things being equal, Net Income in the following year will be USD 1,273 million (at a 40% tax rate), the share count will reduce to 935.897 million shares, and EPS will magically increase to USD 1.36. This 5% increase may seem small, but it’s a colossal (and valuable) assist in reaching internal and/or external EPS targets.
And that’s it, there’s nothing more behind the curtain! There is no attempt to determine an Intrinsic Value or to only buy at an attractive discount to this value. This mechanical EPS analysis/impact approach is the main quantitative driver for share buybacks. Of course, the impact depends on a number of facts/assumptions like your cost of debt, your buyback price, your tax rate etc. but that’s easy to deal with – you just create a couple of assumption grids, review with your CFO and agree strategy accordingly.
What about the more qualitative aspects: I wasn’t joking when I posed the ‘Are we feeling good’ question above, corporates and executives (esp. in the US Fortune 100/500) are notorious for hubristically unleashing huge buybacks just when share prices are peaking. There are some good studies out there on this. And I’ve experienced this personally – to my chagrin, I bought back tens of millions of shares at an average (peak) price that turned out to be about 100% higher than the current market price – aah, just following orders, m’lud – and to add insult to injury for the long suffering shareholders, the company THEN discontinued its share buyback scheme and never bought a single share during the long slow slide in the share price since. Buy high is clearly the rule, a common story. And where were the big corporate share buybacks in 2008, for example?! Then there’s also the more unsavoury aspect, personal greed: Incentives and compensation, particularly in the US, are so lucrative and so biased to raising the EPS and share price at all costs that share buybacks become, consciously or unconsciously, a compelling priority for boards/senior management – often to the detriment of shareholders, EVA and/or even the dividend. Another aspect of this is management using Cash – which belongs to shareholders! – to buyback shares to cover up the consequences of their previous poor decisions and/or prop up a sagging stock price (perhaps now targeted by short sellers).
And once the share buybacks are done, other problems present themselves. Are the shares cancelled immediately? If not, how are they presented? The logical thing is a reduction in Equity through a negative Treasury Stock entry – makes sense, an Asset (Cash) is decreased/eliminated because of the buyback, so we need a corresponding reduction in the Liability side of the B/S, in Equity – but on occasion I’ve seen shares rather bizarrely carried on the B/S as an Asset! It also means that the media, even Bloomberg in some instances, often get the true share count wrong. However, this implies that Mkt Caps may be overstated publically, which from my perspective just applies a (conservative) reduction to the Potential Upside I see in a stock vs. my Fair Value – misleading, but not problematic. No matter the treatment, one should treat these shares as cancelled for analysis purposes – it may take some digging around, but the best thing to do is focus on Net Outstanding Shares not Issued Shares to arrive at the correct share count.
What is problematic are companies who don’t actually cancel these shares. This is sheer corporate arrogance and poor governance. I’ve seen companies with tens of millions of repurchased shares remain uncancelled – why on earth does management think they should have the right to potentially reissue/sell these shares at some point without seeking their shareholders approval? Having this type of ‘back-up kitty’ available to potentially raid just leads to flabby financial decisions. As an exception, I’m comfortable with investment companies leaving shares uncancelled, with the proviso they can only re-issue/sell these shares above NAV. Of course this is the crux of the issue, for companies, when it comes to buying back or re-issuing shares they have no objective NAV to rely on. This presents a real problem, if you don’t at least venture to determine an Intrinsic Value for your stock, you have no way of figuring out if a share buyback is at a discount and adding true economic value for your shareholders. And a mechanical EPS impact analysis doesn’t help you.
Let’s look specifically at Total Produce (TOT:ID). In my previous post, I highlighted I was pleasantly surprised by their 22 million share repurchase at end-2010, considering how unimpressive management has been otherwise. The EPS impact is positive, that’s easy to calculate, but that’s not why I was pleased – to illustrate:
Taking just my P/S valuation (this was only one component, please refer back for my complete TOT valuation!) in isolation, I came up with a EUR 353.4 mio Fair Value based on a 0.125 P/S Ratio tweaked for TOT’s financial strength. That’s EUR 1.071 Fair Value (or Intrinsic Value) per share, based on 329.887 shares outstanding – I think this is a reasonable indication for what TOT might fetch in an M&A situation. Now, let’s assume Total Produce sees sense and wants to eliminate its EUR 89.6 mio Cash hoard. Of course, I’d love to see them buy some cheap/low margin fruit & veg companies, but sure TOT’s a cheap fruit & veg company too, so why not buy themselves?! For simplicity, we’ll presume they just do a successful tender offer at market price of EUR 0.39 – their Cash would allow them to retire 229.733 mio shares. Now, where do they stand? – what is interesting is that Revenue, Operating Margin, and the company’s Leverage and Margin Of Safety are all exactly the same so I would argue that the Fair Value of EUR 353.4 mio is still the same. But we now have 100.154 mio shares outstanding, so in the event of a take-out, you would be receiving EUR 3.53 per share! Remember, just a simplified/ideal example just looking at one aspect of valuation, but you get the idea..!
The key to this uplift in value in this example is the aggressive purchase of shares at a significant discount to Intrinsic Value. Departing (selling) shareholders are selling out at a poor price, whether they realize it or not, while remaining shareholders get to enjoy a larger slice of the pie each. Of course, I have no idea what motivated TOT’s actual share repurchase, but I don’t need to – because I have my own Intrinsic Value for TOT, and/or other companies, I can quickly determine whether current or future share repurchases are at a discount to this Value and therefore attractive – in the case of TOT, based on current metrics, the more share buybacks the merrier!