I have mixed feelings on share buybacks. The good: they suggest a company believes its shares are undervalued. The bad: the company is running out of growth options and relying on capital-management initiatives to prop up the share price.
As a follower of small- and mid-cap companies, I like high-growth companies that reinvest profit, to capitalise on opportunity. But there is a point where successful companies have surplus cash and not enough options to put it to work.
Consider a company that does not need to pay down debt, cannot find attractive acquisitions and is already paying a high proportion of earnings as dividends. Its best option is to repurchase shares, reduce the number of issued shares and thus improve earnings per share.
The strategy is particularly effective if the company believes the market is materially undervaluing its stock and is later shown to be right. Buying shares back when they trade at a discount to their intrinsic value is a good move for shareholders who hold their stock.
Share buybacks can also support struggling share prices because the market knows there is a point where the company will buy back its stock. In theory, buybacks are another way to return cash to shareholders (in exchange for their shares) and are more flexible than dividends. A company can turn off its buyback program but killing a dividend can crush the share price.
The potential downside is buybacks providing a short-term boost to a company at the expense of long-term growth. The company allocates funds to a buyback that could be used to build or maintain other assets, acquire rivals and create future growth.
Consider the ASX50. It’s stacked with large-cap companies that arguably have lower growth prospects and rely on their dividend yield or other capital-management initiatives to maintain investor support. Think Telstra Corporation and its dividend yield.
The other risk is companies overusing capital-management strategies to boost returns. In the rush to buy back stock to appease short-term investors, they lose sight of their day job: improving the company’s return on equity and intrinsic value over time.
That’s happened in the United States. Between 2003 and 2012, companies on the S&P 500 allocated US$2.4 trillion, or 54 per cent of their earnings, to buybacks, reported Harvard Business Review. Put another way, one in every two dollars of earnings in the top 500 US companies was invested in capital-management activities rather than new assets.
Australia is a long way behind the US on buybacks, although there was a jump in their usage during the latest interim reporting season.
BlueScope Steel, Charter Hall Retail REIT, Computershare, Dexus, ERM Power, Genworth Mortgage Insurance Australia, LendLease Group, Mirvac Group, Qantas Airways, QBE Insurance and Rio Tinto announced new, extended or ongoing buybacks, according to Macquarie Group.
Strong balance sheets, growth in operating cash flow and limited options to redeploy excess capital were the main drivers of the jump in buybacks.
Macquarie noted potential for buybacks from Crown, GWA International, Inghams Group, Investa Office Fund, Stockland, Wesfarmers and Woolworths.
It’s possible that several Australian Real Estate Investment Trusts are trading below the true value of their Net Asset Value, given property transactions in the private market, such as shopping-centre sales, which suggests higher future NAVs for some retail REITs.
Qantas Airways looks among the more interesting stocks on the buyback list. It announced a new $378 million share buyback and Macquarie estimates the airline could deploy more than $3.5 billion of capital-management initiatives to FY20 through a mix of buybacks (an estimated $1.6 billion) and a higher dividend payout ratio.
I wrote favourably about Qantas for The Bull in June 2016 when it traded at $3. The stock rallied to $6.39 last year and has retreated to $5.84 in a weakening sharemarket. I remain optimistic on Qantas and believe it offers medium-term value at the current price.
An average share-price target of $6.92, based on the consensus of seven broking firms, suggests Qantas is undervalued. Analyst targets range from $6.50 to $7.50. Macquarie’s 12-month price target is $7.42. I’m normally wary of bullish consensus price targets, particularly those based on a smaller sample, but in this case moderate optimism on Qantas is warranted.
The company, of course, is leveraged to oil prices given fuel is its largest cost, accounting for about 25 per cent of annual expenditure. Against that, Qantas has potential for further cost gains from efficiency improvements, will benefit from an improving domestic economy and stronger demand for international flights.
Having a few billion to buy back shares or lift the dividend won’t hurt the share price either.
Chart 1: Qantas AirwaysSource: The Bull
• Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article you should consider the appropriateness and accuracy of the information, regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at March 28, 2018.