Investment Matters

South32 announced a share buyback. We wish it hadn't.

South32 announced a share buyback this week.  We wish it hadn't.

To understand our position, this week we take a look at the ways companies provide returns to shareholders, and when it is appropriate to do so.

3 ways to reward shareholders

Essentially there are 3 main ways to provide returns to shareholders as recompense to them for providing their capital to a company:

1. ordinary regular dividends (usually paid half yearly),

2. special dividends - occasional extra dividends, and

3. share buybacks.

The latter provides returns to shareholders by increasing their future dividends (as, all else being equal, a given amount of profit is shared among a smaller number of shares i.e. EPS increases, which thus flows though to a higher share price).  This usually flows through to future dividends too.

The best method

The best way to provide returns to shareholders is first and foremost via ongoing dividends, preferably franked. 

We are fans of a progressive dividend policy (where dividends are incrementally increased each year), with a payout ratio that is sustainable.  Sustainable means that the company is providing dividends that are less than profit on an ongoing basis, allowing for the volatility in earnings that the business usually expects.  (Property trusts are a case on point of concern for us at the moment, where we view the distributions of many are unsustainable).  Some company's earnings are more volatile than others, be it for internal or external reasons.  Where a company's earnings are highly volatile because of external factors (resource companies being the case in point), then a percentage of earnings payout policy may be better.

When a company generates franking credits, ongoing dividends are clearly the best method of providing recompense to shareholders. 

There are some instances when not paying a dividend makes sense (even if a company has franking credits) - for smaller growing companies who need the capital to support their growth.  Or even for some larger companies who, for whatever reason at the time, can better put shareholders capital to work in the short term to generate increased returns in the longer term.  Energy Developments is an example when it was under PEP majority control and had many growth opportunities.

What to do with extra earnings

So a question arises as to when, for whatever reason, the company has been able to generate excess earnings - be it because of abnormally high commodity prices in the case of a resource company, conservative payout in the past, regulatory change (requiring less capital to be held for instance), or another reason.  What should the company do with these earnings?

Well, the first thing you would hope a company would do is to re-invest - so that it generates additional profit for shareholders in the future.  Reinvestment could take the form of operational expansions (e.g. new equipment, expanding geographies), or acquiring other businesses (but not paying too much, such as we consider Downer is doing for Spotless).

So when a company announces a share buyback or special dividend, many commentators and market participants get excited.  We don't (generally).  It speaks to a company that doesn't have opportunity to grow (other than organically using its current operations and assets) - certainly no opportunities that are above its cost of capital.  I add the word 'generally' because each circumstance is unique and needs to be individually assessed - a significantly undervalued share price is a clear exception (see below).

No or limited reinvestment opportunities

Where a company elects to return excess earnings, it can provide a special dividend (or maybe a few of them), or enact a share buyback.  The other alternatives are to repay debt (if it has borrowings), or to just sit on the cash - certainly in the short term - until new opportunities arise, or circumstances change.

There are many factors to consider, such as tax (including franking availability), certainty of return, and the current share price.

Some generalities - special dividends are better when a company has a high franking balance.   Franking credits provide no benefit to a company.  And they provide huge benefit to shareholders (assuming you don't hold the shares via a managed fund).  A special dividend is also a certain return - bird in the hand.

A buyback is best when the market is undervaluing the shares.  It provides a longer term benefit to the company, and thus to shareholders in the future (as compared to a one-off special dividend).  But the big risk is buying back shares when the share price is too high - the company is in effect wasting money by paying too much for the additional future earnings per share.  And that is value destroying for shareholders - not value creating. 

BHP Billiton is a case in point.  In Apr-11 it completed an off-market share buyback: 147 million BHP Ltd (Australian listed) shares, or $6.0 billion worth (4.4% of issued capital), at an average price of $40.85.   The company's announcement at the time hailed the successful completion of the buyback and the expected future benefits to shareholders.   The reality is the opposite - the buyback was implemented at a bad time (as can be seen by the following graph), and was hence value destroying.  And to make matters worse, BHP provided proceeds to shareholders who sold their shares as a fully franked dividend - essentially disproportionally giving away significant franking credits. 

The company would have done way better to provide a $6.0 billion special dividend, or even better repay debt (gearing [ND/ND+E] was only 9% or US$5.8 billion at 30-Jun-11, but was about to step up markedly with investments in mines and acquisitions - the most notable being Petrohawk.  Then the resources crash and associated implications for BHP followed shortly thereafter).  Or it could have even just sat on the cash and shareholders would be better off today.  It has also done BHP Plc (UK listed) share buybacks with value-destroying outcomes.

BHP buy back

At the time, it can be difficult to judge when the share price is too high (always easy with hindsight).  But maybe a company's Board should do things like consider P/E or RoE estimates, or company NPV valuation - based on normalised or long-term commodity prices.  Or even just look at the share price graph.  If it is at highs, is it really the time to be doing a buyback?

South32's share buyback

This is the wrong time for South32 to be implementing a share buyback.  The company is generating significant cash with current commodity prices.  This is good, but does create an issue - what to do with it.  In some ways the company's position isn't ideal because it has both a higher share price, no franking credits and no debt to pay down (the latter is in itself is a very good thing at the moment!).  And insufficient investment opportunities.

However, it should sit on the cash until either 1. sufficient franking credits to provide special dividends (even if this doesn't occur for some years), and / or 2. there is a commodity price / share price rout, and / or 3. more opportunities arise to buy mines, or expand its current mines (which we do acknowledge are limited for South32), than exist today.  As we have seen over the last decade, circumstances can rapidly change in the resources sector.

South32

Conclusion

We rate South32's management highly, especially in regards to the operational management of its assets.  However, we consider it highly questionable that it will buy back its own share capital when the share price is at highs, and commodity prices are where they are currently (there is generally considered to be risk to the downside at the moment).