26 October 2015
Company buyback schemes do not bring value for shareholders
Last year Glencore plc, the world’s largest zinc mining company with strong interests also in coal, copper and commodities, conducted a $1 billion share buyback programme. Glencore’s share buyback typified a growing trend of companies to acquire their own shares.
The popularity of companies going into the market to buy their own shares has soared in the US. Last year, the use of company buybacks in the US increased by over 50% and there is growing evidence that many companies in the UK and in other European countries are also resorting to buyback schemes.
However, like many other companies, Glencore plc has attracted criticism in the use of share buybacks. Many analysts are concerned that these schemes are frequently more concerned with boosting a company’s financial indicators or executive remuneration packages rather than enhancing value for shareholders.
In companies’ financial statements the principles underlying the accounting treatment of buybacks is relatively straightforward. A company uses its own cash or borrowed funds to purchase its own equity, often, but not necessarily, in the open market. This equity is then either cancelled – or in some countries treated as treasury stock – for future sale by the company. Generally, private companies and public companies with unlisted shares are required to cancel any shares that are repurchased. To minimise the risk of companies depleting their capital base at the expense of creditors, companies using buybacks are then normally required to transfer an equivalent amount in value from their realised reserves to a capital redemption reserve – that is usually unavailable to justify making distributions. This reserve will usually only be available for a company to later issue bonus shares. Although the accounting entries can be complicated if the shares are self purchased at a premium, these basic accounting principles still apply.
It is often suggested, albeit with a touch of cynicism, that companies implement buyback schemes when they have no idea what to do with their substantial cash resources sitting in their balance sheet. If companies are unable to find investment opportunities to expand – such as by acquiring new companies or other business assets – then the cash continues to remain in unproductive use. The result can then reduce a company’s return on assets and impact on other financial indicators.
Companies who have built up sizeable cash mountains may be indicating that the board is under-performing by failing to make more innovative use of its cash assets in enhancing shareholder value. Share buybacks can be seen by investors as a form of negative signalling about the businesses’ prospects. The underlying danger is that the company has an inherent lack of initiative or business strategies that offer shareholders acceptable returns either now or in the future.
Companies often construct other reasons for share buybacks that cover their lack of effort in identifying opportunities for future investment. These reasons may be cloaked in excuses of improving the company’s financial engineering or for justifying the need for a capital reconstruction. In its half yearly 2014 results, Glencore explained that its equity buyback scheme is part of its ‘prudent capital allocation and balance sheet policies ... following the Xstrata acquisition.’ The company attempted to justify its decision as ‘maintaining balance sheet efficiency and a strong investment grade rating.’
Directors and senior managers usually have other self-interested reasons for supporting the use of buybacks. Many bonus and incentive compensation schemes for directors and senior executives are based on a range of financial and performance indicators. Commonly, the growth in a company’s earnings per share (eps) is used as a basis to determine these payments. The eps is calculated by dividing net corporate profits by the amount of issued equity. The percentage annual change in this eps can then be increased by removing the amount of equity in the market – such as by implementing a share buyback scheme. Some US and European analysts also highlight that it is not just a company’s eps that can be improved by buybacks; equity values may also benefit too. Since some remuneration schemes can also be based on growth in equity prices, there is still every incentive for executives to support the use of buybacks.
Other companies that rely heavily on granting share options to attract and retain staff, such as in new start-up bio-techs and specialised software development companies, have also implemented buybacks. When stock options are granted, the number of increased equity normally causes dilution of earnings. Companies can use share buybacks to then offset this dilution.
The price at which companies buy back shares is critical for the process to effectively work. To maximise benefit to the company, these buyback schemes are generally based on the premise that the price of the shares is ‘undervalued’ by the market. If share values are temporarily low, then a company which buys its shares on the open market will normally tend to benefit shareholders who continue to hold shares in the company. In effect, purchasing shares below their ‘underlying’ or ‘intrinsic’ value has the effect of transferring shareholder value from shareholders who sell to those that continue to hold. Determining what is the ‘underlying’ or ‘intrinsic’ value of a share is far from easy. Some analysts would suggest that in efficient capital markets, a share is merely worth what the market determines it to be worth at a given moment.
In practice, many directors justify their decision to implement a buyback scheme on the basis that the market has failed to understand their company and has unfairly under-valued its shares. The financial markets are however often more realistic about a company’s prospects and the value of its shares than over-optimistic directors. Indeed, very few CEOs will publicly claim that their shares are over-valued.
Companies can destroy considerable existing shareholder value if they acquire their shares when values are high and then markets ‘correct’ or collapse shortly afterwards. Some companies try to minimise these potential losses of shareholder value by setting a value for their share price, above which level there is unacceptable loss of shareholder value. As an alternative, companies can consider distributing their cash mountain as a ‘one-off’ special dividend.
In theory, share buybacks can be a positive economic signal of functioning capital markets. Cash balances can be seen as wasteful and unproductive – so it is often advantageous for cash to be returned to shareholders – who can then to reinvest the returned cash assets themselves to perhaps obtain a better return.
Further support for share buybacks has come from some countries to adopt economic policies based on quantitative easing – which has led to low interest rates. As a result, companies can relatively easily take on debt in order to fund share buybacks. Some analysts on both sides of the Atlantic even suggest that quantitative easing has now provided companies with more incentive to introduce buyback schemes rather than investing in business assets.
Traditionally, share buyback schemes have been more popular in the US than the UK and the rest of Europe. Growth in buybacks in the EU countries still lags behind the US. It is estimated that, last year, US companies had total buybacks of more than $300 billion, whereas European companies totalled just less than $40 billion. Some analysts attribute this difference to the greater use of more complex remuneration packages being based on eps growth in the US. Moreover, US capital markets are regarded as being more flexible than their European counterparts. This leads to European companies acting more cautiously before taking on more debt to fund a share back. In contrast, in the US, it is more financially fashionable for companies who have buybacks to return to their shareholders if they need to raise more cash at a later date. Some analysts believe that continuing low interest rates in Europe will eventually tempt more companies to take on higher levels of debt in order to borrow to fund buybacks.
Over the last year, at the individual company level in the US, the computer giant Apple was reported as being the largest user of buybacks by share value, spending over $6 billion. Other US companies such as Intel, Exxon and Microsoft were also relatively heavy users of share buybacks in 2014. Pointedly, over 70% of the companies in the S&P 500 index engaged in some form of buybacks. Share buyback activity has also increased in the UK this year. During 2015, buybacks are likely to be further encouraged by FTSE 100 companies – which now have a build up of cash holdings approaching £60 billion.
For some companies, buybacks can be particularly problematic. Last year, Glencore’s share buyback programme cost around £3 per share, which was a considerable over-payment, given its share price fell to hover around the £1 level at one point this autumn. Indeed, this collapse in Glencore’s share price has been even more dramatic considering its share price was 530p on its IPO in 2011. However, as its financial fortunes continue to deteriorate, the directors of Glencore must now surely regret even considering a share buyback scheme. Global trading conditions have hammered Glencore’s balance sheet to such an extent that Ivan Glasenberg, the CEO, has recently announced that the company now needs to implement a £1.6 billion fund-raising exercise. Pointedly, the company has moved from a share buyback to raising new equity through a share placement – all within the space of a year.
How many of the buybacks schemes will actually increase long-term shareholder value is another matter. Indeed, companies that get their market timing wrong can substantially over pay for their share buybacks – as Glencore learnt to its cost. More generally, buybacks are regarded as a share support operation, encouraged by self-interested company executives and directors where their compensation packages are frequently related to earnings per share indicators. Perhaps there is a need for increased regulatory accounting measures requiring companies to provide more detailed information on share buybacks and to explain more clearly their impact on performance indicators. Only then might shareholders be better placed to assess the impact of the buyback scheme and the effect on their company’s performance.
John Stittle is a lecturer at the University of Essex