Customs Street Advisors is a full service investor relations firm based in Lagos, Nigeria.

Signal versus Noise: Scrutinizing Share Buybacks

This week on Street Talking in NEXT, I share my reservations on the acclaimed merits of recent capital structure reconfigurations, especially share reconstructions and buy-backs by companies on the Nigerian Stock Exchange. In place of these unproven merits, I urge companies to focus, instead, on other less discussed, but surer benefits of such programs for shareholders.

Equity overhang is the new leprosy. On a single day last week, the papers carried reports about Investment & Allied Assurance’s share reconstruction plans and Custodian & Allied Assurance’s intention to buyback 5% of its outstanding shares through an open market repurchase program. Two months earlier, Goldlink Insurance had completed its own share reconstruction discipline. This week, one paper carried the headline ‘Low Share Prices – Firms Embrace Share Buy-backs’.’ Are we entering an enthusiastic era of aggressive buy-backs? Is stock-swamping an odious condition?

In its published notice, Custodian cited six benefits of the shareholder distribution. Among these, three caught my attention. First, that the program will improve investment ratios and increase shareholder value. Second, that the program will send positive signals to the market that the board and management believe that the shares are undervalued. Third, it will create price stability and reduce selling pressure. In fact, these three reasons are the main arguments traditionally trotted out in defense of share buybacks. They are so intuitive that we almost want to accept them at face value.

On the surface, share buybacks should be an unimaginative choice for companies in this season of low share prices. In the past year, valuations on the Nigerian Stock Exchange have become more attractive to bargain hunters, and, it now seems, to companies themselves. Shares sold at a premium during public offerings in the boom years can now be bought at fire sale discounts. But could their fatality lie precisely in the unimaginativeness of their first-choice?

Traditionally, these share buy-backs have been catalyzed by shareholder agitations for the distribution of large and growing cash balances. It is less common for companies to initiate such actions independently. Many agent-owner conflict theorists would argue that managers prefer to spend excess cash on sub-optimal investments or ruinous diversification.

The June 2007 campaign by John Mayo’s Efficient Capital Structures (ECS) against Vodafone is instructive here. ECS presented four resolutions to the Vodafone board urging the telecoms giant to distribute cash to shareholders through the issuance of £35 billion in new shareholder bonds and spin-out of 45% of its Verizon Wireless holding to shareholders.

Justin Pettit, author of the priceless primer, Strategic Corporate Finance: Applications in Valuation and Capital Structure, rightly observes that share buybacks, like dividends, should be a second order residual policy resorted to only if the company lacks sufficient growth prospects to earn above its weighted average cost of capital (WACC). The first order decisions being the company’s future cash generation potential, investment opportunities, capital structure and liquidity needs.

According to Pettit, ‘contrary to the conventional wisdom, buybacks do not create value by increasing earnings per share (EPS). After all, the company has spent cash to purchase those shares, and its intrinsic value is reduced by the amount of capital redeployed, reflected by reductions in cash and shares.’ This, he explains, effectively cancels any anticipated EPS effects.

On the second point regarding the signal effects of a buy-back as indicative of management’s view on the undervaluation of the company, the jury is still out. The most glaring example that disputes this view would be Lehman Brothers’ January 2008 decision to buy back 100 million ordinary shares, just nine months before the company’s bankruptcy filing. If the board of defunct Lehman Brothers, a first rate investment bank, was not savvy enough to know its own precarious position, what hope is there for companies in other sectors?

Research reveals that the trumpeted signals are loudest when the following conditions are met. One, the board, management and their proxies do not participate in the program or such participation is fully disclosed. Two, a fixed price self-tender as opposed to open market share repurchases is used. Three, the size of the repurchase program must be significant, with a minimum retrenchment of 15% of outstanding shares over a defined period being a generally acceptable threshold. Custodian & Allied has not disclosed on the first, and the last two conditions are not met.

On the third benefit, regarding the price stabilization effects of buy-backs and reduction of selling pressure, the fact is that while it may work in the short-term, on the long term, selling pressure will revert to the historical mean. A share buy-back program cannot cast a voodoo spell over buy-sell orders. The ocean waves do not obey King Canute’s commands.

In the final analysis, companies considering buy-backs need to carefully consider their long term capital structure targets and how it matches with corporate strategy. A shift away from equity implies a correspondent move to take on greater debt, with its attendant obligations and potential benefits, primarily, tax shielding, boost to invested capital and an imposition of fiscal discipline. This, in my view, is where companies need to pay special attention when discussing the attractiveness of buy-backs as shareholder value creating actions. Failure to do so can only send ‘confuguous’ messages, an unpalatable blend of confusion and ambiguity, to the markets.

The original article may be read here on the NEXT website.

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