Even as share buybacks are getting a bipartisan pounding in the US Congress, where critics have argued that such buybacks are bad for the overall economy, there is enough research to show that corporate profits grow fastest when companies give more money back to shareholders, not less.
Only last week, here in India, the board of India's fifth largest IT company Tech Mahindra approved a share buyback for a total sum not exceeding 1,956 crore rupees at a price of 950 rupees per share. This constitutes about 2.1% of the total paid-up equity capital of the company. The 6th of March is fixed as the record date for the purpose of ascertaining the eligibility of shareholders to participate in this buyback. The news of the announcement was welcomed by the Street. Shares of Tech Mahindra hit a 52-week high of 840 rupees, gaining about 3.5%.
The questions we are addressing on our explainer today are - what are share buybacks? Are they a good idea for the company or the shareholder? Why is there a new resistance to them in the US? And what does this buyback mean for Tech Mahindra. These issues addressed on this episode of Pick of the Day with me Rakesh Sharma on Moneycontrol.
What is a share buyback?
As we know, last year, boards of many IT firms including TCS, HCL Technologies and Mphasis approved proposals to buy back shares. TCS announced buybacks worth 16000 crore rupees and HCL 40000 crore worth of share buybacks. Seven weeks into 2019, two dozen companies led by technology major Infosys (8,260 crore rupees) have announced or completed plans to buy 17,050 crore rupees worth of their own stock, according to data compiled by Bloomberg. The latest to join the list is Tech Mahindra.
For the uninitiated among us, what is a share buyback proposal? And why do companies do it?
Investopedia describes share buyback thus:
Stock buybacks refer to the repurchasing of shares of stock by the company that issued them. A buyback occurs when the issuing company pays shareholders the market value per share and re-absorbs that portion of its ownership that was previously distributed among public and private investors. With stock buybacks, aka share buybacks, the company can purchase the stock on the open market or from its shareholders directly. In recent decades, share buybacks have overtaken dividends as a preferred way to return cash to shareholders. Though smaller companies may choose to exercise buybacks, blue-chip companies are much more likely to do so because of the cost involved.
Why would companies do this? There are plenty of reasons. One of the most common reasons cited is ownership consolidation. Let’s say there is a company with one owner and 10,000 shareholders. It effectively means that the company has 10,001 owners. Why do companies issue shares? To raise equity capital to fund expansion. But when a company gets to a point where there are few expansion opportunities in sight, it essentially means holding on to all that equity funding that is not even being used, and sharing ownership for no good reason. Let’s also not forget that shareholders expect dividends which is a cost of equity, meaning the business is paying for the privilege of accessing funds that it is not even using. As Investopedia cited, “Buying back some or all of the outstanding shares can be a simple way to pay off investors and reduce the overall cost of capital. For this reason, Walt Disney (DIS) reduced its number of outstanding shares in the market by buying back 73.8 million shares, collectively valued at $7.5 billion, back in 2016.”
More so, the company is expected to keep the shareholders happy – by giving dividends. And indeed one of the goals of the company executives is to increase shareholder wealth. And this is where the great balancing act comes. They also need to ensure that the company stays in lithe financial condition should there be a recession. The tightrope walk of ensuring the company stays afloat in tough times while also keeping shareholder wealth increasing is a tough one. One way to do that is by offering share buyback. Per Investopedia, “If the economy slows or falls into recession, the bank might be forced to cut its dividend to preserve cash. The result would undoubtedly lead to a sell-off in the stock. However, if the bank decided to buy back fewer shares, achieving the same preservation of capital as a dividend cut, the stock price would likely take less of a hit. Committing to dividend payouts with steady increases will certainly drive a company's stock higher, but the dividend strategy can be a double-edged sword for a company. In the event of a recession, share buybacks can be decreased more easily than dividends, with a far less negative impact on the stock price.”
Share buyback is also a quick fix for the financial statement. By reducing the number of outstanding shares, a company's earnings per share (EPS) ratio is automatically increased – because its annual earnings are now divided by a lower number of outstanding shares.
One analysis of buybacks is that the company offering it is fiscally healthy and wants none of the excess of equity funding. Even though credit rating agencies don’t often see buybacks in a positive light – as it is essentially taking on more debt – it can also be seen by the market that the management has enough confidence in the company to reinvest in itself. Writer Troy Segal says, “Share buybacks are generally seen as less risky than investing in research and development for a new technology or acquiring a competitor; it's a profitable action, as long as the company continues to grow. Investors typically see share buybacks as a positive sign for appreciation in the future. As a result, share buybacks can lead to a rush of investors buying the stock.”
Outlook for the Indian IT sector
Returning to Tech Mahindra now, CFO Manoj Bhat told PTI, "We evaluate the cash needs of the business from time to time and intend to return excess cash to shareholders. In terms of the method adopted, we will be using a combination of buybacks and dividends to return capital to reward our shareholders."
Sanjeev Hota, AVP Research at Sharekhan by BNP Paribas, said Tech Mahindra plans to return around 22 per cent of its cash and cash equivalents to investors through the buyback programme. "Tech Mahindra used to utilise its incremental cash generated by the business in acquisitions/ investments in the earlier years. Now the company has joined the league of the large peers that have opted for the share buyback route to boost the shareholders' returns," he said.
The stock remains a top pick within the IT sector. Domestic brokerage house Edelweiss said in a report, "A strong revival in the telecom vertical before 5G spends kicking in enhances Tech Mahindra’s long-term growth prospects. While the enterprise business looks solid with industry-leading revenue growth, the turnaround in telecom is getting stronger with each quarter." Edelweiss maintains a Buy call on Tech Mahindra, with a target price of 1,002 rupees on the stock.
IT is a sector where there is a good cashflow each year and not great capital expenditure, and companies, in order to maintain healthy return ratios, keep a generous payout ratio in the form of dividends or buybacks. Another reason that is being cited by analysts is expectation of a global slowdown that may in turn affect clients' budgets.
As Sunil Matkar noted on Moneycontrol, while it is a common practice for companies which are facing significant erosion in their stock price but which believe the prospects are good to engage in buybacks (as we have seen in the PSU sector), the IT sector buybacks buck that trend considering the Nifty IT index has rallied as much as 24% in the past year - greater than any other sector - and 44% in the last two years backed by US growth and rupee depreciation.
"The outlook for Indian IT companies is good as growth in the US remains robust, and depreciation of INR versus USD has further strengthened their margins. However, all IT stocks may not do well. We are positive on Tech Mahindra," said Ajay Jaiswal, Strategies & Head of Research at Stewart & Mackertich Wealth Management, adding also, "We presume most IT companies are doing a buyback because dividend payment attracts a 15 percent dividend distribution tax and also individuals who receive dividend income in more than Rs 10 lakh pay a dividend tax of 10 percent."
As Moneycontrol noted, for Q3FY19 IT companies' performances came in line with the estimates (Q3FY19 revenue ranged between 1 percent QoQ and 6.5 percent QoQ in constant currency term). Companies like HCL Technologies and L&T Infotech saw strong revenue growth, while others saw a furlough impact.
Vineeta Sharma, Head of Research at Narnolia Financial Advisors remains optimistic about the sector. She said to Moneycontrol, "In our view, positive triggers of FY20 will be 1) continued growth in financial services revenue in North America; 2); large deals participation; (3) capex visibility owing to 5G roll-out; and (4) strategic M&A activities to build capabilities could lend support to FY20E revenue acceleration."
Infosys, HCL Technologies and Tech Mahindra, are the top picks in that order within the sector, according to the analysts Moneycontrol spoke to.
Why the backlash against buybacks?
We did earlier mention that there is a growing dialogue not just among academics and thinktanks but also now politicians about the widespread use of share buybacks in the US. Politicians of all stripes, including Chuck Schumer (Democratic), Bernie Sanders (Independent), and Marco Rubio (Republican) seem to have found rare common ground in advocating legislation that would restrict buybacks, give the SEC greater oversight over buybacks, and ending their tax advantages, or by banning the practice. For the record, as Fortune magazine noted, buybacks in 2018 reached a record of $800 billion, equivalent to about 75% of all S&P 500 profits. (Or $1 trillion according to one CNN estimate)
Rita McGrath, professor at Columbia Business School, writing for CNN, noted that while there are some legitimate reasons for companies to repurchase their shares - if the leaders believe the stock is undervalued or to make shareholders whole after employees receive stock grants or to boost the company's stock price considering the uncertainty around such big gamechangers as Brexit, trade wars, more government shutdowns - the reasons to not go down the buyback route are just as many and compelling. One of them, she said, was "The bulk of executive pay is now tied to a company's stock price, creating an incentive to make that price as high as possible." Indeed, the buyback phenomenon may be one of the reasons why American business leaders make a whole lot more money than do their counterparts in the rest of the world. The worker-to-CEO pay ratio in American companies is also much higher than in other places, worsening the already terrible income inequality.
Before an SEC rule change in 1982, as a matter of fact, buybacks were illegal, as they were seen as a form of stock price manipulation. Professor McGrath noted that for long-term shareholders, risks are increased. Companies invest in buybacks when the times are good and there is cashflow, and refrain from it during hardtimes, effectively, using current shareholder's money to buy high and sell low.
There is also the oft-raised issue of companies being left with less money for investment. Money spent on repurchasing shares, critics argue, could be spent elsewhere - investing in innovation, storing the money as buffer for hard times, paying and skilling workers, creating healthier local communities. The available numbers are nothing less than staggering. A CNBC analysis found that companies in the S&P 1500 which engaged in the most buybacks relative to their market caps underperformed in comparison to their peers who did not. A Deloitte analysis has found that the percentage share of GDP being directed towards stock buybacks is steadily increasing while that directed towards equipment and structures is either flat or falling.
A solid example cited by critics of buybacks is Sears, which, since 2005 spent $6 billion buying back shares - money it could have used for long-term investment which, who knows, might have prevented it from going bankrupt. GE, for another example, spent $24 billion in buybacks in 2016 and 2017 (average price of $30.2 per share and $19.65 per share respectively). The stock these days is worth around $10. Boop.
The Roosevelt Institute found that if the top five issuers of stock buybacks in the restaurant industry (Starbucks, McDonald's, Domino's being the top three) during the period from 2015 to 2017 ended the practice, these companies could pay their workers an average of 25 percent more each year. The study noted that Starbucks spent the most on buybacks per worker, and if it had reallocated funds from stock buybacks to compensation, could have given each worker more than a $7,000 raise. A much better premise for income equality rather than waiters having to depend on tips for sustenance or visiting Indians crying blue murder about having to tip 15-20%. (Outrageous, for the record.)
As Rita McGrath noted, "Unlike other ways of returning excess cash to investors, such as dividends, buybacks can distort financial measures, such as earnings per share. Fewer shares? Voila, higher earnings per share."
There is, of course, research to indicate otherwise, too - a study from 2003 by Rob Arnott and Cliff Asness, which simply said, higher dividends = higher growth. Which to a large extent, remains true. The 16-year old study did not have access to data about the gigantic buybacks of later times. Rita McGrath again: "Dividends encourage stockholders to retain stocks for a long time, since that's how they will make money. Buybacks, however, reward those who sell their stocks — not those who hang in there."
I can't help but wonder however that if indeed buybacks are restricted, will companies actually invest the extra cash in its workers and innovations or if it might indeed be a better option for a prudent shareholder to take the money and invest in other industries and companies relying on innovation.
For now though, it's buyback time for Tech Mahindra.