Growing piles of surplus cash on balance sheets, modest debt positions, earnings growth and limited opportunity for suitable acquisitions - especially within the mining sector - are expected to make capital management a prevailing theme for 2011. While this is expected to heighten the level of M&A activity this year, analysts also expect a growing number of major diversified miners, generating exceptional cash flow to take their cue from BHP Billiton’s (BHP) and enter share buyback mode.
As well as providing a notional boost to their net tangible assets (NTA), buybacks are a good opportunity for companies to realise their franking account, while acquiring shares back at a discount, usually around 14 percent.
So why are shareholders prepared to sell their shares for less than the market price? Simply put, when they are paid for their shares, they’re deemed to have received a combination of a typically modest capital amount and a franked dividend to boot. So they not only get franked income, but a significant capital loss to set against other profits elsewhere.
BHP is preparing to stage one of the biggest buybacks since Woolworths (WOW) $700 million version last September. In conjunction with its US$4.7 billion purchase of Chesapeake Energy’ shale gas assets, BHP is planning a $5 billion off-market buyback of its ASX-listed stock. Expected to operate somewhat akin to a tender, shareholders will compete to be involved in BHP’s buyback by bidding at a discount to the market price.
Adding an extra impetus to this year’s buyback thematics is an estimated $20 billion in franking credits residing within the top 50 listed companies. Beyond resource stocks – increasingly accused of having ''lazy'' balance sheets, REITs – which have around $20 billion in cash on their balance sheets - are also under increasing pressure to initiate buybacks.
The plan is to buy back units to close the gap between the discount, currently between 10 and 30 percent of their unit price and net tangible asset (NTA) backing. With fewer units on issue, a buyback is expected to improve distributions to unit holders. As a case in point, it’s understood that REIT Charter Hall Office (CQO) could see a 3.6 percent accretion to its earnings and lift its NTA to 4.39c per unit from 4.24c in a 10 percent share buyback.
While industrial stocks look less likely to initiate buybacks this year, Angus Gluskie CIO of White Funds Management expects banks, especially the ‘big-four’ to have the potential for share buybacks within the next couple of years. “With ANZ Banking Group (ANZ) having a more accretive approach to Asia, I would expect the more domestically focused banks like Commonwealth Bank of Australia (CBA) and Westpac (WBC) to be come under greater pressure to allocate excess cash to share buybacks,” says Gluskie. “Carrying excess cash on balance sheet - that can’t be better deployed elsewhere - can negatively impact a firm’s performance and reduce return on equity (ROE).”
According to Fabiola Gibson of Morgan Stanley Smith Barney, buybacks are perceived to be more equitable for all shareholders than other forms of distribution. She says that’s because those who participate in them tend to capitalise much of the benefit in the discounts. Assuming the aggregate value of a buyback discount exceeds the value of franking credits distributed, shareholders can expect to be rewarded with a higher share price. “Assuming the share price is undervalued, buybacks create shareholder value by increasing the net value of the stock,” says Gibson.
As a case point, if 1000 shares are bought back at a discount of $1.00 per share and there are $1,200 of franking credits distributed - which the market values at for arguments sake, $600 - the remaining shareholders are $400 better off and the share price will increase.
There are also benefits for non-participating shareholders too. That’s because the reduced capital base means enhanced performance, notably in earnings per share (EPS), cash flow per share, and asset backing. And sooner or later, both on and off-market share buybacks should be reflected in a relatively higher share price.
If 2011 is shaping up to be the year of the buyback, what other ‘over-capitalised’ stocks look like they’re queuing up behind BHP to do so? Rio Tinto (RIO) has initiated a significant on-market share buyback program, and Oz Minerals (OZL) has also announced a share buyback of up to $200 million following a 12 CPS capital return worth almost $390 million.
Cape Lambert Resources recently took advantage of a dip in its share price to implement an on-market share buyback of up to 10 percent of the company's ordinary shares which was originally flagged last October. Even Fortescue Metals Group (FMG) which only recently paid its first dividend has flagged a future buyback once it exceeds its stated objective of producing 155 million tonnes of iron ore in each of the next two years.
On the listed property front, REITs that have already flagged their interest in on-market unit buy-backs include Commonwealth Property Office Fund (CPA), GPT Group (GPT), Mirvac (MGR), and Charter Hall Retail (CQR) - and analysts expect Charter Hall Office (CQO), and Dexus Property Group (DXS) to follow suit.
Owing to the sheer magnitude of the franking credits – comprising a little under $10 billion between them – Morgan Stanley research expects six stocks: BHP, Woodside Petroleum (WPL), Woolworths (WOW), Harvey Norman (HVN), Origin (ORG), and Premier Investment (PMV) to be the strongest contenders for off-market buybacks later this year (see table below).
So exactly how can investors determine whether they should participate in share buybacks or not? Gluskie says the attractiveness of tendering into a buyback will depend on shareholders’ tax rate and capital cost base of shares. “Share buybacks are primarily an avenue for taxpayers on lower marginal tax rates to access the benefits of both franking credits and capital gains tax (CGT) provisions,” says Gluskie. “Whether shareholders want to remain in the stock shouldn’t be a big issue - as they always have the opportunity to buy back in later.”
But Gibson warns investors from participating in off-market buybacks unless they still wish to own the stock on its own merits. Even if there is a large acceptance, she reminds investors that they’ll still be left with a significant holding.
One determinant of share buyback success, adds Gibson is strong shareholder uptake, with a participation rate of over 20 percent typically making for happy investors. Interestingly, while BHP’s last four buybacks have enjoyed participation rates in the high 30s, Woolworths’ buyback last September received only 12 percent participation.
Being able to claim full benefits of franking credits, shareholders in pension mode – enjoying a tax rate of zero – are looking at a 20 percent return, based on the BHP price at the time. And for those in accumulation mode, the return is 17 percent. Returns at these levels, reminds Gibson means the share price can effectively fall back a fair way before it starts to become an issue.
Given that they typically offer ‘something for nothing’, Dennis Ng research manager with Lincoln Indicators says buybacks are a pretty compelling argument for most shareholders. He says the key is to compare the market price with the discounted price, and whatever tax benefits arise from the capital loss.
While investors on low marginal tax rates may have fewer immediate opportunities to utilise these losses, Ng reminds investors they can be offset against future gains elsewhere. “Ensure the company offering the buyback has franking credits and is able to use them, and keep an eye out for ATO approval,” advises Ng.
A closer look at BHP’s latest buyback illustrates how they work.
Worked buyback example:
At the previous close of A$45.85 a share, a marginal tax rate of 15 percent and a 14 percent discount equates to an effective BHP price of A$53.59 - increasing to A$56.21 at a 0 percent tax rate. The effective after tax price would increase to A$54.08 and A$58.83 respectively at a 10 percent discount (see below).
| ||Effective After Tax BHP Sale Price|
|Current BHP Price & off market buyback discount||Personal |
|$45.85 @ 10% discount||$50.34||$41.27 ||$54.08 ||$58.83 ||$41.27|
|$45.85 @ 14% discount||$48.08||$50.97||$53.59||$56.21||$39.43|
Source: Citi Investment Research and Analysis
|Potential off-market buybacks 2011|
|Stock||Interest Cover 2011 ||Gearing ||2011 P/E ||Franking Credits (A$M)|
|Implied to Release Credits |
|Australian Infrastructure Fund (AIK)||Cash||-2.8%||5.5||21||6.0%|
|Coca Cola Amatil (CCL)||6.8||48.8%||15.5||156||6.1%|
|Harvey Norman (HVN)||12.8||10.9%||11.5||620||67.5%|
|JB Hi-Fi (JBH)||Cash||-4.6%||14.0||119||20.4%|
|Monadelphous Group (MND)||Cash||-495.5%||18.2||37||7.9%|
|Navitas Ltd (NVT)||23.8 ||29.0%||18.3||20||4.8%|
|Origin Energy (ORG)||6.5||16.5%||21.6||433||10.0%|
|Premier Investment PMV||Cash||-24.6%||13.3||221||83.0%|
|Woodside Petroleum (WPL)||10.0||32.7%||26.0||2,329||23.1%|
Source: Morgan Stanley Research
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