QUALIPORT
The Basics Of Buybacks

By Maynard Paton (TMFMayn)
April 26, 2005

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 could be generating excess cash, which is always reassuring to know.

Though share buybacks may be unimaginative and boring to some (including a few company directors), unimaginative and boring traditionally make for a good long-term investment. To see whether a particular quoted company is buying back its shares, check out the Fool's Company Announcement Service. Statements headed 'Transaction In Own Shares', 'Purchase Of Own Shares' or similar tell of buybacks.

Basics

Here's a rundown of the share buyback basics:

* A listed firm must obtain shareholder approval before purchasing its shares in the open market, with (non-binding) authorisation sought and renewed each year at the annual general meeting.

* Company law restricts the amount of share capital that can be acquired during a twelve-month period to 15%. However, companies tend to impose their own tighter restrictions (typically 5% or 10%).

* Share buybacks can only be funded out of 'distributable' profits (i.e. past cumulative earnings, which also fund dividends). In practice, the cash comes from one-off asset sales, existing cash piles or, most attractively, ongoing free cash flow. In addition, some companies effectively borrow money to buy back their shares to (supposedly) increase their financial efficiency.

* Following a rule change in December 2003, listed companies buying back their own shares are now able to hold those shares 'in treasury' rather than have to cancel them immediately.

* Shares held in treasury have two advantages over cancellation: they can be subsequently sold for cash (e.g. through a rights issue) and, unlike new shares, the proceeds can be re-credited to the company's 'distributable' reserves. Furthermore, the administration and listing costs of re-issuing treasury shares is lower than issuing completely new shares.

* Shares held in treasury do not have voting rights, do not receive dividends, are ignored for earnings per share and net asset value calculations and are excluded in the determination of a 'notifiable shareholding'.

* Up to 10% of a company's share capital can be held in treasury. Shares held in treasury can be cancelled at any time.

Financial effect

The financial effect of a share buyback is illustrated in this simple example. In brief, a buyback can be seen as a substitute for dividends and an as alternative way of delivering shareholder value; companies choose to reduce today's share count and investors (in theory) benefit when tomorrow's share price reflects a greater improvement to earnings, dividends and net assets per share. Read more.

Watch list buybacks

Among the companies on the Qualiport's watch list, only three have buybacks recorded in their latest accounts:

Company	Year to	Share buyback (£m)	Dividends paid (£m)
ABP (LSE: ABP)	Dec 2004	95	50
GlaxoSmithKline (LSE: GSK)	Dec 2004	1,000	2,475
Vodafone (LSE: VOD)	Nov 2004	2,789	1,374

Following the appointment of Bo Lerenius as chief executive in 1999, Associated British Ports has disposed of many 'non-core' assets and returned cash via buybacks. Since January 2000, buybacks have totalled £185m (comparable to the £232m of aggregate cash dividends distributed over the same time) and a further £115m for purchases is earmarked for 2005 and beyond.

GlaxoSmithKline announced a £4b share buyback programme in October 2002. In 2003 and 2004, £2b was used for purchases and all of it came from operating cash flow (a further £4.8b of cash was paid in dividends over the same time!). For the record, £1b of annual buybacks diverted instead to dividends would lift Glaxo's full-year payout from 42p to 60p per share.

Vodafone instigated a buyback programme in 2003 and purchases for the year to March 2005 came to £4b -- and entirely from operating cash flow. With the telecom group expected to double its forthcoming final dividend, the full-year payout will cost approximately £3b. At Vodafone, a £4b buyback is equivalent to over 6p a share; the expected annual dividend is worth 4p.

(Watch list share Imperial Tobacco (LSE: IMT) is also worth a mention. It launched its share buyback programme in February this year and intends to spend up to £200m by November. Imperial's dividends currently run at £373m per annum.)

FTSE buybacks

The generous buybacks at Glaxo and Vodafone are part of some bumper buybacks currently being witnessed within the FTSE 100 index. Other blue chips with sizeable purchase programmes include:

Company	Year to	Share buyback (£m)	Dividends paid (£m)
BP (LSE: BP.)	Mar 2005	* 8,343	* 6,372
AstraZeneca (LSE: AZN)	Dec 2004	* 2,212	* 1,378
Diageo (LSE: DGE)	Dec 2004	403	832
BAT (LSE: BATS)	Nov 2004	492	823

(* denotes US dollars)

So far in 205, total FTSE 100 buybacks have come to £4.7b (BP and Vodafone alone account for £3b). Assuming the rate of purchases remain steady, this year's blue chip buyback expenditure could top £15b. Aggregate FTSE 100 dividends are about £36b at present.

Finally, a bad buyback

Despite the general positives of surrounding a buyback programme (sensible management, reliable cash generation, and so on), do be aware individual purchases don't always go on to create shareholder value.

Take Qualiport watch list member Games Workshop (LSE: GAW). It spent over £5m buying its own shares at 450p on 7 September 2001. Three weeks later, the shares touched 313p. Sure, bad luck played a part there.

But then the company spent another £4m buying its shares at 600p in April 2002. Three years on, a recent profit warning has sent earnings into a tailspin and the shares crashing down to 455p! (Sadly, these were relatively significant buybacks; Games Workshop generated earnings of almost £13m in the year to November 2004).

More: The Beauty Of Buybacks | Buybacks Indicate Cheap FTSE

Maynard owns shares in Associated British Ports, Games Workshop and GlaxoSmithKline.

Portfolio value

Holding	Number of shares	Closing price 25/04/05 (p)	Value (£)
Associated British Ports	681	469.75	3,199.00
Emap	372	815	3,031.80
Halma	1,920	154	2,956.80
Johnston Press	1,608	522.5	8,401.80
London Stock Exchange	2,018	465.5	9,393.79
Cash			207.07
Total			27,190.26