A topic that is hotly debated between investors and the companies they own is whether "excess cash" is best returned via dividends or via share buybacks. With Halfords (LON:HFD) AGM coming up, and Halfords being a major component of my high yield portfolio, I need to take a view on this. Of course, where management and investors are agreed that significantly better returns can be generated by re-investing the cash in the business - either via investment for organic growth or by acquisitions, then clearly that is what should be done, but that is not always the case. "A bird in the hand being worth two in the bush" should also be borne in mind, i.e. a cash return is risk free whereas there is risk attached to reinvestment, from investors' POV.
There are certain special cases that I won't discuss here: e.g. investment trusts buying back shares for discount control. My investigation/conclusions relate to trading businesses.
Up until now, my view has been that buybacks can be justified - but only where shares can be bought sufficiently cheaply. I thought I ought to do some analysis to see whether this view is valid and what "sufficiently cheaply" is. For the purposes of my analysis, I imagined a business that is not growing but generates static post-tax earnings of £100m p.a.. I also assume that 50% of these earnings are distributed to shareholders. I then consider two cases over a 5 year period. In the first case the distribution is entirely in the form of dividends. In the second one, the company decides to distribute 25% as a dividend and 25% in the form of buybacks. Further, in the second scenario, I assume that the company's shares trade on a P/E of 8 throughout. Here are the results of this analysis:
| 2011 | 2012 | 2013 | 2014 | 2015 | |
| Earnings (£m) | 100 | 100 | 100 | 100 | 100 |
| Dividend Only | |||||
| Dividend (£m) | 50 | 50 | 50 | 50 | 50 |
| Shares in Issue (m) | 100 | 100 | 100 | 100 | 100 |
| EPS (p) | 100 | 100 | 100 | 100 | 100 |
| DPS (p) | 50 | 50 | 50 | 50 | 50 |
| With buybacks | |||||
| Divdend (£m) | 25 | 25 | 25 | 25 | 25 |
| Shares in Issue (m) | 100 | 97 | 94 | 91 | 88 |
| Share Price (p) | 800 | 826 | 852 | 880 | 908 |
| Shares bought back (m) | 3.13 | 3.03 | 2.93 | 2.84 | 2.75 |
| EPS (p) | 100 | 103.23 | 106.56 | 109.99 | 113.54 |
| DPS (p) | 25 | 25.81 | 26.64 | 27.50 | 28.39 |
The ultimate metric is total shareholder return (TSR). In the "dividend only" case, this is 250p/share over the period considered, comprising the dividend only. In the buyback case, the TSR comprises the sum of dividends and the difference between the initial and final share price (assuming a constant P/E), which totals 146.9p. Though in the very long term buybacks may result in a higher return, over a sensible forecasting period shareholders are clearly much better off with a simple return of cash. A cash return also offers the option of dividend reinvestment, to increase the investors' interest in the business, if he/she finds the shares offering good value.
So, how low does the P/E have to be for the buybacks to actually generate a better TSR? I found that it has to be as low as 2!
There are some other factors that may influence the decision on whether to institute buybacks or just pay a higher dividend:
- Tax considerations. For a higher rate taxpayer, there may be a greater benefit than I have illustrated in receiving some of the return through a capital gain rather than a dividend. However many institutions or individuals have their shares in tax sheltered account, so that isn't a factor. My understanding of current corporate taxation is that it makes no difference from the issuers point of view.
- Share price stabilisation. A buyback programme is likely to reduce share price volatility, as it means that there is always a buyer in the market. That may appeal to shorter term investors and to fund managers (who worry about nonsense such as "alpha" and "beta"), but from the long-term value investor's perspective, that is no benefit at all, and reduces opportunities to pick up shares at attractive prices.
Of course, it also allows managers to turn a no-growth business into one that appears to be growing its EPS (but isn't really adding any economic value at all). That might help achievement of bonuses.
Based on this analysis, I shall vote against Halfords' decision to return £75m of cash in FY2012 through buybacks, vs £44m in the form of dividends: I'd much rather have a 50% higher cash dividend, which should be easily affordable.
Mark
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ShareSoc is a not-for-profit campaigning organisation, promoting individual share ownership, fighting for shareholder rights and providing educational resources to investors. ...read more or visit website »
Disclaimer:
The author may hold shares in this company, all opinions are his own and you should check any statements that appear factual and not rely on them before making an investment decision. The author is NOT a qualified analyst nor authorised to give investment advice. Whilst the author is a director of ShareSoc, all views expressed are entirely his own and not necessarily those of ShareSoc.
Halfords Group plc is a holding company. The principal activities of the Company are retailing of automotive, leisure and cycling products, and car servicing and repair. It operates in two segments: Halfords Retail (Retail) and Halfords Autocentres (Autocentres). It products and services include Friend of the Motorist, Best Cycle Shop in Town and Starting Point for Great Getaways. Retail sells up to 16,000 different product lines with ranges in car parts, in-car technology, child seats, cycling, roof boxes, outdoor leisure and camping equipment. As of March 30, 2012, Retail traded from 467 retail stores, which included 402 superstores, 34 compact stores and 31 metro compact stores, and online through the halfords.com and halfords.ie Websites. Autocentres is the car servicing and repair operator offering maintenance, service and repair services. As of March 30, 2012, Autocentres traded from 260 car servicing centres and online through the www.halfordsautocentres.com Website. more »
41 Comments on this Article show/hide all
This might be of interest - I just came across it - still digesting it - download the two files at the end of the piece
It's by terry smith of fundsmith fame
In reply to schober, post #22
Thanks Schober,
Richard Lambert (ex CBI DG and FT editor) also echos the point Terry Smith and I make in an FT article today:
[my bold]
The problem is that intrinsic value, for a trading business is unknowable (but straightfoward for a business valued on tangible assets) and can only be based on conservative estimates of future return. Therefore buybacks are risky unless conducted at prices a long way below likely intrinsic value.
Mark - haven't had time yet to respond to your #21 yet. Sorry for mixing you up with someone else I corresponded with in a similar vein! I will study your spreadsheet and respond when I can.
Cheers,
Mark
The problem is that intrinsic value, for a trading business is unknowable
Indeed but perhaps more importantly this is likely to be wildly different dependant on your view of :
1) Macro picture
2) If you can combine the assets with your own to create synergies
3) Future prospects
Interesting take from Lex
http://www.ft.com/cms/s/3/b81c6984-cd92-11e0-b267-00144feabdc0.html#axzz1VhPmy9yS
Investors who do not match the buy-back with a proportionate sale are in effect buying more shares. That hurts whenever companies buy back at the wrong time.
Xig
To respond to all the points:
Really like Terry Smith's take on things - especially like the slide he has where he shows low P/B shares respond very well to buybacks. Really wish I could get the same data for P/E but I assume it's similar!
Agree with Lex in it's conclusions. As I said it's exactly the same as buying more shares so for an investor who is truly LTBH and doesn't sell if the share starts getting too highly priced then it can be value destroying. For me though, I don't hold a share unless I think it's significantly undervalued so buybacks complement my investing preferences.
True it's hard to accurately determine the intrinsic value of a trading business as earnings can be very hard to predict but in the case of say Halfords you can buy at such a wide margin of safety you can be reasonable assured of purchasing below intrinsic value.
Mark
Halfords has been buying up a lot of shares in open market over last several months (as per their announcement in April).
It's indicative that much of their buying has been in the 340p-390p range, destroying value. Yes, some recent buys have been at lower levels of less than 300p.
But as a prospective shareholder this does not inspire confidence in the management's ability to allocate shareholder capital efficiently. EPS incentives do not align shareholders and managers equally!
If management could tell which way the share price was going to move in advance they'd be in the wrong job I think! Personally I think Halfords is fairly cheap in the 340-390p range and an absolute steal at 300p. I bought in at 295p and am very happy with my 7.5% yield. For a company that's a market leader in it's field, with a great return on capital, low debt and reasonable long term growth prospects I'm very happy to be able to buy it this cheap.
In reply to PlayDumbh, post #27
Not only do the EPS incentives misalign management and shareholders' interests but I see that the delivery of large elements of management reward in the form of shares also causes a conflict of interest, per this announcement today. The CEO and other directors sold around 250,000 shares (to meet tax libailities on exercise of awards) on a day when the company bought back 100,000 - accounting for a substantial proportion of that day's trading volume.
It is a well known phenomenon that executives tend to be rather poor at making share buying or selling decisions and it is noteworthy that Mr Wild and his colleagues chose to sell towards the bottom of the market.
Not related to the thread but what's with HFD today?
Slowly ginding upwards, trending to the close around 289p then a 1.46m UT trade at 301p !!
That last trade compares to the 2.35m for the day ie a very big deal.
In reply to djpreston, post #30
Could it be technical, to do with triple witching today and position close-outs? There seem to be relatively big UT trades on several stocks that I monitor this evening.
Dunno Mark.
Hadn't seen other trades - that just stood out for size and premium.
Debate on ft.com this morning re Rio Tinto. My contribution;
Share buy backs usually destroy wealth, they only create value for shareholders if the balance sheet assets are undervalued. Buying £100 of assets for £70 is intelligent business, but buying £100 worth of assets for £150 is not agnostic, it is stupid.
In today's markets, the consensus advice is to buy high yielding FYSE-100 blue chips. Mr Elliot, the finance director of Rio Tinto mentioned above, should know that.
MoneyWeek published research which proved that increasing dividends lifts the share price by much more than buy backs, I am asking the editor Merryn Somerset Webb, for permission to send the article to anyone who wants it.
Rio Tinto's dividend is rubbish, only 2.13%. One Rio share earns 450p, but the hapless shareholders receive a 67.4p pittance. That is an unnecessary 6.7 times dividend cover.
I do not buy Rio Tinto shares because of this.
In reply to MadDutch, post #33
Thanks Mike,
That's a useful reference. I'm intending to write to Halfords' FD, expressing my and ShareSoc's disapproval of the approach they're taking, especially as they seem to be financing their buybacks by increasing debt. Something I feel is most imprudent in these difficult times. May well use that Moneyweek article for authoritative backup.
Best,
Mark
In reply to marben100, post #34
Mark, I need a fax number or a real world address to send you the article.
Lel my know if a tough letter is needed to wake up some dozy FD; if you pass the ammo, I will be pleased to bombard them!
Mike
Mark,
Rio Tinto latest;
29/12/12. Reply from Rio Tinto reception. She had a system failure, did not hang up and I accept that. Asked if my mail was resolved. I said no. My reply;
“The problem has not been resolved or even addressed. Rio Tinto’s Finance Director Mr Elliott was quoted in the Financial Times and FT.com, he was reported as justifying the world’s biggest miner’s policy of buying shares instead of returning the shareholders money to the owners of that money. Rio will come under increasing criticism if it does not address this matter.
Mr. Elliott’s name is mentioned, so he must see the FT article and the comments on FT.com. Please ensure that that his assistant, PA or secretary has my email and subsequent correspondence; and gives it to Mr. Elliott to read.
Michael Van Moppes.
In reply to MadDutch, post #36
Mark, that seems to have got their attention! Just got this reply;
FW: Ref. ID: 175766 FW: Your Finance Director Guy Elliott in the Financial Times
To see messages related to this one, group messages by conversation.
13:15
Reply ▼
Servicedesk London Add to contacts
To Bystrom, Ingrid (RTHQ), maddutch3@hotmail.com
Please see the below email from Michael very important for Guy Elliott.
And please reply to Michael once you received this email.
Regards,
Neetu Pillai
Accounts Payable Service Desk
Rio Tinto Shared Services
Rio Tinto
SEZ Building, Hinjewadi Phase 2, Pune-411057, India
Servicedesk.London@riotinto.com http://www.riotinto.com
From: servicedesk.london@riotinto.com
Sent: 12/28/2011 11:45:07 AM
To: Guy.Elliott@riotinto.com
Cc: maddutch3@hotmail.com
Subject: Ref. ID: 175766 FW: Your Finance Director Guy Elliott in the Financial Times
Guy
Below email is for your reference please look into it.
Thank you Michael
Apologize I was on the service call and I didn't hanged your call there was some system problem and the call got auto logged out.
Regards,
Neetu Pillai
Accounts Payable Service Desk
Rio Tinto Shared Services
Rio Tinto
SEZ Building, Hinjewadi Phase 2, Pune-411057, India
Servicedesk.London@riotinto.com http://www.riotinto.com
Yes the FT article was a very distorted view of the situation. For example it said "Having established the extent of surplus cash companies then have a choice of handing it back through a one-off special dividend payment or in a buy-back". One important other option was omitted - namely to return it to shareholders via a tender offer. That is often the best option.
It also quoted Lord Wolfson as saying that "A special dividend.....it's a payment to one set of shareholders at one moment in time". Well it gets paid to all equity shareholders at the time it is declared. I simply do not understand the reference to "one set of shareholders" - was he arguing it should be paid to past or future shareholders?
Another oddity is that the article is focussed around the concept of "surplus cash" when many buy-backs take place when a company often has substantial debt, and sometimes even increases it to enable it to do buy-backs. The motivation is clearly therefore for other reasons than having "excess" or "surplus" cash.
Personally I always as a matter of routine vote now against share buy-back resolutions other than in investment trusts. The more you examine this issue, the less justified they appear. And there have been much better articles in the FT in the past on this subject which gives a better view.
In reply to Roger Lawson, post #38
It was great to see the FT repeating the article and our debate on FT.com this morning; it must be good journalism.
I thought your reply was very good, Roger. I bet Lord Wolfson is not used to public criticism! Especially when it is so justified.
Mike
There's an interesting article on efinancialnews today in which an EC-backed group of economists calls for an outright ban on stock buybacks.
http://www.efinancialnews.com/story/2012-02-03/eu-economists-call-for-ban-on-share-buybacks?ref=email_37191
Terry Smith, CEO of Fundsmith also wades in:
The Finnov report, titled Financing Innovation and Growth: Reforming a Dysfunctional System, was published on Thursday at a conference at the UK House of Commons.
It marks the end of a three-year project started in March 2009, with European Commision funding of €1.49m, as a response to the financial crisis.
I found an interesting alternative to buybacks today, thanks to TMF. I like CLS's novel way of not buying its own shares in the market, but buying them back from its shareholders. Sharescope does give the yield but does give the P/E, which is 4.9. The ticker is CLI. Price yesterday £6.23.
The original article was prepared for my share club, this edited version is for stockopedia because it offers a simple political and financial solution to the share buyback problem. A line of text in the budget perhaps, saying; "Share buybacks will be illegal unless shareholders interests are given priority. To use share buybacks, the company must first offer the buyback to its own shareholders before it makes the offer to the market.
This wording needs a lot of improvement, I will be happy to work on it if my idea has merit.
Here is the link to the detailed article;
http://www.fool.co.uk/news/investing/2012/02/02/40-discount-no-dividend-but-you-still-get-an-incom.aspx?source=ufwflwlnk0000001
MadDutch