QUALIPORT
The Beauty Of Buybacks

By Maynard Paton (TMFMayn)
July 17, 2003

A share buyback is often good news for investors. Quite simply, the company in question is spending money on what it knows best -- itself. A buyback suggests the boardroom is not full of fanciful or aggressive expansion plans, which all too often cause misery for shareholders. A buyback also indicates the company has excess cash on its books, which is always reassuring to know.

Though share buybacks may be unimaginative and boring to some investors and company directors, unimaginative and boring traditionally make for a good long-term investment. And how do you know if a company is buying back its shares? Check out the Fool's Company Announcement Service. Statements headed 'Purchase Of Own Securities' or similar tell of buybacks.

Basics

What's the financial affect of a buyback? In City-speak, it should 'enhance earnings'. Here's how it works. Imagine a business with the following:

Operational earnings:  £1,000
Cash pile:             £1,000
Interest earnings:        £40
Shares in issue:       10,000
Earnings per share:      10.4p
Share price:              200
Market Value:         £20,000

The business decides to use the £1,000 cash pile to buy back 500 shares (at 200p each). If profits stayed flat, earnings per share (EPS) would come to 10.53p:

Operational earnings:  £1,000
Cash pile:                 £0
Interest earnings:         £0
Shares in issue:        9,500
Earnings per share:     10.53p

An earnings-enhancing buyback! In fact, with the cash pile generating a 4% return, earnings would have been enhanced had the shares been bought at anything up to 260p (10.4p / 4%).

But hold on.

Prior to the buyback, the company was worth £20,000. It's fair to assume the market valued the business in two parts: £1,000 for the excess cash pile, and the rest (i.e. £19,000) for the 'operational' side of the business. As such, the 'operational' price to earnings (P/E) ratio comes to 19 (£19,000 / operational earnings of £1,000).

So if the fortunes of the business remain the same after the buyback, the same operational P/E of 19 multiplied by the 10.53p of 'enhanced' EPS comes to... 200p -- the share price seen prior to the buyback.

Conclusion: forget all about 'enhanced earnings'. Buybacks will only provide a benefit if the market subsequently grants the company a higher P/E, or the company produces greater profits in the future. Though having fewer shares in issue will, of course, amplify any benefit.

Classic

Rentokil Initial (LSE: RTO) provides the classic example of a buyback. At the start of 2000, the services group made the decision to give up its growth strategy and dispose of various non-core businesses, with the proceeds of these disposals going towards funding a buyback. The next table shows Rentokil's progress:

Rentokil Initial
Year to 31 December                      2000      2001      2002

Shares purchased (£m)                  1303.8     277.9     234.6
Weighted average number of shares (m)   2,439     1,994     1,897
Shares outstanding                      2,083     1,950     1,861

Reported earnings (£m)                  285.6     265.2     284.6
Earnings per share (p)                   11.7      13.3      15.0

Earnings in 2002 were broadly the same as those reported in 2000, yet nearly £2b spent on a buyback caused EPS to jump 28%. Since the start of 2000, Rentokil's share price has remained broadly flat, which is commendable, given the wider market's performance.

So, a company spending a billion or two on a buyback will automatically make a good investment?  Not exactly.

Cable & Wireless
Year to 31 March                         2001      2002      2003

Shares purchased (£m)                       0     1,107         0
Reported earnings (£m)                  2,854    (4,954)   (6,533)
Earnings per share (p)                    105      (181)     (280)

Cable & Wireless (LSE: CW.) spent over a billion during 2001/02 on its shares, buying at an average of 262p a pop. Trouble was, things in 2002/03 got a whole lot worse for the telecom firm, which took the share price down to today's 120p.

Cable & Wireless demonstrates that well-intentioned directors can be wrong when initiating a sizeable buyback. Take note: no matter what the size of the purchase, if the company doesn't perform in the future, the buyback will count for little.

Watch list

As with most other companies, Rentokil and Cable & Wireless made regular purchases of their shares and thus benefited from pound-cost averaging. Some firms though make one-off purchases, which means running the risk of buying at short-term peaks.

Take Qualiport watch list member Games Workshop (LSE: GAW). It spent £5.5m buying its own shares at 450p on 7 September 2001. Three weeks later, the shares touched 313p. Sure, bad luck played its part there. But then the company spent another £4m buying shares at 600p one day in April 2002. Fifteen months on, the shares closed above 600p for the first time following the transaction. (To put the buybacks into perspective, Games Workshop generated earnings of £8.6m during that financial year).

So what of the other watch list members? The two that stand out buyback-wise are Associated British Ports (LSE: ABP) and Carpetright (LSE: CPR).

The installation of a new chief executive prompted ABP to sell off non-core businesses and fund a £150m buyback between 1998 and 2001. Meanwhile, Carpetright has reduced the number of its shares in issue by 9% over the past five years. Canny purchases were made between 1998 and 2000, when the shares often traded below 400p. More recently, £12m was spent buying shares at an average of 600p .

And is there a Qualiport company that should be contemplating a buyback? The London Stock Exchange (LSE: LSE) is probably top of the list. Final results from the Exchange showed a £211m cash hoard, which is undoubtedly earmarked for some sort of merger and acquisition activity. Spending the cash pile on the business it knows best is most likely to provide greater rewards to LSE shareholders.

The author owns shares in Carpetright, Games Workshop and London Stock Exchange.

More: Learn More About Share Buybacks