Corporate Finance: The Buyback Yo-Yoanza

A strong management, a happy shareholder, a robust strategy, and a healthy company. That is what the buyback promises to deliver if it is used strategically.

They can, finally, buy back their future. Corporate India wants to decide its fortunes, build strategic moats, drive out its foreign rivals, and be certain of its tomorrows. That is the big, bold promise of the buyback--a technique that has taken as many as 37 months, 2 governments, and incessant lobbying to fructify. It even promises to create a new future: where shareholders will be rewarded generously, where financial profiles will emerge stronger, where market capitalisations will reflect the intrinsic strengths of balance-sheets, where companies will not have to bother about M&A marauders

Deceptive in its looks, the buyback has the potential of becoming a management, rather than a financial, tool. For, the buyback reflects a corporate's faith in its financial abilities, its strategic goals, and its knowledge-base. It sends the unequivocal message of value-consciousness to the employee, the shareholder, and the customer. Although such a buy-in into one's strategy can be cheap--share-prices are ruling at their lowest levels in the last 5 years--there is no denying the fact that the buyback strengthens the voice of the majority in corporate boardrooms by consolidating shareholdings and quickening response- times. In an era where survival has become a pre-occupation, the buyback has become a potent weapon.

Yet, corporates may not enjoy the complete freedom to brandish it. Although the buyback norms announced by the Securities & Exchange Board of India (SEBI) on November 10, 1998--which fears that dishonest promoters could misuse the tool for personal gains--are stringent, the calculated use of the buyback can rake in the benefits. The sole qualification: adequate cash reserves. BT investigates this financial tool, and analyses if the buyback is really the CFO's best strategic option today.

Use the buyback to do that for you. Because it stands out among the other options: bonus issues, rights issues, and dividends. Each has its own limitations: share issues bloat equity capital, which has to be serviced forever, and dividends cannot escape taxes. Crucially, large dividends are not always sustainable, and smaller pay-outs erode share values. By contrast, the buyback not only returns cash to the shareholder, it also reduces the company's capital-servicing costs, and increases its Net Worth Per Share and Earnings Per Share (EPS) too.

In saturated markets, where investment opportunities have dried up, it makes eminent sense to reward shareholders. Although the argument may not hold water in a developing market like ours, there still are a number of sectors reeling because of over-capacity--such as cement, sugar, man-made fibres, and textiles--where growth is slow and returns are poor. Both the Rs 1,955-crore Century Textiles and the Rs 3,500-crore Grasim Industries have caches of reserves, but relatively poor growth prospects. If expansion, diversification, and modernisation do not generate adequate returns for them, they could well vote for the buyback. Cautions Hari Mundra, 48, the CFO of the Rs 6,500-crore R.P. Goenka Group: "Companies should go in for a buyback only if they are sure that they cannot exploit their market potential."

The buyback is a sound safety-valve too. Often, surplus cash-reserves tempt CEOs and CFOs to venture into risky investments and unrelated businesses. But it is also true that cash outflows can hamper a corporate's investment capability by increasing its gearing-ratio and reducing its reserves. Regulation is the biggest bottleneck, though: the SEBI's rules do not allow companies to issue fresh shares for 24 months after a buyback. Agrees Kishore Shah, 34, the CFO of the Rs 322-crore Balrampur Chini Mills: "The cooling-off period is not only too harsh, it is also unnecessary. A fast-growing entrepreneur will find that restriction the biggest hurdle in the buyback process."

Bank on the buyback to do that for you. CFOs hesitate to fund new projects with equity because it depresses share-values, and compels the company to service the new capital. With the buyback in their hands, they can now fund capital-intensive projects with equity, which can be shrunk later. For example, the Rs 1,706-crore National Aluminium Company's (Nalco's) equity-base of Rs 1,268 crore results in a Sales-To-Equity ratio of only 1.34 while the Rs 1,466-crore Hindalco's equity capital of Rs 75 crore translates into a Sales-to-Equity ratio of 20. Clearly, the buyback is a prescription for Nalco's ills.

An identical snapshot is provided by the fast-moving consumer goods sector . With an equity capital of Rs 136 crore, bloated by frequent bonus issues, the Rs 946-crore Colgate-Palmolive's Sales-to-Equity ratio is 7; its rival, the Rs 7,795-crore Hindustan Lever Ltd (HLL), has a ratio of 39. Although the figures provide a compelling case, the extent to which a corporate can decapitalise itself will depend on its free reserves and its post-buyback Debt-To-Equity ratio. As per the SEBI guidelines, the ratio should not cross 2:1. Points out Bharat Doshi, 49, the Executive Director (Finance) of the Rs 4,121-crore Mahindra & Mahindra: "That debt-equity ratio, in my opinion, is an ideal one because it will also protect the unsecured creditors of the company."

Count on the buyback to do that for you. When your company's shares are quoting below their intrinsic value--the book value, that is--a buyback can send signals out that they are undervalued. Statistical studies in the US--where $150 billion of buyback was announced in 1996--show that stocks soar after such announcements, and continue to rule high for a long time after. Returns On Net Worth (RONW) rise; so do EPS and Book Values. When a flagship company opts for the buyback, the impact can be felt across the group: the market-values of its sister companies rise too.

However, the buyback doesn't come cheap. To make a significant impact on their market capitalisations, companies will have to announce a large offer--at least 15 per cent of the equity capital--at an attractive price: at least 25 per cent more than the ruling market value. Agrees Jayant Basrur, 41, the CFO of the Rs 1,262-crore Lloyds Steel: "A token buyback of, say, 5 per cent will have little impact on the price if the floating stock is large."

Take the case of the Rs 1,024-crore Bombay Dyeing, whose shares quoted at Rs 50 on the Bombay Stock Exchange (BSE) on November 11, 1998. To buy back 20 per cent of its 410 lakh equity shares at Rs 65 per share, Bombay Dyeing will have to spend Rs 53 crore from its reserves. Of course, the payoffs will accrue in the long run because the post-buyback book value per share will go up from Rs 166 to Rs 170, the EPS will rise from Rs 5.60 to Rs 7, and the RONW will increase from 3.38 to 3.60 per cent. Agrees Balrampur Chini Mills' Shah: "Since value-boosting is a costly option, companies must conduct a cost-benefit analysis before taking the plunge."

Depend on the buyback to do that for you. If a company is quoting at a low price on the stockmarket, it can delist itself cheaply through a buyback, and re-issue its shares at a higher price after 2 years. Take the case of the Rs 104-crore TTK Prestige, where the promoters hold 60 per cent of its equity; the remaining being held by the public and the institutional investors. Now, TTK's scrip-price, at Rs 40 on November 11, 1998, is 34 per cent lower than its book value of Rs 60. This low valuation makes it attractive for the promoters to take the company private through a buyback. Since the SEBI guidelines stipulate that it should not consume more than 25 per cent of the free net worth (free reserves plus equity capital), TTK will have to buy back its shares in 2 stages.

First, it can purchase 20 per cent of its equity capital of 113 lakh shares at Rs 50 per share (25 per cent more than the market price), spending Rs 11.50 crore (17 per cent of its net worth of Rs 63 crore). Post-buyback, the number of equity shares and the free net worth will come down to 90 lakh and Rs 55.50 crore, respectively. Now, if TTK buys the remaining 23 lakh shares from the public at Rs 60 per share, its buyback bill will be Rs 13.80 crore (24 per cent of the remaining free net worth.

Companies that have deep pockets can easily buy back and re-issue shares in quick succession. If TTK re-issues 46 lakh shares at Rs 100 each, it could mop up Rs 46 crore--which is 81 per cent more than it spent on the buyback. Elucidates RPG's Mundra: "After going private, a corporate can even place shares with the private equity funds at a higher price."

Deploy the buyback to do that for you. The buyback is frowned upon because it manages the denominator (your equity-base); not the numerator (profits). Contrary to CFO beliefs, the buyback is an excellent tool for financial reengineering. In the case of profit-making, high dividend-paying companies whose share prices are languishing, buybacks can actually boost bottomlines. Remember: dividends are cash outflows, and also attract a 10 per cent tax. A buyback, and the subsequent neutralisation of shares, can reduce dividend outflows, and if the opportunity cost of funds used is lower than the dividend savings, the CFO can only be a winner.

Such thinking has prompted the Rs 877-crore Great Eastern Shipping Company (Gesco), whose shares were quoting at Rs 20 on November 11, 1998--a discount of 50 per cent on the book value--to opt for a buyback. If the company buys 20 per cent of its Rs 28.76-crore equity at Rs 25 per share, its buyback bill will be Rs 144 crore.

Since the company paid a 40 per cent dividend in 1997-98, its dividend and tax-savings on the extinguished shares will be Rs 25.30 crore (Rs 23 crore + Rs 2.30 crore). The opportunity cost of Rs 144 crore, when invested in tax-free and risk-free treasury bonds of the Reserve Bank of India at the rate of 10.50 per cent, will be Rs 15.12 crore. Gesco will, thus, save Rs 10.18 crore if it opts for a buyback. And this one-time equity reduction would lead to similar savings year after year until the company expands its equity again. Points out M&M's Doshi: "If you can directly boost the bottomline through the buyback, your benefits double."

The cheapest way to mop up stock is through a market purchase. But the regulator has made the process difficult: all such purchases will not only have to be notified to the stock exchanges, they will have to be advertised daily in the newspapers. And even when a company buys its shares through stockbrokers, the buyer's name must appear on the electronic trading screen. Since that identification will encourage sellers to demand a higher price, a company may be unable to seize the advantage of low market-prices.

Choose the buyback to do that for you. Are you worried about losing your company to a corporate raider because of your low equity stake? If you have already built some financial muscle, you have nothing to worry. True, the Takeover Code allows promoters to acquire upto 5 per cent of the equity every year, but that would soak up a promoter's own money or his subsidiaries' funds. The latter route is littered with hurdles: the shareholders of the acquiring companies may vote against the acquisition, realising that there is nothing in it for them. But when a company purchases its own shares in a transparent manner, the non-promoter shareholders are bound to support the move since they stand to gain too.

A buyback is, probably, the best defence in a takeover tussle. The Takeover Code allows a corporate to announce a buyback even after an acquirer has bid for it with an open offer. It can also work as a counter-offer or a competitive bid. All that a management has to do is pass a special resolution to purchase shares at a maximum price which the predator can never match. That is only a ceiling; it can actually be much lower. Expounds Jayant Thakur, 34, a Mumbai-based chartered accountant: "The intelligent use of the buyback by promoters can stonewall hostile takeovers."

Weapon? Or armour? Tactic? Or strategy? Clearly, the buyback is a flexible firearm in the era of corporate warfare. But the licence to defend, attack, or capture market value has little significance in an environment where the business value (what is perceived by the promoter) and market value (what the market decides) is large. So, any attempt to narrow the gap by using shareholder wealth is unlikely to fulfil the management's or the stakeholder's expectations. And with good reason since the buyback can make sound companies sounder, and the sick, sicker. Indeed, the buyback must be an intrinsic part of your business strategy. Unless you buy into that, the buyback may only prove to be a boomerang that will backfire on you.

HOW TO BOOST THE BENEFITS OF THE BUYBACK

The benefits of the buyback hinge on the size of the corporate coffers, the rationale behind a management's objective--capital restructuring, increasing market value, or warding off predators--the offer-price, and the mode of purchase. Without a clear-cut programme, the buyback will only be a blight on strategy--not a bonanza for shareholders.

ASSESS YOUR FINANCIAL CAPABILITY. If the Internal Rate of Return from investments in, say, expansion is more than the benefits derived from the buyback, avoid it. The buyback regulations also limit a corporate's financial capability. Post-buyback, the 2:1 debt-equity stipulation will stop high-debt corporates from purchasing shares; instead, they will have to use the money for retiring debt and reducing interest pay-outs. Besides, only 25 per cent of a company's paid-up share capital and free reserves can be employed for a buyback.

DECIDE YOUR OBJECTIVE. Top managements must be absolutely clear about the purpose of the buyback. For instance, if the objective of a buyback is to return cash to the shareholder, a corporate can also opt for a fixed tender offer at an attractive price. But if the aim is to support the company's share price, a market purchase is the best option.

CHOOSE YOUR BEST FUNDING OPTION. What can a corporate do if its free reserves are not large enough? It can encash its non-strategic investments by selling off non-core, or loss-making, businesses. When Lakme got Rs 200 crore by selling its brands and plants to Hindustan Lever in early 1998, it rewarded shareholders with a dividend of 1,200 per cent. Today, it could have resorted to the buyback. In fact, companies can even raise loans to purchase shares. But they must weigh the gains from a buyback with the opportunity cost of the funds deployed.

OFFER AN ATTRACTIVE PRICE. The buyback price will always hover between the market value and the maximum ceiling allowed by the shareholders. While the buybacks will have to be priced attractively within this range, the price will be decided by the purpose and the quantity of the buyback.

SEEK YOUR SHAREHOLDERS' APPROVAL. To seek the shareholders' approval, a special resolution has to be passed at an Annual General Meeting (AGM) or an Extraordinary General Meeting (EGM). The notice to the shareholders for the AGM or EGM must have the following details:

The purpose of the buyback.
The number of shares the company intends to purchase.
The total cost of the buyback.
The maximum buyback price.
The mode of the buyback.
The solvency declaration signed by the company's managing director and another director.
The post-buyback Debt-to-Equity ratio of the company.
The time-limit for the completion of the buyback.

FINALISE THE MODE. The buyback mode you choose will determine your success. It can be done through tender offers, reverse book-building (Dutch Auctions), and open-market purchases. In the US, the latter accounts for 90 per cent of the buybacks. But the SEBI's stringent regulations make this option less tempting.

Another cheap way is the Dutch Auction, where the company invites bids from willing sellers; the sellers get the first preference. Both the tender offer and the Dutch Auction--which involve an investment banker and an escrow account--are perceived to be transparent transactions. And because the offer price is at a premium over the market price, they allow the market value to move up in tandem.

Fearing insider trading, the SEBI has disallowed negotiated deals. This has curtailed a corporate's flexibility to buy out large shareholders. And reduced the buyback's potential.

THE LIMITATIONS OF THE BUYBACK

THE REGULATION

Post-buyback, shares must be extinguished within 7 days of their receipt
The post-buyback Debt:Equity ratio should not be more than 2:1
Buyback must be funded from free and share premium reserves or proceeds from previous issues
Buyback must be authorised by passing a specialresolution
Buyback cannot exceed 25% of the total paid-up capital and free reserves of a company
Shares can be bought through tender offers, open market purchases, and Dutch Auctions
Fresh issue of capital is not allowed within 24 months of buyback
The process of buyback has to be completed within 12 months
Promoters are not allowed to sell their shares if the buyback is through open market purchases
Buyback is exempt from the Takeover Code if there is no change in management after the purchase

WHAT IT IMPLIES

A company's share capital will stand reduced after the buyback
Companies with large surplus funds and low debt will be more eligible for buyback
Only funds which are used for dividend payouts can be employed for buyback
Buyback will have to be approved by 75 per cent of an AGM or EGM
There is no specific limit on the amount of equity purchase
Corporates have the flexibility of choosing the buyback mode suited to their requirements
Corporates can issue bonus shares or convert warrants and debentures
Companies are allowed to make multiple buybacks in one year
Promoters can use other modes if the price of the shares is disclosed in special resolutions
Promoters can raise their holdings in the company through the buyback

WHAT IT DOESN'T ALLOW

A corporate cannot hold on to shares or re-issue them whenever it desires to
A highly-leveraged company will find buyback a difficult proposition
Corporates cannot use funds from bond redemption or revaluation reserves
Without the shareholder's approval, buyback is just not possible
A small free net worth but large specific reserves make buyback a no-no
A negotiated deal, an important buyback mode, is not permitted
Companies cannot re-issue shares through rights or public issues for 2 years
Companies can be punished if they fail to comply with the time-limit
Such a stipulation will restrict manipulative buybacks
Promoters cannot take over companies through buyback