SHARE BUYBACKS
A good deal, or a bad strategy?
THREE of Ireland’s largest companies are spending up to €2.3bn buying back their own shares. But are such buybacks the best use of companies’ cash? Last week, quoted bookie Paddy Power Betfair, which announced a £500m share buyback in May, unveiled its results for the first six months of the year.
PBF revealed that it had already spent almost £200m buying back its own shares and that it would shortly commence buying back a second £300m tranche of shares.
Paddy Power Betfair isn’t the only Irish-quoted company that is buying back its own shares. In April, CRH, Ireland’s largest industrial company and the most valuable company on the Irish Stock Exchange, announced that it would be spending €1bn buying back its own shares over the following 12 months.
However, the king of share buybacks is budget airline Ryanair, which is spending €750m on its latest share buyback programme. It has spent more than €4.2bn buying back its shares since 2007. It has also paid out a further €1.5bn on three special dividends and €398m on a special distribution, for a total of €6.15bn, over the same period.
Irish companies are not alone in buying back their own shares.
US-quoted companies spent a scarcely credible $5.1 trillion (that’s $5,100bn) buying back their own shares over the past decade. The Trump tax cuts have further stimulated the buyback boom with Cisco ($25bn), Wells Fargo ($22.6bn) and Pepsi ($15bn) being among the major US companies to announce share buybacks this year.
These buybacks are dwarfed by the latest $100bn share buyback announced by tech giant Apple in May. This will bring to $300bn the amount it has spent on buying back its own shares since 2012.
And the US buyback boom shows no signs of abating. US companies announced a record $437bn of buybacks in the second quarter of 2018, beating the previous record of $242bn, which had been set in the first quarter of 2018.
Something similar is happening in the UK. Quoted companies there spent £15bn buying back their own shares in the year to January, only marginally less than the £17bn which they raised from issuing new shares over the same period.
Oil giant BP is spending up to $1.6bn a year buying back its shares, Lloyds is spending £1bn on a share buyback, Aviva is spending £500m while Royal Dutch Shell is planning to spend up to $25bn on buying back its shares by 2020.
For companies, the main advantage of buying back their own shares is that, by reducing the number of shares, earnings per share — and hopefully the share price — will rise.
This is good news for shareholders, including senior executives, as a portion of their remuneration is often tied to the share price.
Critics are less keen on buybacks, with the Economist newspaper once famously describing them “as a kind of corporate cocaine that induces a temporary feeling of invincibility but masks weakness and vacuity”.
The 449 companies that were continuously included in the S&P 500 index of America’s leading companies between 2003 and 2012 spent $2.4trn, or 54pc of their earnings, basically after-tax profits, to buy back their own shares over that period.
Dividends absorbed a further 37pc of their earnings, according to William Lazonick, professor of economics at the University of Massachusetts Lowell in a September 2014 Harvard Business Review article. US companies spent an annual average of $316bn more on share buybacks than they raised from issuing new shares between 2004 and 2013. “That left very little for investments in productive capabilities or higher incomes for employees,” he wrote.
One company that came in for particular criticism from Lazonick was pharmaceutical manufacturer Pfizer which, he estimates, spent the equivalent of 71pc of its profits on buybacks and a further 75pc on dividends in the period from 2003 to 2012. In other words, Pfizer spent more on payouts to shareholders than it earned and had to dip into its capital reserves to fund these payouts.
Overall, the top 10 share repurchasers spent $859bn, 68pc of their total after-tax profits, on share buybacks between 2003 and 2012. Over the same period only three of this top 10, Exxon Mobil, Procter & Gamble and IBM, outperformed the S&P 500.
Based on the first-half numbers, US companies are now the largest purchasers of American shares. Regardless of whether or not one agrees with Lazonick’s opinion of buybacks, the empirical evidence strongly suggests that most companies buying back their own shares get the timing wrong and end up buying at, or close to, the top of the market.
While a handful of companies, most notably British clothing retailer Next, have consistently got their buyback timing right, much more common is the experience of GE.
It spent $3.2bn buying back its shares at an average price of $31.84 during the first three quarters of 2008 only to turn around in the final quarter and issue new shares at an average price of just $22.25 in a $12bn capital raising that tried and failed to save GE Capital’s triple-A rating.
The behaviour of US shares prices this year also does little to ease these fears. After a 6pc surge in January, the S&P 500 has been basically flat for the past six months despite the tsunami of buybacks.
Of the Irish companies buying back their own shares, the CRH share price is 13pc off its five-year high of €29.00 recorded in May 2017, Ryanair is 40pc down from its August 2017 peak of €18.60 while Paddy Power Betfair shares are 30pc down on their February 2016 peak of £10.70.
These price falls provide shareholders of these companies with at least some reassurance that managements aren’t overpaying in share buybacks. CRH sources say that the share buyback programme was triggered by more rigorous capital allocation which also saw the group dispose of its Benelux distribution business in 2017 and is likely to result in further disposals in 2018.
The main reason for the Paddy Power Betfair buyback was the company’s 2017 decision to abandon its traditional unborrowed status. PPB is now aiming at leverage of one times ebitda (earnings before interest, depreciation and amortisation).
Both companies are adamant that the share buybacks will not result in any slackening of the pace of acquisitions.
While share buybacks have come in for a lot of criticism, there is another, much more positive, view. “Firms that buy back stock subsequently beat their peers by 12.1pc over the next four years. Rather than eroding long-term firm value, buybacks create value by ensuring that surplus capital is not wasted”, wrote London Business School professor Alex Edmans in a September 2017 Harvard Business Review article.
Edmans argues that those who claim that share buybacks restrict investment by companies have got things the wrong way around: “It is the exhaustion of a firm’s investment opportunities that lead to buybacks, rather than buybacks causing investment cuts.”
Before buybacks became commonplace, dividends were the main method by which companies returned cash to their shareholders. Dividends remain an important conduit for companies returning cash. The big problem with dividends is their inflexibility. As any company which has had to cut or reduce its dividend can testify, shareholders take it very badly and the share price suffers accordingly.
“Buybacks offer firms the flexibility to vary how much they return to their shareholders year to year. Even if a company repurchases lots of stock last year, it can buy back zero this year. Even after announcing a repurchase programme this year, it can decide not to follow through with it with few negative consequences. While a company can chop and change its repurchase policy depending on its investment requirements, it needs to maintain historic dividend levels since dividend cuts lead to significant stock price fall.
“This means that it is better to return surplus capital in the form of repurchases because increasing the ordinary dividend implicitly commits the firm to maintaining the higher dividend level in the future,” writes Edmans.
The decision by three of Ireland’s largest companies to spend significant chunks of cash buying back their own shares is likely to be followed by others. With their balance sheets awash with surplus capital, share prices going nowhere and profitable lending opportunities still hard to come by, will AIB and Bank of Ireland be tempted to go down the buyback road as soon as the regulators allow them to do so?
While buybacks are unlikely to disappear any time soon, what we are currently witnessing in the US and UK almost certainly represents a cyclical peak in activity. The British government has established an inquiry into buybacks, citing fears that they may be “crowding out the allocation of surplus capital to productive investment”, while in the US Senator Elizabeth Warren, a likely contender for the Democratic presidential nomination in 2020, has accused companies of not investing in the future due to share buybacks.
The current tax advantages of share buybacks to investors, which are taxed as capital gains rather than income, could yet prove an irresistible target to future revenue-hungry governments on both sides of the Atlantic. In the meantime, stand by for lots more share buybacks.
US-quoted firms spent a scarcely credible $5.1 trillion over a decade