In the latest US craze to hit the stock market, UK firms are handing large sums of money back to shareholders in the form of buy-backs. Can capital be better employed in their hands than those of company managements?
Strange happenings are afoot in the corporate jungle: shareholders are being given their money back - and in large lumps. Curious as share buy-backs and special dividends may appear, these extraordinary payouts are symptomatic of louder corporate rumblings. Many UK companies and investors are now pursuing an alternative system of evaluating company performance: share prices and capital allocations are being driven by factors very different from the much-abused earnings per share calculations. Shareholder value is the ultimate quarry and returning money to investors now appears a legitimate step in that quest.
Major UK companies, including Reuters, PowerGen, Boots and eight out of the 12 regional electricity companies, have all recently chosen to return money to shareholders by buying back their own shares. Guinness is considering the buy-back option; Barclays, the UK's largest domestic bank, is seeking powers to return any excess capital to investors in the form of share buy-backs; and retailer Wickes approached shareholders for the right to buy back up to 10% of its shares at the group's AGM in April. Great Universal Stores, the retail and finance group, handed back £300 million of its £1.5 billion cash pile in the form of a 30p per share special dividend to shareholders last November.
A company wishing to return abnormally large amounts of cash to shareholders - ie, larger than the normal dividend payout - can take one of two options: it can buy back shares or pay a special dividend. The effect is the same - more money in the hands of shareholders and less money in the hands of the company. A special dividend is the same as any other dividend but usually bigger, paid on a one-off basis and, unlike a share buy-back, the cash is distributed among all shareholders. Conversely, under a share buy-back only those shareholders who choose to tender some or all of their shares receive the cash. Yet, whether buy-back or special dividend, managements are growing to love them, investors appear to favour them, and City analysts and corporate financial advisers hardly have a bad word to say about them. But where has this latest craze to hit the stock markets come from, and who really benefits?
Like many crazes to hit the City, share buy-backs originated in the US. Following the 1987 stock-market collapse, more than 600 US companies, including Coca Cola, Walt Disney, Merck, McDonnell Douglas, IBM, Philip Morris, Kellogg and HJ Heinz, bought back shares. Last year buy-back programmes announced in the US amounted to $53.8 billion, second only to 1989's record of $61.9 billion. Today buy-backs remain popular and Eastman Kodak is considering a share buy-back or special dividend later this year as a follow-up to its disposal programme. Are buy-backs a straight admission that investors can do better in other companies and with other managements? Returning money to shareholders for them to invest elsewhere suggests so. But there is an obvious and immediate benefit to the company. As the number of shares in issue is reduced the earnings per share can be expected to increase, assuming the cash in the company was contributing little towards earnings. Given the stock market's focus on earning per share, shareholders can expect the share price of their remaining shares to move up as the market notes the improving trend.
But there are other reasons why share buy-backs are becoming the rage. One of these is the change in inflationary conditions. In the 1970s and 1980s cash tended to be in short supply. Large profit increases and apparently high returns on shareholders' funds were accompanied by escalating capital expenditure and high levels of stock and debtors. In contrast, in today's low-inflation environment there is limited need for more working capital which is only required if there is genuine organic growth in the business. In times of low inflation it is far easier for profits to turn into cash; as companies become more cash generative they have a correspondingly lower need for capital.
If low inflation can spell surplus cash what should a company do with its embarrassment of riches? If it simply holds on to cash, then at current interest rates of under 7%, the return from this investment is correspondingly low. Few investors will clamour to invest money in a company which will merely sit on it. One option is to return that capital to investors.
But the main reason that share buy-backs are drawing the attention of both investors and managers alike is the increased understanding of the concept of shareholder value. Put simply, no investor chooses to invest in a company if the return on the investment is less than that of a rock solid investment such as a government bond. Equity investors thus expect a premium to the 8-9% currently obtainable on government bonds. Even in the most established of companies, shareholders expect a return of at least 15% which therefore becomes the cost of capital to the company. Since funds lying around in bank accounts or financing underperforming businesses cannot achieve this rate of return, the solution is to give this poorly utilised capital back to the shareholders and only retain capital on which adequate returns can be earned.
Of course, the difficulty for investors - and managers - is understanding how well a business is doing. Traditional methods of performance measurement do not inspire confidence. Return on equity (ROE), which is calculated from profits and shareholders' funds, continues to be used, despite its hopeless susceptibility to manipulation, but the market is starting to understand that a company's investment is not the same as shareholders' funds and that profits do not adequately measure returns. Increasingly, sophisticated investors are improving their techniques of assessing how far shareholder value is either being enhanced (ie, achieving a return on capital in excess of 15%) or destroyed ( ie, achieving a return on capital of less than 15%). Analysts and consultants are perfecting new measures (see box, above), but the focus of most of such work is back to the old adage that profit is someone's opinion whereas cash is a fact. Cash flow rather than profit-based measures give the most reliable view of company performance. Of these, cash flow return on investment (CFROI) is becoming increasingly the yardstick by which sophisticated investors assess the performance of management.
Having worked out that a company is earning less than its cost of capital, the strategy for management should be clear-cut - return capital to shareholders who may be able to achieve better returns elsewhere. When this happens, companies benefit as shareholders realise that the capital which the management has chosen to retain can be expected to achieve appropriate returns. The effect of this strategy is then enthusiastic shareholders and a spiralling share price.
Giving money back, of course, goes very much against the managerial grain, particularly among the managers who captain the massive, headline-grabbing corporate super-tankers. Where, after all, is the fun or kudos to be had in shrinking their ship? Sadly, as the examples of British Aerospace (BAe) or General Motors (see boxes) prove, managerial megalomania does not always serve a company well. It is simply not that easy to buy one's way out of trouble. During a season of poor or ill-timed investments, including Rover and Royal Ordnance, BAe effectively destroyed shareholder value. Its share price performance only took a turn for the better in 1993 when its management ceased to throw good money after bad.
Indeed, the share price reaction when BAe shed its corporate jet business and construction division Ballast Nedam in 1993 and the following year sold Rover to BMW suggests an alternative way for investors to seek outperformance. If investors consider returns on capital at all, they typically look for a company whose returns are already consistently superior to its cost of capital. The BAe example raises another possibility: look for a company which is earning an inadequate return but is disinvesting. The result of this strategy is that less capital is needed and any excess can be returned to shareholders through dividends or share repurchases. By discontinuing unprofitable parts of the business or parts which are achieving an unacceptable CFROI, the capital base will shrink and the overall CFROI will be increased.
Coincidentally, this type of approach may lead management to concentrate on the core business, where the processes and economies are best understood, and divest peripheral activities. This change in focus reflects recent trends in UK and US corporate strategy and the notion that investors should make their own choice about diversifying their portfolios, rather than have managements do so expensively through acquisitions. It also tallies with the view that most managers are at best good at one activity.
Of course, one of the problems in pursuing a strategy to create shareholder value in a mature industry such as BAe is that it frequently involves actions which fly in the face of accepted strategic thinking. Managers may also fear that they will shrink the business to the point where some or all of them are redundant. The traditional way to raise returns in a mature business is to invest more, not less. If only we have the most advanced plant, managers reason, then we will become competitive. Wrong. In fact, the very act of investing more makes it harder to raise returns to the cost of capital and so create shareholder value, particularly in a mature industry in which growth opportunities are severely limited.
Investor opinion in the US endorses the view that shrinking through special payouts and buy-backs can pay off. Bartley J Madden of Harbor Capital Advisors, a US institutional investor, argues that there is one key aspect of managerial skill that affects shareholder value: its reliability in judging when it is beneficial to slow the firm's growth, or even reduce the size of the company. He cites the case of the stock market's enthusiasm for General Dynamics' decision to repurchase $1 billion of its stock. He believes that shareholders of companies in mature industries, such as defence, are generally best served when management is willing to return cash. The economy benefits, too, because investors can reinvest returned cash and thereby recycle resources into more promising growth opportunities.
Madden supports the view that over time, as a company grows in size and competition gains strength, then its ability to earn above-average returns decreases. Apple, for example, has found it more and more difficult to earn operating returns substantially above average as its asset base increased and growing competition reduced its profitability. Indeed, companies such as Eastman Kodak matured to the point where investors only expected average returns on investment.
Companies that have declined rapidly to the point where they have substantially below-average returns on investment have, he maintains, often contributed to their own decline through excessive investment. 'Management has a tendency to use the (often considerable) cash flows from its mature businesses to fund major investment programmes based on the assumption that the future will repeat the past,' he argues. Often a better policy is not to invest at all. In the late 1960s and 1970s, Bethlehem Steel embarked on a progamme of capital expenditure, unfortunately at a time when its rate of return was in sharp decline and the market was clearly calling for contraction. Bethlehem Steel's problems, says Madden, had more to do with over-than underinvestment. US giant Sears made a better decision, he believes, when despite below-average returns, it opted to reverse an earlier decision to diversify into financial services.
Madden's belief in the value of corporate shrinkage is supported by US research. A Yale study of 1,239 share repurchases from 1980 to 1990 reveals that those shares outperformed the market index by 12.6% a year for an average of four years after a share buy-back announcement. The Yale study may give heart perhaps to those UK companies teetering on the buy-back brink. Chief among those are the UK banks - a sector of inadequate returns and thus a prime candidate for shrinkage and the return of excess capital to shareholders.
At this month's AGM, Barclays' shareholders will be asked to vote in favour of granting it share buy-back powers. Barclays chief executive Martin Taylor won his business spurs at textiles giant Courtaulds, and it is hard to think of a more mature industry in which the management of capital is a prerequisite to delivering shareholder value than textiles. As UK demand for loans is currently insufficient to require the commitment of additional capital by the banks, and with peripheral businesses to divest, Taylor is in pole position at Barclays to raise returns and generate shareholder value by giving some capital back. However, if loan demand unexpectedly picks up, Taylor then has the option not to pursue the buy-back course, but to become embroiled in the bankers' usual game of chasing new business. Is giving it away such a tempting prospect?
Terry Smith is a partner at stockbroking research boutique Collins Stewart & Co and author of Accounting for Growth.