The Buyback Boost

Buyback of shares is the most eagerly awaited provision in the new Companies Bill.

A report on why it is so important.

On July 24, Essel Packaging Ltd announced its intentions to buy back 34 million equity shares (around 22 per cent of its paid up equity capital) at a price of Rs 225 per share as soon as the new Companies Act comes into force. And it is not the only Indian company planning to buy back its shares. Reliance Industries, at its annual general meeting, also said that it would consider buying back its shares. Bajaj Auto, Apollo Tyres and Jindal Iron are some of the other companies which have announced their intentions of buying back shares.

 

One of the most eagerly awaited provisions of the Companies' Bill being introduced in the current session of the Parliament is the buyback of shares. In fact, both corporations as well as investors are equally keen for this provision to come into force. But exactly what are buybacks, and what advantages do they offer to companies and their shareholders?

The concept: Buyback, which is common in the western countries, is a simple operation. A company, often uses its free reserves to buyback a portion of its shares. It then either extinguishes those shares, thereby reducing its equity, or retains them as treasury capital to be reissued at a later date. Either way, the floating stock gets reduced.

What makes buybacks so attractive to companies and their shareholders? "When a company announces a buyback," says J Rajagopal, managing director, Coopers & Lybrand "it sends very powerful signals into the market." Foremost among them is that the management has confidence in its business. At the same time if it extinguishes this equity then the advantage normally accrues to all parties involved. Since the buyback is invariably at a price higher than the ruling market prices, shareholders can sell out for a quick profit. The shareholders who choose not to sell out will gain too -- since the shares are being extinguished by the company, the earnings-per-share (EPS) of the balance rises by that proportion. In case the promoters abstain from the buyback, they gain since their own stake in the company increases proportionately. This effectively makes them stronger to combat hostile takeover bids. Above all, the stock itself is rerated and often gets a higher discounting.

Buybacks are attractive to corporations for several other reasons as well. One is that a buyback operation is an excellent defense for a fundamentally sound company whose stock is being hammered down by bears. Currently, companies can only watch helplessly when their shares are being hammered but once buybacks become a reality, they can easily counter the bears.

Another advantage is that it allows companies to invest surplus funds advantageously compared to investing in other companies. It would help corporates to productively use excess funds generated from specific projects. Some analysts also feel that buy-back will ensure that companies (which invest their funds in intercorporate deposits) stick to their core business as these companies will channelise their surplus funds in their own shares rather than in some other business.

To get a feel of the benefits of buy-back, let's look at the US-based company, Hershey Foods. The company had announced a series of share buyback programmes between June 1993 and February 1996. During this period, the company acquired 14.9 per cent of the shares outstanding against an announced target of 19.8 per cent.

The methods of repurchase were open market operations and negotiated private deals with a block holder. A part of the shares have been extinguished and the rest maintained as treasury stock. The results of the buyback on the Hershey stock has been phenomenal. The five year share price compounded annual growth rate (CAGR) outperformed both the S&P Food and S&P 400 indices. The market value of the company increased by 63 per cent over the three year period. The price-earning ratio declined sharply on announcement (because of the cash outflow) and again declined in 1995 (when large repurchase got executed) and has since risen to a level higher than 1994.

The buyback candidates: Who among the Indian corporates would be interested in a share buyback their own shares? Apart from the big companies that have already announced their intentions, there are dozens more to whom this would be an attractive option. According to some estimates, even in the current bull phase, more than 70 per cent of the listed companies, especially in the B1 and B2 categories, are traded below their intrinsic worth. Theoretically, all companies in this list with enough free reserves can easily go in for

buyback to boost the values of their stocks.

Of course, not all of them are potential buyback candidates. For one, only those companies with adequate free reserves can go in for buybacks because of the safeguards in the Companies bill. Then again, many are anyway small cap stocks, and they are unlikely to reduce their already small equity bases. Finally, even some of the companies with enough free reserves might find better ways to utilise that money -- for their expansion plans, for example -- instead of embarking on a buyback operation. The critical factor, therefore, will be cash -- or rather how much cash a company has after making allowances for its current needs and expansion plans, which it can utilise for the buyback operation. Because it will have to fork out hard cash for the buyback operation. That, in essence, is the eliminating factor.

That still leaves a sizeable number of companies though that will contemplate buybacks in the near future. Many of the large cap companies, which have no immediate expansion plans in the offing, and have also accumulated sizeable free reserves, might increasingly go in for buybacks. In fact, some market players feel that companies which had no other avenue of rewarding shareholders except issuing bonus shares might also go in for buybacks if they have enough cash in hand. (While both the operations are meant to reward shareholders, the critical difference comes in this way: in both cases, reserves are utilised in buybacks, the shareholder actually gets cash in hand while in bonus, the reserves are capitalised and shareholders receive bonus shares instead of cash.)

In fact, during bear phases, many companies might be tempted to go in for buybacks to boost confidence back in the stock. Says Shailesh Haribhakti, partner, Haribhakti financial services: "The buyback operations will help the Indian capital market and boost investor confidence in these companies and see their portfolios attain their true worth."

The safeguards: To make sure that the buyback options are not misused by company managements and promoters (for example, a promoter can corner shares earlier and then announce a buyback at a high price and sell out), the Companies Bill has built in several safeguards. As per Section 68 of the Companies Bill '97, a company can buy back its shares from out of its free reserves, share premium account by passing a special resolution to the effect in the general meeting.

The company buying back its securities has the option to cancel it or hold on as treasury shares (if it intends to reissue these shares) but with the restriction that they cannot be reissued before 24 months after repurchase. The company is required to maintain a register giving full details about the repurchased shares and file with the registrar a return containing such particulars. In case of default (non compliance) the officer of the company who is found guilty is punishable with an imprisonment upto two years and / or a fine of Rs 10,000.