The buyback rush
Firms may not be optimistic about growth prospects
Buybacks are in vogue due to a change in the tax laws. The dividend distribution tax, which had to be paid by the company, has been abolished. All companies now have to pay a tax on “income distributed” by the medium of buybacks, whereas only unlisted companies were liable to pay the “buyback tax” earlier. From 2020-21, the shareholder also has to pay income tax on dividends received. On the other hand, the shareholder, who accepts a buyback offer, is no longer liable to pay capital gains tax on the associated profits. Consequent to these changes, buybacks have become a more attractive way for promoters to reward themselves and other large shareholders, compared to paying dividends. The impact is already apparent. The tally so far this financial year stands at over ~28,000 crore, including the recent buybacks announced by TCS and Wipro. This exceeds the buyback quantum for 2019-20, by a massive 42 per cent, with almost six months still to go in the current fiscal.
But tax efficiency versus a dividend payout is just one reason for any company to offer buybacks. There are several deeper implications when a business chooses to offer a buyback. In the simplest case, this means the business is depleting its reserves to return cash to shareholders. Reserves consist of accumulated profits. This is the cheapest cash at a company’s disposal. If a company is offering a buyback, it does so in preference to investing cheap funds in growing the business, or in retiring debt (if it has any). Hence, a buyback implies that the firm does not think it can generate returns on cheap cash, which indicates it is not optimistic about growth prospects. Buybacks don’t make strategic sense when there are growth prospects. Even paying dividends may not be an optimal strategy in such situations. A company may deliver far higher returns by ploughing profits back into generating growth. This will be reflected in rising share-prices. Amazon (listed in 1997) has never paid dividends; Microsoft issued its first-ever dividend in 2003, some 22 years after listing; and Apple did not pay dividends between 1995 and 2012.
Unlike dividends, a buyback permanently changes the balance sheet structure, and it must come at a substantial premium over current share price to be attractive. Once a buyback is completed, there are fewer outstanding shares, and maybe, fewer shareholders and different shareholding patterns. If the business stays profitable, earnings per share may increase in future, due to a smaller equity base. This can push up valuations. Shareholders must take this possibility into account when weighing the current gains of opting for buyback, versus retaining shares in the hopes of future profits.
Given the tax changes, a buyback is a tax-efficient way for promoters to reward themselves. But in theory, promoters with low stakes could lose control if they subscribe to buybacks over long periods. On the other hand, promoters could also consolidate and increase stakes by not offering their shares, while minority shareholders exit. In mature first-world economies with low growth, buybacks make sense for established businesses. But given that India needs strong, sustained growth, it can be argued that tax laws should not have been rewritten this way. By definition, only companies with decent profitability and strong balance sheets can offer buybacks. Investors should not be encouraged to pull risk capital out of outperformers of this nature.