Share buybacks and special dividends

Article #501 by Edward Rizzo - Published Weekly

In my 500th article last week I had mentioned that one of the topics I covered in an article several years ago related to the concept of a share buyback which is used as an alternative or in conjunction with special cash dividends to distribute excess cash to shareholders.

A share buyback entails the purchase by a company of its own shares and since the number of shares in issue declines as a result of a buyback and a subsequent cancellation of shares, the profit or earnings per share rises for the benefit of all investors who maintained their stake in the company. Essentially, the company’s profits are distributed among fewer shares which should translate into a higher share price. A share buyback is normally taken as a signal to the market that the company’s shares are believed to be undervalued. Share buybacks are very popular across international financial markets but never took place in Malta.

When is a company considered to have excess cash or in a position of low leverage? The common measure used across international financial markets is the net debt to EBITDA multiple. I had published an article about this concept some time ago when I had explained that it is also one of the main ratios used to analyse debt issuers to gauge whether they can easily sustain their debt obligations.

The use of the net debt to EBITDA multiple as a measure of surplus capital was very evident a few weeks ago when Diageo plc, the world’s largest distiller which produces various spirits under a wide range of brands including Johnnie Walker and Smirnoff, announced a GBP1.5 billion share buyback. The CEO of Diageo stated that the stronger cash flow generation and improved financial results had “brought our leverage down below where we want it to be”. The articles across the international media as well as the company’s publications showed that the ratio used for the measurement of surplus capital was the net debt to EBITDA multiple. Diageo’s net debt to EBITDA dropped to 2 times, below its target range of 2.5 to 3 times.

There are various other examples of such buybacks and special dividends internationally.

InterContinental Hotels, one of the world’s largest hotel operators with 1 million rooms, has a capital-light strategy since it is mainly a hotel management company rather than having ownership of properties. The company generates a significant amount of cash and as a result of its low capital outlay and its strong metrics (it has a net debt to EBITDA of 2.5 times), it paid a special dividend of USD400 million last May and recently raised its ordinary dividend by 10%.

Also in May, Compass Group, the world’s largest contract catering company, announced a GBP1 billion special dividend. The Group had taken the view that it is under-leveraged and in fact the special dividend was funded by taking on additional debt after it had examined various opportunities for acquisitions which had not been suitable at the time. Compass Group retained a policy of a net debt to EBITDA of 1.5 times and instead of maintaining the cash pile or using it on projects with a low probability of an attractive return, the company opted to distribute a special dividend to shareholders.

Very often, there is pressure from certain shareholders or activist investors for companies to announce share buybacks or special dividends. Earlier this year, Nestlé announced it would buy back up to CHF20 billion in shares, only a few days after the US activist investor Daniel Loeb took a stake in the world’s biggest food company and called for a shake-up. Likewise, Unilever’s €5 billion share buyback announced in April 2017 was triggered after it fended off a USD143 billion takeover approach from Kraft Heinz, the US food company.

In Malta, no share buyback has ever taken place although some companies had actually obtained approval from shareholders via general meetings to conduct such a buyback if the need arose.

Some investors still believe that the local equity market is rather illiquid making it difficult for the larger shareholders to liquidate part or all of their position. A share buyback could prove to be a good strategy for assisting such investors to liquidate their positions always if the company’s financial situation permits this.

On the other hand, a common problem that may be overlooked with a share buyback in Malta would be the free float restriction. If a company conducts a buyback and the shares are acquired from the investing public rather than from a controlling or a significant shareholder who has representation on the board of directors, the percentage of shares in free float would shrink and could result in a company’s free float to drop below the limit of 25%. Several Maltese companies could therefore be possibly prohibited from conducting a share buyback since six companies are already in breach of the free float rule.

As such, special cash dividends may be the only way for Maltese companies to distribute excess cash to shareholders. Some investors may recall that between 2004 and 2007, HSBC Bank Malta plc had distributed various special dividends to all shareholders since the bank had accumulated too much capital on its balance sheet. Likewise, FIMBank plc had also distributed a special dividend in early 2008 after it had generated a sizeable capital gain from the sale of its shareholding in its Indian associate company.

Some weeks ago, I had questioned whether Malta International Airport plc was correct in maintaining such a high cash balance (€36.6 million as at 30 June 2017) when it has such a low level of bank borrowings and generates over €40 million in EBITDA on an annual basis. As at 30 June 2017, MIA had a net debt of only €7.9 million and this is expected to be reduced to zero by the end of the year as a result of the significant improvement in profitability and therefore the accumulation of further cash. The airport operator is clearly in a situation where their financial leverage is very low indeed and additionally the company also has a high cash balance. Although it is fair to say that they may be looking at a significant capital expenditure programme should their planning permits be approved,  the company ought to take on debt to fund these investments in order to maintain a strong return on equity going forward. With an EBITDA generation of over €40 million, MIA could easily obtain the required borrowings to fund their investment programme.

While other Maltese equity issuers may not have such an evident high level of idle cash, there are three companies in particular with a very low net debt to EBITDA multiple and by international standards they should also be seeking on improving their financial structure to enhance shareholder returns.

In such circumstances, they should gradually increase their ordinary cash dividends to shareholders on a semi-annual basis and take on additional debt to fund any upcoming projects especially at a time of very low interest rates.

Maltese institutional investors need to adopt a more activist approach to ensure that company directors carry out certain changes to enhance shareholder returns. Maintaining an optimum level of debt on a company’s balance sheet is one of the key factors behind sustaining an attractive return on equity.

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