An Investor Relations Perspective on Share Buybacks

Canadian public companies were far more active in repurchasing their shares in 2018 than in any year since recordkeeping began in 1989. Through October, 627 million shares had been repurchased for cancellation by 209 issuers. The previous annual record of 557 million shares was set in 2007.

While popular with Boards and many shareholders, buybacks have also received bad press from those – including U.S. Senator Elizabeth Warren – who argue that they artificially boost share prices in the short run while doing nothing to generate long-term corporate value. In this edition of IR focus, we examine investor sentiment toward this use of capital and provide IR advice to those companies planning to launch a buyback in 2019.

Background

Share buybacks come in more than one variety. A Normal Course Issuer Bid (NCIB) is used most often and is defined under the TSX Company Manual (Section 628) as an offer, made by the issuer, through the facilities of the TSX, to acquire listed securities issued by that issuer over the ensuing 12-month period. There are several restrictions on the use of a NCIB. A significant one is that a company cannot repurchase more than 10% of its public float on the date of acceptance of the notice of the NCIB.

Conversely, a Substantial Issuer Bid (SIB) provides the means to purchase outstanding securities for cancellation in amounts well above the levels permitted under NCIB rules – often up to 20% or more of the public float – and within a much shorter time frame.

The reasons for using an Issuer Bid will vary, as will shareholder reactions to their use.

The Case For Buybacks

In considering the benefit of repurchasing shares, it's first necessary to think about the alternatives for allocation of residual or ‘excess’ cash. There are many. A short list would include: i) reinvest in pursuit of value-creating organic growth opportunities such as introducing a new product, building a new plant or drilling a new well ii) make an acquisition iii) pay down debt iv) increase the dividend v) declare a special one-time dividend vi) do some combination of the above. How a company uses cash involves trade-offs and is a key managerial responsibility.

In deciding to implement a NCIB, the company's Board has, presumably, weighed these alternatives and determined that investment options (organic and inorganic) have been exhausted or are not adequate to provide hurdle rate returns, and that the balance sheet is underleveraged (or at least appropriated leveraged). Presumably, the Board has also developed a standard cost of capital framework that allows it to compare the expected rate of return from buybacks to returns available from other cash uses.

After these determinations have been made, a NCIB offers the following benefits:
      a) it will decrease the float and, all things being equal, increase per share earnings;
      b) unlike a dividend increase, it does not create an ongoing cash burden and is flexible because a company does not have to repurchase any shares if it so chooses; and
      c) unlike a special dividend paid to all shareholders (with unavoidable tax implications), it provides each shareholder with the choice of whether or not to tender shares to the offer.

For these reasons, and if the share price is below a reasonable estimate of intrinsic value (the discounted value of future cash flows), NCIBs can be viewed positively by the capital markets. This is especially true in situations where the alternative use of capital might involve, in the minds of shareholders, frittering away cash on value-destroying pursuits such as poorly conceived acquisitions. If pursued appropriately, buybacks may be seen as a risk-mitigation/value conservation strategy. For instance, Canadian oil and gas companies have become significant users of share buybacks because allocating more capital to exploration and development when the price of Canadian oil is depressed may be a poor decision.

The Knock Against Buybacks

Buybacks have detractors, and not only Senator Warren. More than one institutional shareholder has questioned a company on the efficacy of the practice because in the eyes of such owners, the outlay of cash starves the company of capital needed to create long-term value. Criticisms are also levelled at companies using share repurchases simply to offset dilution.

In his 2014 annual letter to public company CEOs, BlackRock CEO Laurence Fink said, in part: "It concerns us that, in the wake of the financial crisis, many companies have shied away from investing in the future growth of their companies. Too many companies have cut capital expenditure and even increased debt to boost dividends and increase share buybacks. We certainly believe that returning cash to shareholders should be part of a balanced capital strategy; however, when done for the wrong reasons and at the expense of capital investment, it can jeopardize a company's ability to generate sustainable long-term returns."

Another knock against buybacks is that they turn a company's Board/CEO into portfolio managers who may be poor repurchasers of their own company's shares. The evidence to support this view is provided by IBM and GE where ‘excess’ capital was used liberally to buy back shares while the market value of these organizations continued to decline. In fairness, given the information these companies' executives had at the time, if their stocks traded at sufficient discounts to reasonable assessments of intrinsic value when the buybacks were announced, the later price decline is not evidence of a bad buyback decision – but likely indicative of poor capital allocations more generally.

Another criticism is that buybacks ‘manipulate’ the short-term stock price and reward executives whose compensation is tied to share value. This argument postulates that buybacks offer hypothetical value to shareholders (value being judged over the short-term and long-run) but actual value to option-holding executives. Whether or not this is a motivating factor in their use, ‘supporting’ an undervalued share price is an important reason for NCIB use.

As to whether or not issuer bids prop up share prices, there have been a number of studies on the impact. The findings make interesting and sometimes conflicting reading. In a 2017 article on the practice written in Harvard Business Review, Alex Edmans said: "firms that buy back stock subsequently beat their peers by 12.1% over the next four years." The difficulty with assigning a positive or negative grade to buybacks is that much can happen to share price that has nothing to do with buybacks per se and it is difficult to determine the return a company would have achieved for shareholders using an alternative allocation of cash. Here, shareholders need to trust management's judgement.

How IR Can Help

IROs must be 'in the know' if they are to effectively communicate the efficacy of any capital allocation, share buyback or otherwise. In the know means understanding why a particular decision is being made and why it – out of all competing options – is in the best interests of the company and the shareholders. From this position of knowledge, IROs can frame discussions with shareholders appropriately when a decision has been made and effectively defend against criticisms. In cases when a company announces a buyback and then does not execute it, the IRO must be prepared to address why. (The reason is often that the share price did not need ‘support’.)

Several of the institutional shareholders IR focus spoke to suggested that IROs should convince their CEOs to disclose the framework or ‘decision tree’ they follow for capital allocations and pointed to organizations such as Morningstar and Texas Instruments (the latter produces a capital management scorecard) that have done so.

IROs can also help to shape company plans before they are enacted by engaging shareholders in capital allocation discussions. Knowing how a buyback would be received and feeding this insight to the C-suite will be enormously valuable to deliberations.

Overall, the shareholders we spoke to agreed that buybacks can be useful in certain circumstances but that because conditions change, uses of cash should change as well. In short, not all institutional investors will support all share buybacks. This is important for IROs to remember as they provide guidance to CEOs in 2019 and beyond.

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