Indian companies are queuing up to return capital to shareholders by way of share buybacks. For now, investors aren't complaining
Mumbai: Most shareholders have a clear motto: returning capital through dividends is good but capital appreciation is sweeter. Share buy-backs—by which a company signals its intent to return some excess cash to its shareholders and improve shareholder returns— tick both boxes. Between FY13 till date, companies were planning to return about ₹ 1 lakh crore to shareholders, although the amount actually returned was a bit lower, at ₹ 95,977crore.
The latest to jump on to the bandwagon is Larsen & Toubro Ltd. Its shares jumped on news of the buyback that was at a 13% premium to the ruling market price. But, it also raised questions on why the company is returning money to shareholders. Ordinarily, the company would conserve capital and use it to fund growth. Does this mean it is seeing fewer avenues for growth or does it have more cash than it requires?
A little over three-fourth of the value of buybacks in calendar year (CY) 2017 were from the information technology sector. Cognizant Technologies Ltd, Infosys Technologies Ltd, Wipro Ltd, TCS Ltd and HCL Technologies Ltd bought back stock from shareholders. Then there were mid-sized firms across sectors such as Jagran Prakash Ltd, KPR Mills Ltd, Balrampur Chini Mills Ltd and Pidilite Industries Ltd to mention a few. In some cases, tax efficiency of buybacks over dividends while returning excess cash, was said to be a main reason.
The buyback bug appears to have bitten the public sector companies too. About ten days ago, the government gave an in-principle nod to 13 PSUs for buybacks. These may have been influenced by the government’s desire to achieve its revenue targets. Even earlier, buybacks were counted in the divestment kitty.
Ultimately, buybacks are a way of returning capital to shareholders and in conjunction with dividends, they form a good way of telling the market, that the firm considers its shares to be undervalued or that it has excess cash on the books.
Incidentally, buybacks are in vogue not just in India. The last decade saw the trend in US too. According to Rohit Seksaria, fund manager, Sundaram Mutual Fund AMC, “In the last decade, low interest rates has seen companies taking debt and gearing their balance sheets too, to buy back shares and improve shareholder returns."
To be sure, the trend has taken root in India too. FY18 had the highest number of buybacks in a decade at 59, while FY17 was not far behind at 49. However, in India firms are not permitted to borrow for the purpose of a buyback. We are already seeing a trend where institutional investors are taking an active interest in how companies are governed. It may not be long before investors become more vocal in demanding that companies return capital to shareholders. Here are some key reasons why a company buys back its shares.
Prudent management principles suggest that a company must return excess cash to its shareholders. After all, they are the rightful owners. According to Shankar Raman, chief financial officer, Larsen & Toubro Ltd, “Our cash balance position is beyond the growth and capex requirements, in the near to medium term. Even if needed, we are confident of raising the same. So, the buyback is the management’s decision to reward shareholders who have had faith in our vision over the years."
That said, the Securities and Exchanges Board of India diktat is that a stock buyback can only be to the extent of 25% of its net worth. So, one way of identifying a firm is a potential buyback candidate is to see if it has consistently held cash that exceeds a quarter of its net worth. A case in point is the pharmaceutical firm Novartis India Ltd. Over the last three years, its cash pile was over 80% of its net worth. Likewise, Infosys’ cash balance was steadily above 50% of the net worth until after the buyback. Wipro too, was sitting on cash for several years.
The software giants’ net profit to cash conversion rate is about 80-85%. Although firms hinted at large acquisitions to drive growth, they didn’t fructify for a long time. Hence, some of them returned cash to shareholders. Sometimes, asset monetization (like in the case of L&T) brings in a cash pile that is used to reward shareholders. Analysts reckon that with more asset sales expected in L&T, there may be more buybacks underway.
Buybacks can also be triggered by unanticipated drop in valuations. This was seen in FY2008-09, when the global economy suffered a blow from the Lehman crisis. Equity markets world over tumbled. India was no exception. The BSE-500 one-year forward aggregate valuation plummeted to 9.7 in FY2009 from 14.4 in the previous year.
Data from PRIME Database shows an incredible jump in the number of buybacks (46) during that period. The reason then was not merely the high cash balances. It was the precipitous drop in valuation for no strong fundamental reason. “Companies used the opportunity to buy back shares that were anyway undervalued," says Yogesh Bhatt, senior VP (investments), ICICI Prudential AMC Ltd.
Companies used cash balances to buy back shares. These shares got extinguished, shrinking equity capital in one stroke to improve earnings per share. Earnings ramp up helped to improve the stock valuation even as shareholders were rewarded through the buyback. Here’s how the buy back helps boost earnings and valuation. Let’s say a company has a total of 100 equity shares and the profit in a given year is ₹ 2,000, the earnings per share (EPS) is ₹ 20. After a buyback, if the equity shrinks to 50 shares and profit falls to ₹ 1,500, the EPS is ₹ 30 (higher than earlier when the net profit was more).
Reiterating this, Rusmik Oza, head of fundamental research, Kotak Securities says that buyback gives a leg up to valuation. Often, a buyback is offered at a premium to the ruling price and this helps to support the stock price. If one chooses to sell the stock, the investor would get the benefit of capital appreciation too.
Improve return ratios
A common metric that investors consider is the price to earnings ratio. The P/E multiple, got by dividing the price over earnings per share, is not the only one though. Profitability ratios such as return on equity and return on capital employed are equally important. Return on equity tells shareholders how much they are earning on their funds that are invested in the company. Equity here is the sum of equity capital and free reserves. Return on capital employed tells how much the company is earning on the entire capital invested, which is net worth plus debt.
Over a period of time, the cash and liquid investments on a company’s balance sheet increases. There may be little debt to repay. Now, if the operating business earns a post-tax return of say 20%, the treasury return on the cash and liquid investment may only be 7% post-tax. This tends to depress the return ratios, as the proportion of cash and investments in the capital increases. According to Yogesh Bhatt, senior vice-president (investments), ICICI Prudential AMC Ltd, “when the cash and bank balance of a company is invested in government securities or such other financial instruments, the rate of return (in India) is about 8%. This would drag the overall return ratios of a company down, even if the business is generating strong returns."
Investors do tolerate a temporary deterioration, especially if the company has a sizeable investment plan coming up. If that is not the case, they know these ratios will continue to decline and valuations take a slight hit. For instance, take two-wheeler company Bajaj Auto Ltd. A three-fold increase in cash and liquid investments saw its return on equity fall over the past three years from 32.2% to 22.2%. A buyback can set this right by taking the excess cash out of the books and paying it back to shareholders. The business gets rid of excess cash and return ratios improve. Simultaneously, investors can re-deploy the cash in investments of their choice. Both parties benefit.
A few years ago, multinational firms particularly in the capital goods sector made compelling offers to buyback shares. In 2011, German parent Siemens AG made a buyback offer at a hefty 30% premium to the market price. This was close on the heels of peers like ABB Ltd and Areva Transmission & Distribution Ltd. The buyback was a part of the global management decision to increase the parent stake to the maximum of 75% that was allowed in India.
There could be other reasons such as a strategic change in business models. L&T, which adopts a five-year management strategy, is a classic example. The five-year vision in FY11 was “growth through investments" that led to investments in super critical power plants, roads and other assets to generate returns. This changed in FY16, when the management tweaked the strategy towards an asset-light growth plan, thereby divesting assets to unlock capital. The cash generated thereof, would give low returns if parked in short-term investments. This prompted the ₹ 9,000 crore buyback amounting to 4.3% of the equity capital.
Scant investment options
So, while buybacks show companies in positive light in that they are willing to share idle cash, it also mirrors the lack of investment opportunities. The current spate of buybacks echoes this too. Since FY09, manufacturing activity is languishing. Investment cycle had hit the trough about five to six years ago. Core sector growth moved into the slow lane and industries are plagued with overcapacity At such times, “When excess cash is not earning much for the company, buyback ensures that similar profits are generated from lower capital, thereby leading to better return ratios," adds Seksaria.
It is better to return cash to shareholders than keep it virtually idle in the hope that some investments would happen. Perhaps, being a one-off, a buyback does not raise investor hopes in the following years, as in the case of dividends. A high-dividend paying firm is always expected to do so by investors. Also, buybacks help contract equity and permanently extinguish shares, thereby reducing the quantum of equity that needs to be serviced.
That said, there is a debate in the west on buybacks. Although optimists look at it as a way of enhancing shareholder rewards, critics feel investment avenues in core areas of business are drying up. Some view it as window dressing to boost valuation, when compared to dividends that determine the company’s ability to steadily distribute profits with its shareholders. There is still time for this debate to extend to India’s corporate sector. At some point, India may enter a phase when buybacks become as regular as dividends and when that happens, investors will look at it differently. For now, it’s mostly good news for investors, as companies are able to rid themselves of excess cash and improve valuations in one stroke.