Share buy-backs

Share buy-backs are a capital management tool which companies can implement as an alternative way to return capital to shareholders with the potential benefit of providing share price appreciation and income.

What is a share buy-back?

A share buy-back is when a company uses excess capital to re-purchase some of its shares from existing shareholders with the aim of reducing the number of shares on issue, thus increasing earnings per share (EPS) with the potential benefit of share price appreciation. The use of share buy-backs increased in popularity from 1995, as provisions were made to remove red tape, while safeguards were put in to protect shareholders and creditors.

The below chart outlines total dividends and buy-backs for companies in the S&P/ASX 300 and while dividends clearly dwarf buy-backs, it is evident that buy-backs have grown in popularity, notwithstanding the significant volatility around the timing of buy-backs, particularly around major share market events such as the Global Financial Crisis in 2007/2008, when companies needed to preserve excess capital on their balance sheets.

A company may conduct a share buy-back for several reasons, including:

1. Use of surplus cash that is not being used for growth initiatives e.g. acquisitions

2. Boost shareholders returns – in the form of income and share price appreciation

3. Close the discount between the shares intrinsic value and trading price

4. Change the company’s capital structure

5. Reduce the dilutive effect if a company uses options and rights to remunerate staff.

Types of buy-backs

1. On market

This takes place when a listed company buys back its shares on an exchange in the ordinary course of trading. This approach is straightforward and simple whereby a shareholder sells their shares on the exchange. As such, a shareholder will not know if they have sold shares back to the company or to another market participant, namely another investor.  

The tax consequences for an on-market buy-back differ from an off-market one, it is treated as a normal sale for a shareholder who sells into an on-market buy-back.

2. Off market

The second type of buy-back relates to when a company tenders directly to shareholders. The buy-back does not take place via the exchange but rather the shareholder must make an election to the company to sell a portion or all of their shares.

The two main types of off market buy-back are:

1) Equal access buy-back – which is the most common and straightforward of off-market buy-backs, where a company offers to buy back a certain percentage of shares from all shareholders. The offer does not vary from shareholder to shareholder.

2) Selective buy-backs – is when a company makes an offer to certain shareholders in the company and thus does not make an identical offer to every shareholder. For a selective buy-back to take place, it must be approved by shareholders via special resolution which requires a 75% majority. Those shareholders who are included in the selective buyback are not eligible to vote on the resolution.

Given the different nature of an off-market buy-back, with a shareholder entering into a direct arrangement with the company, this results in a different tax treatment compared to an on-market buy-back. The difference relates to the portion of proceeds which are treated as a franked dividend and the portion which is treated as a capital return. Given the more complex tax implications companies often suggest shareholders seek tax advice before participating in an off-market buyback.

Off market buy-backs are often used by companies as a means to deliver excess franking credits to shareholders.

Buy-back rules

While there are a number of rules regarding buy-backs, one of the key rules to note is the 10/12 limit, meaning that a company can buy back up to 10% of the total shares on issue within a twelve-month period without seeking shareholder approval. For companies buying back more than 10% of the total shares on issue, they must seek shareholder approval (vote is passed by an ordinary resolution). The 10/12 limit does not apply to selective buy-backs.

Finally, companies must provide notice to shareholders and creditors (generally 14 days) and provide adequate time for shareholders to consider the buy-back.

Criticism of buy-backs

While buy-backs do have some key benefits being a reduction in shares on issue (which can lead to higher earnings per share) and likely share price appreciation, there are several common criticisms of buybacks:

1. Although buy-backs are a capital allocation tool that a Board has at its disposal, it may indicate to the market and investors that it does not have any growth opportunities that are worth pursuing.

2. Conducting a buy-back uses excess capital, which may be considered smart at the time, however if there is an economic shock such as the GFC or more recently the COVID-19 pandemic, a lack of surplus capital could place the company in a difficult financial situation.

One example of this was the large buy-back programs conducted by some major US Airlines. American Airlines spent ~USD$12.4 billion, while Southwest Airlines spent USD$10.7 billion on buy-backs since 2014, which placed their balance sheets in a stretched position heading into the COVID-19 pandemic. As international flights were grounded, these companies found themselves asking for debt relief and large low-interest government loans.

3. Buy-backs can potentially lead to higher executive compensation if the management team’s remuneration is tied to share price appreciation.

Finally, it is worth highlighting that although a company may use a share buy-back to return excess capital to shareholders, it could have implications for the company and investors over the longer-term. Thus, each buy-back should be thoroughly assessed on its merits against any potential impacts on the long-term growth prospects of the company.

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