Tuesday, 1 February 2011

Share Repurchases vs Cash Dividends - Ins and Outs

Cash dividends and share repurchases are described as ways of returning money to shareholders (e.g. Still Waiting for the Payout in the Financial Post) but they differ substantially as to mechanics and the potential effect on stock value.

Trend - More Repurchasing Compared to Dividends
Decades ago, company spending on repurchases amounted to very little compared to dividends but there has been a steady, almost un-interrupted rise over the years. NYU professor Aswath Damodaran's Musings on Markets blog post Stock Buybacks: What is happening and why? has a great chart that plots dividends and repurchases from 1988 to 2009 in the bellwether US stock index, the S&P 500. After the exceptional reversal in 2009 due to the financial crisis, 2010 has seen a rebound in the dominance of buybacks according to the S&P report covering up to the 3rd quarter. In Canada, the sources in the Financial Post article say it is much the same (unfortunately, there is no parallel report by S&P for the TSX). No one expects the trend to reverse, so investors must understand and deal with buybacks substituting for dividends.

Cash dividends
are familiar to most investors and easy enough to understand. Some of the key features:
  • A company pays out cash to all shareholders, usually out of its earnings
  • Regular payments, most often on a quarterly basis.
  • On-going expectations - Once a quarterly amount has been set, shareholders and company management expect that the dividend will continue to be paid regularly quarter after quarter and increase as profits increase. Often companies set a formal policy for the percentage of earnings to be paid out. Cuts in dividends usually signal a bad turn in company fortunes.
  • Analysis is mostly about the cash flows and profitability of the business - whether a company's dividend is too high or too low and whether it is sustainable.
  • Dividend data is readily available as any stock quote will show the amount of the current dividend and the dividend yield, which is the current annual dividend as a percentage of the share price. There is even a weighted average dividend yield readily available for the overall stock market - for instance, according to the official Toronto stock market website TMX.com as of January 28th, 2010 the S&P/TSX Composite Index dividend yield was 2.44%.

Share repurchases, also known as stock buybacks, differ in a number of ways:
  • Repurchase cash goes to a limited number of shareholders, the ones from whom the company buys the shares. The normal method for buying the shares is on the stock market at the going price in a Normal Course Issuer Bid (NCIB). Since this occurs on the stock market, the sellers do not know that they are taking company cash as opposed to another investor's but the effect is still that all shareholders do not directly receive the company cash.
  • Repurchased shares are then cancelled (almost always this is the case, though the company could hold them on the books as Treasury shares), which reduces the number of shares in circulation. Fewer shares and the same earnings increases earnings per share, normally a good thing that would increase share price but the reality is more complicated than that, as we explain below.
  • Each buyback is different - dollar and percent of share targets vary and actual purchases may not match announced intentions. There is a constraint in Canada that NCIB purchases may not exceed 5% of outstanding shares within any 12 month period (see law firm Davies, Ward, Phillips and Vineberg's Revised Canadian Take-over Bid and Issuer Bid Regime). Repurchases, even announced, are voluntary and flexible. A direct issuer bid may also be made direct to shareholders at a fixed price, which may be above market price. After announcing an intention to buy back stock, the company is not obliged to do so and may buy only a portion or no stock at all.
  • Analysis considers multiple factors simultaneously - share price over- or under-valuation, company leverage/debt levels (some buyouts are done with borrowed money), capital gains vs dividend tax rates, management/employee options, company waste or productive use of cash
  • Data is only available piecemeal - a company intending to buy back stock is obliged to announce the amount and timing in advance through a news release, and that seems to be the only way to get data - company by company through a news release source.
The Why's of a Repurchase - Good or Bad?
As the above implies, every repurchase is different. Sometimes it is good for the shareholder investor and sometimes not. The different factors that come into play and ideas for ways to assess them include:
  1. Management / Employee Stock Options - Some companies, the worst culprits being in high technology (see S&P report above), routinely issue large numbers of stock options as compensation. The buyback then mops up the excess in shares created when the options are exercised. That may be fine if the compensation occurs in a high-growth company whose earnings rise fast enough to reward the public shareholders as well. Or it may be bad if it only amounts to diversion of profits away from shareholders towards the managers/employees. Checking the company financial statements will reveal the presence of options issuance and then assessment can move to other factors.
  2. Leverage or Debt / Equity - Sometimes companies borrow money to fund repurchases (e.g. Potash Corporation recently issued $1 billion in new debt to pay for half the $2 billion repurchase program announced in November). As Prof. Damodaran points out in another post Buybacks and Stock Prices: Good or Bad News? whether that is good or bad depends on the company having too much or too little debt to begin with. Adding debt to the point of too-much raises risk of default and will lower stock price while adding when there is too-little promises to increase profits for shareholders and thus the stock price.
  3. Shares Under-Priced or Over-Priced - A good reason for buying back stock is if management thinks shares are under-priced and it is true. The purchase is a way of saying it to investors in the market. If not believed immediately by the market, existing shareholders will benefit from higher profits later, which presumably would be followed by higher actual dividends and/or share price. If believed immediately, share prices will rise right away to reflect the true valuation of the company to the benefit of existing shareholders. If insiders are buying while a share repurchase is underway, it is a confirming signal that management believes the under-priced story.
  4. Uncertainty about Earnings - The flexibility of buybacks to match volatile earnings instead of the more locked-in nature of cash dividends may better suit businesses in cyclical sectors or those where deregulation has reduced predictability. To that extent it may be perfectly ok.
  5. Taxes on Dividends vs Capital Gains - This is the argument that some types of investors like hedge funds prefer to receive profits as capital gains over dividends. There is more skepticism than belief about this factor as a driving force in the trend. Its impact depends on one's own tax circumstances.
  6. Cash Being, or Likely to be, Wasted by Management - The current situation where large amounts of cash are apparently sitting on corporate balance sheets raises the question of how profitably it will be deployed. Ironically, if management decides that it cannot do better than give the money back to shareholders through buybacks and investors agree, there may well be a positive boost to the stock price. Prof. Damodaran suggests a good place to start looking for cash efficiency - large, established, mature companies with poor returns on assets and little debt may benefit from repurchases. High-growth companies with strong returns on assets and little debt capacity may suffer a stock decline if cash is returned through a buyback since that may be a signal that the future will not be as rosy as the past.
How to Find the Companies Doing Repurchases
  • Canada - Enter the word "repurchase" as the search term in the news release site CNW; then look through the resulting list which appears with recent announcements first. That's how we compiled the list below.
  • USA - The Online Investor maintains a handy list, though of course its completeness and accuracy must be checked
  • Individual Companies - check the Investor section of the company website for the complete details in press releases and financial statements
Recent Canadian Repurchase Examples

Bottom Line
Each repurchase by each company must be assessed individually for what factors are at play and how they will work out. Uncertainty of analysis and eventual outcome will always exist but the effort is worthwhile since something notable is being revealed about the company that regular cash dividends do not impart.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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