Buybacks to drive ASX in 2018 - South 32 Focus

Rodney  Forrest

The ASX currently has ~121 companies undertaking share buybacks. The top 22 companies (in size of buyback) have a planned buyback program of $7.73b.

When you step back and consider this, it is an all-time record for the ASX.

As the table shows, there still remains $5.03b to buyback or 65.1% of the targeted investment to complete, ranging from $1.5m by ANZ Bank (ANZ) to $960m by South32 (S32), a company we will discuss in more detail shortly.

Source: ASX Announcements, Bell Potter, Coppo Report

Compare this however to the United States who in 2018 will spend over US$800 billion on buybacks (according to J.P Morgan), which is an all-time record. This is up from US$517.7b spent in the trailing last 4 quarters, as shown in the table below. According to Goldman Sachs, over $200 billion of buybacks are due to the "Trump" repatriation law changes. One company alone, Wells Fargo, has a $22b buyback in place, some three times the total of the ASX buybacks.

It is also important to note that for the SP500 the buybacks as a % of the SP500 index represents 3.3% (Index size US$24.45 trillion), which is some six times higher than the ASX buyback program, as it is only 0.41% of the total ASX Index (index size AU$1.88 trillion). A significant gap for the ASX to close!

Buybacks are incredibly important to EPS. U.S. firms have spent roughly $4 trillion on buybacks since 2009, which according to US capital management firm Artemis’s calculations, buybacks have “accounted for over 40% of the total earnings-per-share growth since 2009, and an astounding +72% of the earnings growth since 2012.

Could we then say the relative underperformance YTD of the ASX in 2018 (-2.01%) to the SP500 (+2.00%) is due in part to the strength of the US undertaking buybacks? Why do a buyback? How do buybacks provide benefits? What do the World’s Investment Masters have to say about buybacks? When should it be done compared to intrinsic value? Could ASX companies do more buybacks? These are all questions we will look to answer.

So first, let’s look at what the World’s Investment Masters have to say about buybacks, from without question the greatest collection of teachings and wisdom of successful investors at (VIEW LINK) - a must read site built by an experienced 25yr Australian Investment Banker.

“Repurchases are sensible for a company when its shares sell at a meaningful discount to conservatively calculated intrinsic value. Indeed, disciplined repurchases are the surest way to use funds intelligently. It’s hard to go wrong when you’re buying dollar bills for 80c or less. But never forget: In repurchase decisions: price is all important. Value is destroyed when purchases are made above intrinsic value”

"I look more favourably if a company is doing significant buybacks. That actually adds something to the equation for me. The dividends particularly are not of interest"

"Buying back shares is the simplest and best way a company can reward its investors. If a company has faith in its own future, then why shouldn't it invest in itself, just as the shareholders do?"

"Boards that authorise share-repurchase initiatives at market prices below what the businesses are intrinsically worth per share (without foregoing investment in even more compelling growth opportunities and with due regard for the financial security of the remaining shareholders) are clearly putting the shareholder's interest high on the priority list"

The above is very compelling evidence on buybacks. What I do believe Buffett hints at here, is that buybacks are also a proxy for management discipline. Often, managers flush with cash elect to use that cash to acquire other firms or invest in new ventures that are speculative or unlikely to earn an acceptable rate of return (that is, a return above some hurdle rate). These sorts of reckless investments often destroy shareholder value. For example, a variety of studies have shown that between 70–90 percent of mergers fail to create value for shareholders

There have also been many comprehensive research papers that have been conducted on buybacks. We show below the findings from three key reports.

The first, a recent November 2017 research paper by the London Business School and AQR Management on a study of the US Russell 3000 Index from 1990 to 2017 found the following:

  • Current levels of aggregate share repurchase activity for the Russell 3000 show we are not even at all time highs and yields are below pre-2008 levels at around 3.0%, given the peak was 4.1%;
  • Academic evidence suggests that the announcement impact on returns immediately post a buyback annoucment is 2% on average, then an annualised gain compounding of 1-2%; and
  • Share repurchase critics will argue that share repurchases are designed to “artificially” increase EPS. The problem it raises with this argument is that it ignores the fact that decreased cash means lower earnings, either due to less interest earned on the cash or the loss of returns from other uses of the cash.

Second, the comprehensive study by Credit Suisse comparing buybacks and Dividends called “Disbursing Cash to Shareholder,” found:

  • When surveyed, three-fourths of CFOs cite increasing EPS as an important or very important factor in the decision to buy back shares;
  • Buybacks offer more flexibility than dividends because they allow the shareholder to control the timing of taxes. A shareholder can choose to hold on to her shares instead of selling them back to the company, hence deferring a tax consequence. The same shareholder who receives a dividend in a taxable account must pay taxes at that time. This is significant; and
  • … wait for it any companies buying back between 0-5% of their shares (which is far more common and makes up most of the dollars spent on buybacks – shown below) don’t display nearly as strong a pattern. So, you need to find companies that buyback > 5% of market capitilisation (yield).

SP500 Companies by Buyback Yield

And finally, O’Shaughnessy Asset Management published a detailed paper titled “The Power of Share Repurchases,” concluding:

  • One of the most effective stock selection strategies in the U.S. over the past several decades has been to buy stocks that are in the midst of repurchasing significant quantities of their share;
  • Investors should focus on “net” buyback yield, which takes share issuance into account rather than “gross” yield which does not and only buy if the company is trading at a discount multiple; and
  • The table below shows the returns from the buybacks are best when a company is in the bottom quintileon Value (1) with the highest yield (5), which generates +15.3% returns. This compares to expensive valuation quartile (5) and low yield (1), which generates +3.5% return. It is clear then that investors should avoid buying stocks trading at very expensive multiples, no matter how significant their buyback programs.

All the combined evidence shows the multitude of benefits by conducting buybacks. However, one of the largest benefits, which all three papers mention extensively is EPS accretion.

In my example of EPS dilution/accretion, I will step through the EPS logic.

Firstly it depends on the relationship between the after-tax interest rate (either foregone from cash or incurred from debt) and the inverse of the price/earnings (P/E) multiple. Since the appropriate P/E multiple for a stock reflects factors other than the discount rate, including growth prospects and incremental return on invested capital, the accretion or dilution says little about the virtue of the program. Say a company has excess cash that is earning 3 percent and has a tax rate of 30 percent. You can calculate the “EPS breakeven P/E” with the following equation.

So therefore in this case the EPS breakeven P/E multiple is 48 (1/[0.03 *0.70]). This means that any buyback below a 48 P/E will add to EPS, and any buyback above 48 will subtract from EPS. Say the same company decides to fund the buyback with debt that has a pre-tax cost of six percent, the EPS breakeven P/E multiple is 24 (1/[0.06 * 0.70]), so a buyback below 24 P/E will add to EPS. With prevailing interest rates as low as they are and with P/E multiples on forward earnings near historic averages, buybacks are currently a bonanza for EPS accretion. Compared to the US it is suprising the ASX does not have more.

So why aren't more ASX companies doing buybacks? This is a clear question we continue to ask ourselves as the evidence above shows Australia significantly under-indexes compared to the United States on buybacks. It may be an opportunity for Turnbull to revisit Transfer Pricing regulations in Australia and enable benefits of repatration for Australian listed companies, or for companies with strong balance sheets to look at options to growth through a buyback.

South32's (S32) has the largest buyback on the ASX by amount. With a total $1.5b to buyback (6.3% of market capitilisation), there are many reasons for the buyback:

  • It is a diversified miner with strong fundamentals – It is in the top 30% of all ASX listed companies on an equal weight of growth (YOY), profitability ratios (EBITDA/NPAT), and debt profile. Further, commodities are at a 50-year low based on the ratio of GSCI/S&P500 (Gundlach/Tudor research);
  • Aluminium smelting and alumina refining assets are in the bottom half of their respective industry operating cost curves;
  • The highest-quality operations are the Australian manganese and Cannington silver/lead/zinc, both of which are in the lowest-cost quartile of the cost curve and have historically generated solid returns;
  • It is currently one of only two ASX listed manganese ore producers;
  • Net cash positive at the latest update to market with cash surplus of $1.4b;
  • Historical return on capital is 11.4% - unique for a miner;
  • FY17 free cash flow from operations of $1.5b, with H1FY18 free cash flow in our opinion now at the bottom of the cycle given it was hit by unique weather impacts at South Africa Coal, non-cash items that will now be cycled ove, and working capital to unwind in H2FY18;
  • High management quality. The CEO is ex CFO of BHP and the board are experienced miners;
  • For the last twelve months, some analysts have been gradually revising upwards their EPS forecast for the upcoming fiscal year. UBS has FY19 forward P/E of 10.1 and an impressive Dividend Yield of 6.2% (before franking credits) with 19.3c per share;
  • The buyback has been happening up to $3.51, yet the current share price is $3.38. It is also currently 19% down from its peak share price of $4.02, only some 60 days ago;
  • It is trading at a low x4.5 Acquirer's Multiple (a valuation tool we have written about before), given Mkt Cap ($16.4b) - Cash ($1.4b) + Debt ($0b) with trailing EBITDA $3.3b; and
  • S32 has a Ben Graham valuation of $5.31 where the formula is (V= (LY EPS x(8.5+2G)x4.4)/(AU Bond 15 yr Yield), which is $0.29x(8.5+8)x4.4)/3.96%, as we have added 100bp as a risk to the yield.

So, when you bring S32 back to the tests of some the Investment Masters, it appears to trade significantly below intrinsic value. It is also funding the buyback through free cash flow, not debt. There's also the potential for a re-rating on the back of higher commodity prices, which could give more upside.

It may also be that for any company undertaking a buyback that a powerful variable to consider is that a company must have asymmetric information to profitability pursue a buyback approach, as company management has information that the stock price fails to reflect.

It could therefore be worth considering watching these 22 ASX companies with buybacks in place. As O’Shaughnessy Asset Management research found, seek out those with high buyback yields and trading below intrinsic value to offer the best returns.

------------------------------------------------------------------------------------------------------

Sources:

J.P. Morgan's has an $800b list of Buybacks but lists its top 50 stocks that it selected based on five criteria; cash held overseas; net income growth over the next two years; last 12-month buyback announcements as a percentage of market cap; last 12-month net buyback yield; market cap greater than $20 billion. The list includes Dow components Boeing Co. (BA), Coca-Cola Co.(KO), Procter & Gamble Co.(PG), Johnson & Johnson (JNJ), Citigroup Inc. (C), American Express Co. (AXP), Goldman Sachs Group Inc. (GS), Mircrosoft Corp(MSFT), Apple Inc.(AAPL), Cisco Systems Inc. (CSCO). and Intel Corp.(INTC)

A study by KPMG International (1999) found 83 percent fail to create shareholder value, a study by Bain & Company (2004) found 70 percent fail, and a study by the Hay Group at the Sorbonne (2007) found 90 percent of mergers in Europe failed to add value

General advice disclaimer: The information contained is general information only. Any research should not be interpreted as one that provides personal financial or investment advice. Past performance is not a reliable indicator of future performance. No person, persons or organisation should invest monies or take action on the reliance of the material contained in this, but instead should satisfy themselves independently (whether by expert advice or others) of the appropriateness of any such action. Forrest Equities Pty Ltd, holds S32.

------------------------------------------------------------------------------------------------------


Rodney  Forrest

Forrest Equities conducts sell side research for Investment Banks. Rodney has 15 years Finance experience with postgraduate degrees in Economics/Econometrics, Finance, and Taxation Law.

Expertise

ASX:S32

Comments

Please sign in to comment on this wire.
Avatar fallback

Gregory Norman Dunn

Excellent article -- outstanding research

Join the conversation