Author: Hugh Dive

Bad and Fake Buy-backs

Earlier this month casino operator Crown Resorts announced a buy-back of up to 4.2% of its outstanding shares, which builds on the $500 million of stock the company had already bought back over the past 12 months. Despite this prima facie positive announcement Crown has fallen 9% in August as the market looked past the buy-back and focused on concerns about returns from the $1.5 billion Sydney Casino.

In last week’s piece give me my money back, we looked at buy-backs that have a positive influence on a company’s share price. However, as you can see with the Crown example, buy-backs are not always positive. This week in the second part of our deeper dive into buy-backs, we are going to look at bad buy-backs and the cheapest ones of all to execute: the fake buy-backs that create the illusion of share price support.

Bad Buy-backs

Theoretically, a company should raise capital when the market is over-valuing their company, and buy back their shares when the market is undervaluing their company. One of the greatest examples in history of a company using their over-valued stock to make an acquisition was dial-up internet company AOL’s US$164 billion purchase of Time Warner in 2000. By issuing shares, AOL shareholders ended up owning the majority of the new media entity, despite Time Warner having significantly more assets and revenue, and ultimately a viable business. In 2009, Time Warner spun off AOL for $3 billion, 2% of the entity’s value in 2000.

Buybacks should only be pursued when management is very confident the shares are undervalued, as companies are no different than regular investors. If a company is buying up shares for $20 each when they are only worth $10, the company is clearly making a poor investment decision

Lack of options

Sometimes buy-backs may be taken as a signal of a lack of attractive growth opportunities in which the company can invest. Particularly in the case of cyclical companies such as miners and airlines, bad buy-backs are conducted after a period of buoyant activity. They are typically done at the top of the cycle, when the costs to develop news assets or buy competitors are at their highest. Whilst this is clearly preferable to a large acquisition such as Rio Tinto’s purchase of Alcan, this approach to capital management often this leaves the company operating in a cyclical industry vulnerable during the inevitable downturns. We view that in some situations it may be best for companies to hoard cash at the top of the stock-market cycle and use it in the next trough to buy back shares at a discount or buy the assets of distressed competitors.

This week BHP resisted the urge to follow Rio Tinto’s lead in announcing a buy-back funded by the sharply increased profits from high commodity prices, ultimately funded by a 2016 Chinese stimulus plan. By paying off debt, BHP may have more options when commodity prices come off.

Offset dilution from executive stock options

Another situation where buybacks are not positive is where they are done to offset the dilution from executive stock options being exercised. This is more common in the US where stock options often form a bigger component of remuneration, but here there is no earnings per share accretion as the number of shares on issue don’t change. This is a poor outcome for shareholders, as the new shares issued to executives via stock options are exercised at a discount to the prevailing share price and those bought via buy-backs are bought on market at the current price! In 2015, IT networking company Cisco Systems bought back 155 million shares, but after the effects of employee stock compensation it only reduced the total shares outstanding by 38 million. Here the buy-back is not capital management, but executive remuneration.

Short term sugar hit to the share price

Many listed companies award senior management bonuses based on the share price of the company they manage. This provides management with an incentive to recommend actions that may deliver a short-term boost to the company’s share price, such as a large buy-back delivering earnings accretion over a long-term investment opportunity. Companies deliver long term growth in their business by investing in future growth.

Buy high sell low

When a company either issues new shares to the market via a placement or buys back their own shares, they are effectively acting as a fund manager in valuing their own shares, making a judgement as to whether their shares are cheap or expensive. However, company management teams have access to a far greater array of information on their company’s finances and future prospects than an external investor could ever hope to have.

Qantas has a long history of capital management, buying back $506M worth of stock in 2008 (average price $5.56), $100M in 2013 (average price $1.45), $500M in 2016 (average price $3.50), and $366M in 2017 (average price $3.32). However in between was a large equity issue of $525 million shares QAN issued at $1.85 in 2009, and in 2014 Qantas’ debt was rated as junk, as the CEO lobbied the federal government for a bail-out of the then embattled national carrier.

 

 

Similarly, steelmaker BlueScope is currently buying back stock over 80% above the level at which it issued over $2 billion in equity not so long ago. Certainly, this has pushed up the share price along with some solid profit growth. However, one may think that retaining capital rather than buying-back shares could prove to be a more prudent cause of action for the steel company. Two years ago, BlueScope were seeking assistance from the government with their struggling Port Kembla steelworks in New South Wales and the company announced a $1 billion loss in 2012!

Fake Buy Backs

In some situations, the company announces the buy-back and enjoys a short-term bounce in the share price without actually buying much in the way of stock. In the listed property trust space, the buy-back often acts to support the price at NTA. For example, in 2014 SCA Property Group announced its intention to undertake an on-market buy-back of up to 5% of its units, as the price jumped above NTA ultimately no units were bought and the buy-back faded into the ether.

Unlike property trusts that have a reference point of net tangible assets per share, it is harder for industrial companies to justify announcing a buy-back and then sitting on their hands. Building materials company CSR last bought back a share in its $150M buy-back in late September. Platinum Asset Management are yet to open their wallet for their $300M share buy-back, also announced last September. Insurer QBE announced a $1 billion buy-back in February, but bought their first share back on 21 August.

Our take

Whilst we are generally in favour of companies returning excess capital to investors rather than retaining it, we concede that not all buy-backs are in the best long-term interest of shareholders. Companies that are returning all their earnings to shareholders may not be investing in research and development or new growth projects. These strategies are necessary to generate returns over the longer term that are ahead of inflation.

 

 

 

Give me my money back!

Two weeks ago, shopping centre owner Vicinity announced it would buy back up to 5% of its stock on market after it delivered its full-year results on August 15. This delivered investors an immediate 5% bounce in the trust’s share price, as the market anticipated over $500 million of Vicinity’s stock being repurchased over the next 12 months.

In this week’s piece, we are going to look at share buy-backs and why they generally have a positive influence on a company’s share price. However, buy-backs are not always positive. Next week in the second part of our deeper dive into buy-backs, we will analyse the bad buy-backs and the cheapest ones of all to execute: the fake buy-backs that create the illusion of share price support.

Buy-backs are almost universally popular with investors as they not only reduce the number of shares outstanding by which to divide a company’s profit, but they return certain capital to investors today, rather than waiting for an uncertain return tomorrow. This is important, in light of the numerous occasions where company management teams have frittered away excess cash on questionable acquisitions or hastily conceived expansion plans designed to buy growth or move into new markets.

Types of buy-backs

There are essentially two ways that a company can repurchase or buy-back its shares. They can do it on-market using a stock broker, or off-market by inviting shareholders to tender their shares for repurchase. Off-market buy backs are generally done by companies such as BHP that have large balances of franking credits, as the buy-back can be structured in a tax-effective manner for domestic investors by returning a combination of cash and tax credits. Companies such as CSL that earn the bulk of their profits offshore are more likely to buy back their shares directly from investors on the ASX as they don’t have excess franking credits.
Occasionally companies will limit the buy-back to a particular investor, though this is usually very poorly received by the wider investor base. The last company that tried to do this was Woodside in 2014 when it offered the equivalent of $48 per share to buy back$2.7 billion in shares from Shell. This failed to get shareholder approval and with the share price currently around $29, it was clearly the right move for shareholders to block this move. Currently Rio Tinto is conducting an on-market buy-back that is limited to the company’s London listed shares. This selective buy-back is being done to close the price discount at which Rio’s shares trade on the London exchange compared with the price in Australia.

Why investors like buy-backs
Signal that future prospects are good

Buy-backs signal to the markets that a company’s management has strong confidence in the future financial prospects of the company, as the company is returning what it sees as excess capital to shareholders. A weak company in a weak financial position, with nervous lenders raising concerns about the repayment of debts due is extremely unlikely to be returning capital to shareholders. As raising new capital is both time consuming and expensive (fees going to investment bankers in sharp suits), if a management team has some concerns about the outlook, they will retain excess capital on their balance sheet.

Change in capital structure

By returning cash to shareholders, the buy-back alters the capital structure of a company, by increasing the proportion of debt on its balance sheet used to fund its activities. Similarly, it increases the financial leverage or net gearing by reducing the cash component in the denominator of the below calculation.
Net Gearing = (Total Debt – Cash) / Book Value of Equity
If the company is “under-geared”, repurchasing of shares increases leverage. In the case of shopping centre owner Vicinity, due to the $1.5 billion in asset sales sold over the past 18 months, the trust’s gearing decreased to 24.7%. Buying back stock below net tangible assets (NTA) is not only earnings accretive, but it organically increases financial leverage and thus the equity owner’s share of rising profits.

Reduces the chance of poor acquisitions

A buy-back also provides investors with comfort that excess cash is not just being retained for empire building, possibly to be squandered on bad investments which tend to be made by companies in cyclical industries at their peak. A great example of this was Rio Tinto’s purchase of Canada’s Alcan in 2007, which not only drained the company of the excess capital built up by the mining boom, but resulted in an ignominious and highly dilutive rights issue in 2009.

Scares off short sellers

Buy-backs tend to cause share prices to trade upwards, as the companies’ buying puts upwards pressure on shares. When buying back shares, companies are required to file a new notice after each day when they buy shares. This notice is posted on the ASX for investors to see and details the number of shares bought and the price paid.

This may cause short sellers to close their short positions in a company conducting a buy-back (also causing upward price pressure), as they know that there will be a new buyer consistently purchasing shares in a company in which they have a short interest. Further, a company is likely to step up that program and increase buying on any share price weakness.

When I was working at a US investment bank writing research on building materials company James Hardie, I was able to observe the wave of buying from short sellers of James Hardie on the morning that the company announced a share buy-back. This pushed the share price higher than the announcement actually warranted.

Our Take

Returning excess capital to investors as distributions rather than retaining it reduces the capacity for management teams (acting as investors’ agents) to expend capital in ways that might not be in the best interests of investors. Where excess capital is returned to investors in the form of distributions and buy-backs, this excess capital sits in investors’ bank accounts rather than the company’s. If management want additional equity for an acquisition they are then required to make an investment case to their investors. We are expecting the announcements of a few buy-backs over the next few weeks, especially in the Listed Property space from trusts that are able to buy back their own shares that are trading below net tangible assets per share.

Monthly Performance July 2017

  • July was again a very volatile month in the Listed Property sector and after falling heavily mid-month, the index rallied to finish down -0.1%. Normally July is a quiet month as property trust management cannot speak to the market in the lead-up to revealing their results in August.

 

  • The Fund slightly underperformed the index, declining by -0.3%, with the primary cause of being the position in Westfield which generates profits in USD and GBP. Westfield’s share price was impacted by the strength in the AUD/USD which surged +4% over the month to finish at US$0.80.

Go to  Monthly Newsletters for a more detailed discussion of the listed property market in July and the fund’s strategy

The biggest IPO of all Time

Since mid-June the oil price is up 15%, which has breathed fresh hope into beleaguered energy companies globally.  The catalyst for the recovery in the oil price was the announcement that Saudi Arabia, OPEC’s largest producer, will limit exports to 6.6 million barrels a day in August, 1 million lower than production this time last year.  This has been interpreted as rational profit maximising behaviour by the world’s largest producer, which has traditionally sought to defend market share and maximise oil revenues to prop up the Kingdom’s budget.

We see this as behaviour designed to boost the profit margins temporarily, similar to what is done by many vendors prior to any IPO.  In early 2018 the Saudi’s are looking to conduct an initial public offering (IPO) of around 5% of energy giant Saudi Aramco for a predicted price of US$100 billion. In this week’s piece, we are going to look at how to analyse IPOs and specifically this one, which is likely to be the biggest IPO of all time.

When analysing IPOs, few have been more eloquent on this subject than Benjamin Graham, the Father of Value Investing;

“Our recommendation is that all investors should be wary of new issues – which usually mean, simply, that these should be subjected to careful examination and unusually severe tests before they are purchased. There are two reasons for this double caveat. The first is that new issues have special salesmanship behind them, which calls therefore for a special degree of sales resistance. The second is that most new issues are sold under ‘favorable market conditions’ – which means favorable for the sellers and consequently less favorable for the buyer.” (The Intelligent Investor 1949 edition, p.80)

The biggest IPO in history

Last January the Saudi Arabian Crown Prince Mohammad bin Salman Al Saud announced that the Saudi government intends to offer shares representing about 5% of Saudi Aramco, its national oil company. Aramco has been under government control since the Saudi Arabian Oil Company was nationalised nationalized in the 1974 following US support for Israel in the Yom Kippur War.

Aramco is the largest global oil producer and therefore this IPO marks a shift in thinking in the Kingdom as the proceeds are being used to help diversify the economy away from oil. The IPO is planned to be listed on exchanges in Riyadh, with a secondary listing in London, New York, Hong Kong or Singapore. The expected value of 5% being floated in 2018 is touted as around US$100 billion which would value the entire company around US$2 trillion. This is significantly larger than Apple (US$742 billion), Google (US$653 billion) or Exxon Mobil ($342 billion). Under these circumstances the Saudi’s have a very strong incentive to move the oil price higher over the next 9 months!

Factors to look at in an IPO

Why is the vendor selling?

The motivation behind the IPO is one of the first things we consider. Historically investors tend to do well where the IPO is a spin-off from a large company exiting a line of business. An example of this is Orica and their paints division Dulux. New investors also tend to do well when the vendors are using the proceeds to expand their business. The probability of new investors doing well from an IPO is far lower when the seller is just looking to maximise their exit price. A classic example of this is the Myer IPO. In the case of Aramco, the IPO is designed to help makes changes to the Saudi economy and increase investments in non-oil assets. Cynically it could be viewed that the vendor is concerned about the longer-term demand for oil with increasing amounts of Teslas roaming the streets, though only 5% is being floated off at this stage.

Is the business easily understood?

Given the reduced level of historical financial data it is important that an investor can easily understand how the company makes money and maintains competitive advantage. When Shopping Centres Australasia was listed in November 2012, it was clear how the company made money from collecting rents on Woolworths’ shopping centres. Similarly, in the case of the best float of 2015 (+127% since listing) it was easy to understand the Costa Group’s business model of growing mushrooms, berries, citrus and tomatoes with the logistics operations to deliver these to consumers.

Whilst the Aramco business of extracting oil easy to understand, like most IPOs the financial data may be limited. The secretive company has never needed to disclose any kind of financial statements and details about the company’s most important asset, its oil reserves are state secrets.

Is the company profitable?

Any IPO is presented to the market in the most favourable light (albeit with a large number of disclaimers), and at a time of the seller’s choosing. Over the last six months we have seen a number of businesses being listed that have been unprofitable for a number of years, yet are expected to switch into profitability in the years immediately after the IPO. We put little store in the notion that companies are being listed for the altruistic benefit of new investors. Thus, investors should be sceptical of predictions of dramatic improvements after listing, especially when the IPO vendors have significant incentives to show profits before listing!

Saudi Aramco is likely to be very profitable with international energy consultant estimating costs of production around US$9 per barrel. The cost of production is so cheap as the oil in Saudi is primarily located near the surface of the desert and pooled in vast fields, so unlike Australia it doesn’t need to invest very expensive offshore oil platforms taping into reserves often 100kms off the coast.

The question for minority investors is the extent to which this enormous company will be run in the interests of the minority investors committing $100 billion or whether profits may be diverted to the state.  Two months ago, the Crown Prince said that decisions about oil and gas production and investment will remain in the hands of the Saudi government after the IPO.  In March 2017 in what looks like a move to improve the books prior to the IPO, the Saudi government reduced the tax rate levied on Aramco from 85% to 50%. Investors in this IPO would probably be concerned that this tax rate could change post-IPO to fund government budget deficits given that Aramco currently accounts for 80% of the Kingdom’s budget revenue.

Is the price attractive?

The sole reason behind any new investment is the view that it will generate a higher rate of return than alternative options in an investor’s portfolio.  It is too early to make any pronouncements as the financials have not been released, but any investment would want to take a conservative long-term oil price into account and discount stronger oil prices that we may see over the next nine months.

Despite what is contained in the marketing documents for every IPO, in determining a valuation potential investor should apply a discount to currently listed companies. Due to an IPO lacking a listed track record and investors having less financial data; a discount to currently-listed comparable companies should be applied when valuing an IPO. In the case of Aramco, in our opinion the price investors should pay would be a 20% discount or greater to valuations at which companies such as Exxon Mobil, Chevron or Shell are trading at.

Our Take

Whilst new IPOs are presented as fresh, exciting ways for investors to make money and access different high growth companies or assets, we see that the best approach to evaluating IPOs is to start from the default position that the vendors are trying to cheat you and then work backwards from there.  The best IPOs I have seen over the past 20 years have been one’s where the vendor is under-pricing the asset being sold, leaving some upside or “margin of safety” for the new investors.

Understandably this is a very rare occurrence for profit-maximising private equity owners and possibly Middle Eastern Kingdoms.  The Saudi government (just like private equity vendors) may face some domestic backlash for pricing the IPO too low if Aramco performs strongly post listing!