Share Buy Backs - This year's model

Companies and financial markets follow fashions. Periodically, we go through a mergers and takeovers boom, followed a few years later by a round of demergers and management buyouts.

Diversification was in vogue some years ago, which bred conglomerates on the basis that good management could manage any business.

Just a few years later, we saw enterprises cutting back to their core businesses on the basis that a cobbler should stick to his last.

Recently we had businesses enthusiastically de-layering to achieve a flat management structure as opposed to the traditional pyramid. Now we have management gurus telling us that a flat management structure is flawed, and that businesses should go back to the management pyramid.

A variation on this theme is the building up of head office staff to work on a group basis; time passes, however, and soon functions and jobs are moved out of head office and returned to the subsidiaries.

Outsourcing is a phenomenon of the last few years and one wonders if, given time, there will be a move to bring some of these jobs back in-house.

And in the last few years, merchant and investment banks have taken to speculating in derivatives on their own account.

Some have stopped since, particularly since the Barings collapse and the Long-Term Capital Management affair. Speculating in derivatives can generate spectacular profits, or massive losses.

Years ago, most businesses did not employ university graduates because they did not wish to employ ‘over-educated numbskulls’. Now many ask for a university degree when they hire filing clerks.

Why buy back your own shares?

The point of the above is to put into perspective one of the latest fashions – the share buy-back – in which a company (normally quoted) buys back a proportion of its issued shares from the shareholders. Companies which have recently undertaken share buy-backs include the Halifax, Diageo, Greenalls, and Thistle Hotels. This fashion has been aided by recent tax legislation – specifically the abolition of advance corporation tax.

Reasons behind companies buying back shares include the following: it increases earnings per share; this boosts the share price, which in turn lifts the value of executive share options. Buy-backs can also make a company less vulnerable to unwelcome takeovers, as the prospective predator would have to pay a higher price per share without acquiring the surplus cash.

Share buy-backs can be a good idea, particularly when the company concerned can show strong cash flow, genuinely surplus cash, low or non-existent levels of debt, and no plans to spend substantial sums expanding the business in the near future.

In the past, such a company could find the surplus cash burning a hole in its pocket, and would make an acquisition – even in a field of activity totally unrelated to its mainstream business – just to spend the surplus.

Such an acquisition would often be a disaster. Using the share buy-back device to mop up surplus cash removes this temptation.

What to do with surplus cash, apart from placing it on deposit with the bank, might otherwise create a puzzle for the directors, and might even have made them lax at raising further money internally, but a share buy-back can solve that problem and provide a greater incentive to reduce stocks and debts, or sell other poorly performing assets for cash.

If there is no surplus capital – where the share buy-back is paid for from the normal bank balances of a company, for example – this can be called into question. Cash in the bank can be reserved for emergencies for example, or for the carefully researched and judiciously priced takeover of a company that fits well with the purchasing firm’s business (unlike the disastrous theoretical example suggested above).

According to the Financial Times, US companies are currently embarked on a massive borrowing binge – gross issuance of corporate bonds has doubled in the last two years – and are retiring equity at nearly $200bn (£123bn) a year.

One of the principle reasons behind this phenomenon is that US corporations are borrowing the money to pay for their share buy-backs – as well as issuing corporate bonds instead of shares when engaged in raising cash.

Some UK companies are borrowing money to fund share buy-backs, one of the arguments being that overdraft or loan stock interest is deductible for corporation tax purposes while dividends are non-deductible.

Seen from the contrary point of view – when a company has its back against the wall – it can reduce or cancel its dividend, but cannot refuse to pay the interest on its borrowings. And borrowing money for a share buy-back can become dangerous if the company subsequently encounters financial problems and starts to make losses, if a major customer collapses or takes its business away or we enter a period of recession.

The company’s bankers can bring pressure to bear on the directors to reduce its overdraft. If the money to fund the share buy-back was raised by issuing loan stock and – perhaps many years later – that loan stock fails to be repaid in recessionary times when bank balances are insufficient for the purpose, the company will have to raise money at a very difficult time.

There are other risks attached to funding a share buy-back with borrowing.

The early 1970s, 1980s and 1990s all experienced recessions. We do not know when the next one will be, but it is sure to come.

If we have a serious recession in the years ahead or, worse still, a genuine depression, both sales and profits can drop dramatically, and the interest on borrowed money becomes a millstone around a company’s neck. Credit will be tight as well, and new money difficult to raise. Indeed, in a severe recession or depression, the value of a company’s assets can fall, reducing the available security for loans and overdrafts. As well as the predictable collapse of sales and profits in a recession, some companies will adopt inappropriate strategies and require a sizeable cash cushion until the economic climate improves.

Diageo and Grand Metropolitan

This scenario may appear overly gloomy, but let us look closely at the recent £1.1bn Diageo share buy-back. Diageo, formed in December 1997 through the merger of Grand Metropolitan and Guinness, has now returned £4bn to shareholders and reduced its equity by more than 18%. The buy-back increases net debt to above £6bn against operating profits of £2bn a year, and with disposals to come.

When we look back in time, however, Grand Metropolitan entered the 1972 to 1975 recession with historically high gearing – a high ratio of borrowings to equity. This period saw a credit crunch, the commercial property crash, the secondary banking crisis and rumours that at least one of the big four banks could go under.

The Financial Times 30 Share index lost more than 70% of its value between 1972 and 1975, while Grand Metropolitan’s own share price took a vicious pounding and dropped more than most. The company’s high gearing suggested to the stock market that the company was drifting towards the financial rocks.

The recession – like all booms and busts – eventually passed into history, as did the credit crunch. Grand Met’s shares made a spectacular recovery, along with the rest of the stock market. And now, some 24 years later, one wonders whether anyone in the Diageo hierarchy remembers those desperate times, when many well-known companies feared for their bank’s solvency as well as their own.

We must remember that hard times, whether for a particular company or the economy as a whole, are seldom predicted or, if they are, the prophets concerned are dismissed as Jeremiahs. After all, who predicted Marks & Spencer’s recent trading difficulties or the Barings collapse? Who predicted the recession of the early 1990s (or for that matter any other recession) and particularly its severity?

Allow for the unexpected

Finance directors and company directors, as well as maintaining strong internal controls, should build a margin of safety into their future plans to allow for unexpected events that can damage their businesses’ financial health.

It is generally not a good idea for a company to fund a share buy-back by borrowing, and expose itself to hazards in the years ahead. It is all very well to raise earnings per share – and thus the share price and the value of executives’ stock options – while times are good, but never to the extent of putting the company in jeopardy in the future.

Equity share capital serves an important role, as Japanese companies have learned in the late 1990s, and German companies may soon be reminded if their recession deepens. As opposed to borrowings, it never has to be repaid – either in good times or bad.

The concept of equity share capital has stood the test of time and a company must be adequately capitalised both to grow and to withstand financial storms. When advising on a share buy-back, the only criterion finance directors should consider is whether or not the technique is in the long-term interests of the shareholders.

So, back where we came in – the fashion trends followed by companies and financial markets – if the firms which borrowed money to implement a share buy-back strike financial difficulties in the next recession, we may well have seen the end of this particular fashion.

Michael Goddard, FCA, is a chartered accountant. Until recently, he was FD of Concorde Express Transport plc.