Dividends vs. Share Buybacks? A Halfords Case Study

This might be of interest - I just came across it - still digesting it - download the two files at the end of the piece

It's by terry smith of fundsmith fame

Thanks Schober,

Richard Lambert (ex CBI DG and FT editor) also echos the point Terry Smith and I make in an FT article today:

...Moreover, these transactions have the mechanical effect of increasing earnings per share – but not the overall profitability of the business – as the number of outstanding shares is reduced. This tends to make executives feel smarter, and richer too, if their compensation is tied to increases in their companies’ EPS as is sometimes still the case.

But there are losers from this process as well as winners. Long-term shareholders will always be worse off, unless the shares are bought at below their intrinsic value and their company can see no better way of using the money by investing in building value for the future. The public interest also suffers, as money that could have been used to create long-term returns and jobs is frittered away in uneconomic transactions.

In this way, share buy-backs have an adverse impact on the long-term competitiveness of UK business, which means that they should be on the agenda of John Kay as he works on his review of UK equity markets for the government. The solutions are not difficult to find: Terry Smith, the straight-talking City of London pundit, has spelt them out. Among other things, he suggests that management should be required to justify buy-backs by reference to the price paid and the implied return on the investment, and to compare this with alternative uses of the cash. He also argues that the repurchased shares should be reflected as assets on the balance sheet, and the return on these assets should flow through the profit-and-loss account...

[my bold]

The problem is that intrinsic value, for a trading business is unknowable (but straightfoward for a business valued on tangible assets) and can only be based on conservative estimates of future return. Therefore buybacks are risky unless conducted at prices a long way below likely intrinsic value.

Mark - haven't had time yet to respond to your #21 yet. Sorry for mixing you up with someone else I corresponded with in a similar vein! I will study your spreadsheet and respond when I can.

Cheers,

Mark

The problem is that intrinsic value, for a trading business is unknowable

Indeed but perhaps more importantly this is likely to be wildly different dependant on your view of :

1) Macro picture
2) If you can combine the assets with your own to create synergies
3) Future prospects

Interesting take from Lex

http://www.ft.com/cms/s/3/b81c6984-cd92-11e0-b267-00144feabdc0.html#axzz1VhPmy9yS

Investors who do not match the buy-back with a proportionate sale are in effect buying more shares. That hurts whenever companies buy back at the wrong time.

Xig

To respond to all the points:

Really like Terry Smith's take on things - especially like the slide he has where he shows low P/B shares respond very well to buybacks. Really wish I could get the same data for P/E but I assume it's similar!

Agree with Lex in it's conclusions. As I said it's exactly the same as buying more shares so for an investor who is truly LTBH and doesn't sell if the share starts getting too highly priced then it can be value destroying. For me though, I don't hold a share unless I think it's significantly undervalued so buybacks complement my investing preferences.

True it's hard to accurately determine the intrinsic value of a trading business as earnings can be very hard to predict but in the case of say Halfords you can buy at such a wide margin of safety you can be reasonable assured of purchasing below intrinsic value.

Mark

Halfords has been buying up a lot of shares in open market over last several months (as per their announcement in April).
It's indicative that much of their buying has been in the 340p-390p range, destroying value. Yes, some recent buys have been at lower levels of less than 300p. 
But as a prospective shareholder this does not inspire confidence in the management's ability to allocate shareholder capital efficiently. EPS incentives do not align shareholders and managers equally!

If management could tell which way the share price was going to move in advance they'd be in the wrong job I think! Personally I think Halfords is fairly cheap in the 340-390p range and an absolute steal at 300p. I bought in at 295p and am very happy with my 7.5% yield. For a company that's a market leader in it's field, with a great return on capital, low debt and reasonable long term growth prospects I'm very happy to be able to buy it this cheap.

Not only do the EPS incentives misalign management and shareholders' interests but I see that the delivery of large elements of management reward in the form of shares also causes a conflict of interest, per this announcement today. The CEO and other directors sold around 250,000 shares (to meet tax libailities on exercise of awards) on a day when the company bought back 100,000 - accounting for a substantial proportion of that day's trading volume.

It is a well known phenomenon that executives tend to be rather poor at making share buying or selling decisions and it is noteworthy that Mr Wild and his colleagues chose to sell towards the bottom of the market.

Not related to the thread but what's with HFD today?

Slowly ginding upwards, trending to the close around 289p then a 1.46m UT trade at 301p !!

That last trade compares to the 2.35m for the day ie a very big deal.

Could it be technical, to do with triple witching today and position close-outs? There seem to be relatively big UT trades on several stocks that I monitor this evening.

Dunno Mark.

Hadn't seen other trades - that just stood out for size and premium.

Debate on ft.com this morning re Rio Tinto. My contribution;


Share buy backs usually destroy wealth, they only create value for shareholders if the balance sheet assets are undervalued. Buying £100 of assets for £70 is intelligent business, but buying £100 worth of assets for £150 is not agnostic, it is stupid.

In today's markets, the consensus advice is to buy high yielding FYSE-100 blue chips. Mr Elliot, the finance director of Rio Tinto mentioned above, should know that.

MoneyWeek published research which proved that increasing dividends lifts the share price by much more than buy backs, I am asking the editor Merryn Somerset Webb, for permission to send the article to anyone who wants it.

Rio Tinto's dividend is rubbish, only 2.13%. One Rio share earns 450p, but the hapless shareholders receive a 67.4p pittance. That is an unnecessary 6.7 times dividend cover.

I do not buy Rio Tinto shares because of this.

Thanks Mike,

That's a useful reference. I'm intending to write to Halfords' FD, expressing my and ShareSoc's disapproval of the approach they're taking, especially as they seem to be financing their buybacks by increasing debt. Something I feel is most imprudent in these difficult times. May well use that Moneyweek article for authoritative backup.

Best,

Mark

Mark, I need a fax number or a real world address to send you the article.

Lel my know if a tough letter is needed to wake up some dozy FD; if you pass the ammo, I will be pleased to bombard them!

Mike

Mark,

Rio Tinto latest;


29/12/12. Reply from Rio Tinto reception. She had a system failure, did not hang up and I accept that. Asked if my mail was resolved. I said no. My reply;

“The problem has not been resolved or even addressed. Rio Tinto’s Finance Director Mr Elliott was quoted in the Financial Times and FT.com, he was reported as justifying the world’s biggest miner’s policy of buying shares instead of returning the shareholders money to the owners of that money. Rio will come under increasing criticism if it does not address this matter.
Mr. Elliott’s name is mentioned, so he must see the FT article and the comments on FT.com. Please ensure that that his assistant, PA or secretary has my email and subsequent correspondence; and gives it to Mr. Elliott to read.
Michael Van Moppes.

Mark, that seems to have got their attention! Just got this reply;



FW: Ref. ID: 175766 FW: Your Finance Director Guy Elliott in the Financial Times?
To see messages related to this one, group messages by conversation.

13:15
Reply ?
Servicedes?k London Add to contacts
To Bystrom, Ingrid (RTHQ), maddutch3@hotmail.com

Please see the below email from Michael very important for Guy Elliott.

And please reply to Michael once you received this email.

Regards,
Neetu Pillai
Accounts Payable Service Desk
Rio Tinto Shared Services
Rio Tinto
SEZ Building, Hinjewadi Phase 2, Pune-411057, India
Servicedesk.London@riotinto.com http://www.riotinto.com

From: servicedesk.london@riotinto.com
Sent: 12/28/2011 11:45:07 AM
To: Guy.Elliott@riotinto.com
Cc: maddutch3@hotmail.com
Subject: Ref. ID: 175766 FW: Your Finance Director Guy Elliott in the Financial Times

Guy

Below email is for your reference please look into it.

Thank you Michael

Apologize I was on the service call and I didn't hanged your call there was some system problem and the call got auto logged out.


Regards,
Neetu Pillai
Accounts Payable Service Desk
Rio Tinto Shared Services
Rio Tinto
SEZ Building, Hinjewadi Phase 2, Pune-411057, India
Servicedesk.London@riotinto.com http://www.riotinto.com

Yes the FT article was a very distorted view of the situation. For example it said "Having established the extent of surplus cash companies then have a choice of handing it back through a one-off special dividend payment or in a buy-back". One important other option was omitted - namely to return it to shareholders via a tender offer. That is often the best option.

It also quoted Lord Wolfson as saying that "A special dividend.....it's a payment to one set of shareholders at one moment in time". Well it gets paid to all equity shareholders at the time it is declared. I simply do not understand the reference to "one set of shareholders" - was he arguing it should be paid to past or future shareholders?

Another oddity is that the article is focussed around the concept of "surplus cash" when many buy-backs take place when a company often has substantial debt, and sometimes even increases it to enable it to do buy-backs. The motivation is clearly therefore for other reasons than having "excess" or "surplus" cash.

Personally I always as a matter of routine vote now against share buy-back resolutions other than in investment trusts. The more you examine this issue, the less justified they appear. And there have been much better articles in the FT in the past on this subject which gives a better view.

It was great to see the FT repeating the article and our debate on FT.com this morning; it must be good journalism.

I thought your reply was very good, Roger. I bet Lord Wolfson is not used to public criticism! Especially when it is so justified.

Mike

There's an interesting article on efinancialnews today in which an EC-backed group of economists calls for an outright ban on stock buybacks.

http://www.efinancialnews.com/story/2012-02-03/eu-economists-call-for-ban-on-share-buybacks?ref=email_37191

Finnov, a research collaboration between seven European academic institutions including the UK’s University of Cambridge, said share buybacks should be subject to stronger governance control or banned outright.

It said the measure, used by publicly-listed companies to boost flagging share prices, was a symptom of “impatient capital” that threatened to undermine the stability of financial markets.

Terry Smith, CEO of Fundsmith also wades in:

“There should be a degree of disclosure and transparency. Companies should have to say why they’re buying back shares and why it’s better than paying a dividend.”He also said that share buybacks could contribute to financial instability. He said: “It’s a form of de-equitisation, to pay out in that manner reduces the capital base of a company and makes it more unstable under adverse conditions.

The Finnov report, titled Financing Innovation and Growth: Reforming a Dysfunctional System, was published on Thursday at a conference at the UK House of Commons.

It marks the end of a three-year project started in March 2009, with European Commision funding of €1.49m, as a response to the financial crisis.

I found an interesting alternative to buybacks today, thanks to TMF. I like CLS's novel way of not buying its own shares in the market, but buying them back from its shareholders. Sharescope does give the yield but does give the P/E, which is 4.9. The ticker is CLI. Price yesterday £6.23.

The original article was prepared for my share club, this edited version is for stockopedia because it offers a simple political and financial solution to the share buyback problem. A line of text in the budget perhaps, saying; "Share buybacks will be illegal unless shareholders interests are given priority. To use share buybacks, the company must first offer the buyback to its own shareholders before it makes the offer to the market.

This wording needs a lot of improvement, I will be happy to work on it if my idea has merit.

Here is the link to the detailed article;

http://www.fool.co.uk/news/investing/2012/02/02/40-discount-no-dividend-but-you-still-get-an-incom.aspx?source=ufwflwlnk0000001

MadDutch