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With South Africa’s corporate treasuries bulging with cash and little debt, shareholders are looking forward to some fat payouts. Investors Monthly digs through the likely candidates and dredges up the all-important debate – are dividends or share buybacks the best way to do it?
As the extreme effects of the financial crisis fade and a semblance of normality returns, companies that had accumulated cash safety nets, or had nervously paid down debt to leave themselves ungeared, are having to face up to questions about the efficiency of their balance sheets. Large cash piles and low gearing damage returns on equity.
With an economic recovery now seemingly entrenched, calls are growing for companies to take on more risk in order to improve shareholder returns. This means a return to past plans – dividends that were suspended can be reintroduced, share buyback programmes can resume, stalled acquisitions and slashed capital expenditure budgets are being reconsidered.
While it’s not certain the good times are back, some companies have announced plans to revive or continue share repurchases, while others have promised to return more cash through dividends. In investment circles, the debate about the relative merits of these two methods of returning cash to shareholders is raging once again.
Dividends are more straightforward – cash payments are distributed to shareholders in proportion to the number of shares they own. Buybacks are indirect – the company buys back shares in the market and cancels them, increasing each shareholder’s allocation of future dividends. What is certain is that companies are reluctant to adjust their standard dividend payout policies, which usually specify a percentage-of-profits formula for determining the payout.
Earlier this year, the bulk of South African financial directors surveyed by Deloitte said they expected an improved operational and cash-flow performance going into 2011. And yet, says Lindie Muller, a senior manager at Deloitte, two thirds expect to keep their dividend payout ratio steady over this period, choosing to maintain a buffer against uncertainty.
Only around one tenth plans to embark on a repurchase of shares, and one third has the stomach for a stepped-up dividend payout ratio. The reticence is understandable. Anglo American’s zealous share buyback scheme two years ago, which won shareholder approval before the financial crisis hit, looked rather unwise thereafter.
The share price plummeted well below the average repurchase price and, as cash dried up, management was forced not only to interrupt a proud dividend-paying history but, in a number of its subsidiaries, to come humbly to market with rights issues. It’s a broad problem.
US-listed General Electric suffered a similar indignity; an extensive share buyback scheme morphed into a rights issue in 2008, and the company cut its dividend. But the clamour for cash is back. In the US, shareholder pressure and access to cheap debt has contributed to a surge in the number of share repurchase programmes, particularly among tech stocks.
Investment information firm Dealogic says the value of share repurchase announcements totalled $245bn over the eight months to August, nearly five times more than during the same period last year. Hewlett Packard’s hefty $15bn share buyback declaration is one of the biggest recent announcements.
Moves to return cash to shareholders are less dramatic in SA, partly because the initial pullback in shareholder remuneration was less spectacular than in the advanced economies. Additionally, South African companies don’t have access to cheap corporate debt to fund buybacks. There nevertheless are a few companies likely to show shareholders increased largesse over the coming year (see sidebar, Show us the money).
Even where management and shareholders are in agreement on the imperative of so-called shareholder remuneration, the choice between buying back shares or increasing dividend payouts is not without controversy.
“The framework for allocating cash is built around the ideal capital structure for the company and the sustainability of cash flows,” says Jako van der Walt, managing director of JP Morgan in SA. “If cash-flow generation is constant, one has much more flexibility on the balance sheet.”
This assessment of the likely future stream of cash inflows will inform the dividend policy. In particular, increasing the ordinary dividend payout ratio – the proportion of earnings distributed as cash – is viable only if the company is able to sustain it.
“I’ve learnt that shareholders will not forgive you if you have a decline in your dividend per share,” quips Sanlam’s head of investor relations, David Barnes.
“Markets consider it a negative sign when companies scale back or interrupt their dividend,” explains Richard Stout from Absa Capital. “Companies are therefore rightfully cautious about upping the ordinary dividend if they cannot continue the pace over the long term.”
Nevertheless, insofar as a company is able to increase its dividend payout ratio – as Vodacom has done, for instance – it signals confidence to the market.
“It gives shareholders a reliable, recurring income stream – which is especially appealing to retail investors,” says Van der Walt. “Not surprisingly, then, stocks with a good dividend track record usually have a higher valuation,” says Kokkie Kooyman, head of Sanlam Investment Management Global.
“This track record is a reliable source of information on management, seeing that you can’t fudge the amount of cash that you pay out.” Adrian Saville, chief investment officer at Cannon Asset Management, agrees, citing empirical research which shows that dividends and dividend growth contribute about three quarters of total investment returns over five- to 10-year periods. “This applies across countries, over time, through industry boundaries and across a given firm’s history.”
An added consideration particular to SA, and one which might even sway the decision making, is that many empowerment structures rely on predictable dividend flows to pay off debt. Typically, excess cash – cash beyond the company’s needs and which is unlikely to be sustained through inflows – is allocated to shareholders through buybacks and special dividends.
The benefit of these two approaches relative to tinkering with the ordinary dividend payment is the flexibility that it affords the company. “The choice between the two depends on the company’s objectives,” says Stanlib portfolio manager Paul Swanson. “Reducing the number of shares in issue through a buyback would serve to enhance earnings per share and to optimise the balance sheet. Additionally, it would suit a company planning to change shareholding structures, for instance for a black-empowerment deal.”
This same effect applies to share ownership schemes, says Van der Walt, who cites Telkom as an example of a company which has funded its staff share incentive scheme through repurchases rather than the issue of new shares.
“Share repurchase programmes moreover set a benchmark for mergerand- acquisition investing,” he says, “as they signal that management views the return on capital within the company as superior to any returns that might be generated from an acquisition”.
Massmart’s financial director, Guy Hayward, argues that a share buyback is the best way in which a company can return cash to shareholders, though he adds a caveat: “You [management] need to behave as an investor, buying shares only if you believe they are cheap.
Share buybacks are always predicated on a company’s view of the share price.” That, however, is one of the criticisms of share buybacks. “In my experience, management at companies are poor judges of share valuation,” says Kooyman. “They tend to be swept up by markets and analysts, buying stock when it is too expensive, destroying shareholder value in the process.
Absa Capital’s Stout agrees that this might be a risk. “If companies have excess cash and are wondering what to do with it, it is generally a good sign about the health of the company. The company might therefore be trading above fair value, implying that a share repurchase would not make sense.”
However, Saville cites empirical evidence from SA that suggests that, on average, companies have a better sense of their own value than markets. Data spanning 15 years show that companies that buy back stock tend to outperform the market after two years, with the outperformance of the top fifth of repurchasers reaching as high as 12%.
Kooyman’s objections extend further, though. He says the share buyback process goes against the grain of investing – the desire for cash returns – and takes the decision away from the shareholder. “Investors would prefer to be the ones choosing how to apply this cash.
” The trouble is also that the company could be signalling to the market that it no longer has growth prospects, or that it has run out of good ideas for expansion, says Nedbank retail analyst Syd Vianello.
Then there is the risk of abuse. Lehman Brothers, for example, was on a stock-buying spree in the run-up to the financial crisis, perhaps partly because it was hoping to convince the market that all was well within the financial institution. “With the benefit of hindsight, shareholders would have preferred dividend payouts rather than share repurchases,” says Stout. “That way they would have extracted some monetary value before it went bankrupt and their shares became worthless.”
Kooyman argues that share repurchases “effectively are an effort to manipulate the share price. By reducing the number of shares in issue, one is upsetting the supply-demand balance, which will eventually push up the price”.
He is not alone in his concern. Other critics point out that management, whose compensation is linked to the share price, might prefer share repurchases over special dividends, seeing as the former boosts demand for the stock and therefore the price, while the latter reduces the book value of the firm.
In most option schemes there is no adjustment to the strike price in the event of a buyback. So managers are likely to be more enthusiastic about buybacks than dividends for that reason. Most fund managers say they would like to see more option schemes that include an automatic adjustment to the strike price in the event of a buyback, to remove this incentive for managers. But the less cynical would say that an enhanced share price is good for shareholders, too. What’s more, strict rules and limitations relating to company purchases of its own stock are designed to prevent any ill-motivated manipulation of the share price.
The practicalities of share repurchase schemes pose both benefits and constraints, for the company and shareholders alike. Precisely because the company would be avoiding an aggressive buying spree, the execution could be drawn out.
The salvo of share repurchases announced so far this year in the US, for instance, is unlikely to translate into immediate and extensive stock buying, as companies would be treading with care across a still-troubled market terrain.
Vianello identifies another limitation: companies with low trading liquidity are restricted in their ability to implement large-scale share repurchases, as these would crimp the free float further. Unlike a dividend, of which the shareholder is a passive and automatic recipient, a shareholder wishing to receive the cash implied in a share repurchase would need to make the active decision to sell stock – with the added burden of trading costs.
Van der Walt, who stresses that the choice between a special dividend and share repurchases depends on company circumstances, lists some of the virtues of the former relative to the latter. “Unlike a share buyback scheme, a special dividend can be declared and executed quickly, is highly visible and treats all shareholders equally. It also avoids the market risk associated with a repurchase, in the sense that it can be distributed at any price-earnings level, without destroying shareholder value.”
However, whereas a share repurchase plan requires shareholder approval, shareholders have no say in the company’s decision to declare a special dividend – or, for that matter, an ordinary dividend. There is also the matter of shareholder perceptions and expectations. “In the case of a company which declares special dividends frequently, shareholders come to expect the payout. This creates the risk of market disappointment if they do not materialise,” says Van der Walt.
Related to this, a spate of special dividends alters a company’s dividend growth history, complicating an assessment of its dividend-yield potential. Tax considerations may play a role in the decision, although this is less of a consideration in SA than in, say, the US. When opting for dividends, companies are liable for secondary tax on companies, at a rate of 10%; the shareholder is exempt from any dividends tax, says Billy Joubert, head of transfer pricing at Deloitte.
Although the new dividends tax will shift the burden of taxation onto the shareholder through a withholding tax mechanism, “the timing of the introduction of the new mechanism is by no means clear”. For the company, the tax implications of a share repurchase depend on how the funds are derived. If the distribution is funded out of retained earnings, it is treated as a dividend payment and taxed accordingly. If, however, it is funded from share capital or from the share premium, the distribution is taxed as a capital gain in the hands of the shareholder.
Typically, then, a share buyback might be more tax efficient from a company perspective than a dividend payment. From an investor’s viewpoint, Cannon’s Saville is equally enthusiastic about special dividends and share repurchases, referring to empirical evidence of strong market response to both.
Significantly, though, markets respond quickly to a dividend announcement – in both directions – but react with a lag of three to six months to a share repurchase announcement. Nevertheless, “allowing for modest lags in market response, share buybacks contribute to significant share price outperformance”, Saville says. As with dividends, this “is true through time, across countries, across industries and within a company’s own history”.
The sluggish market response to share repurchase announcements does have the potential to create pricing inefficiencies, and therefore a temporary opportunity for outperformance, Saville says. Though these are universal investment features of dividends and share buybacks, they can not be treated as principles, he warns: a positive share price response to the intended return of excess cash to shareholders is no guarantee of positive performance over the longer term. Investors in Anglo American, Lehman’s and General Electric can attest to that.
By Erika van der Merwe
30 | IM | October 27 – November 23 2010
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