Some investors would be better selling on the open market, according to new research by Kim Wyatt and Jarrod McDonald
Over the last decade share buybacks have become an increasingly popular option for companies due to the relaxing of Australias share buyback legislation in 1995.
Buybacks enable companies to more efficiently manage their capital while returning surplus funds and distributing excess franking credits to shareholders.
The benefit to companies is better use of excess cash, and a buyback signals to the market that their shares are presently undervalued. Off-market share buybacks are also advantageous to shareholders, in that no transaction costs are incurred, making it a cost-effective way for smaller shareholders to dispose of their holdings.
There are two main methods of share buybacks: on-market and off-market. On-market share buybacks involve a company buying their own shares on the market and then cancelling them.
Off-market share buybacks have two main types; floating price and a tender process. Insurance Australia Group (IAG) used the first method in May 2002, where it set an initial buyback price of $3.18, which was then adjusted for the movement of the S&P/ASX 200 Index during the offer period. As a result, IAGs final buyback price was $3.05.
The tender process involves shareholders being given a range of share prices to offer their shares for sale. Woolworths used the tender prices in an off-market share buyback in March last year. Shareholders were able to tender their shares for sale between $9.00 and $11.70 a share, with the final tender price being set at $11.40. All shareholders who tendered their shares at $11.40 or below participated in the share buyback.
Since the buyback-related amendment to the Corporations Law in 1995, over 35 off-market buybacks have been initiated.
Companies who have participated in off-market buybacks have sought a tax ruling which would allow them to split the buyback price between a capital amount and an amount deemed to be a fully franked dividend. This can have tax advantages for some investors, so shareholders may be willing to sell their shares at a tender price below the companys current sharemarket price. However, while the franking credits and lower capital costs do offer value, not all share buybacks will benefit all investors.
To identify the conditions under which shareholders may benefit from company share buybacks, six companies that recently conducted buybacks were studied (Telstra, Fosters, IAG, Woolworths, Channel Seven, and Commonwealth Bank of Australia).
A spreadsheet model has been developed that analyses the effectiveness of these companies buybacks for individual shareholders at varying marginal tax rates (MTR), and for super funds which are taxed at 15 per cent.
The model compares the buyback price, comprising the capital and dividend component, with the price that would be obtained by selling the shares directly on the market.
We have assumed that the MTRs include a Medicare Levy of 1.5 per cent; individual and super funds are fully entitled to the franking credits; and capital losses incurred can be fully offset against capital gains. Also, the discount capital gain method applies, and the market price for each company is at close of trading on the last day of the buyback offer. Brokerage of 1 per cent has been allowed for the alternative of selling on the open market.
Amounts have also been rounded to the nearest cent.
In November last year, Telstra bought back over $1 billion worth of shares at $4.20 per share. On 21 November, when the buyback tender period closed, the market price of Telstra shares was $4.87.
The buyback price comprised a fully franked dividend of $2.70 and a capital component of $1.50.
Due to the large difference of 67c between the market and the buyback prices, our analysis shows that the buyback was only beneficial to superannuation funds and individual shareholders on a MTR of 0 per cent or 18.5 per cent. It shows that shareholders with 5000 shares and on a MTR of 18.5 per cent, would have been better-off by $647 had they participated in the buyback rather than sold their shares on the market.
A super fund with 5000 shares would have been better-off by $1447 from participating in the buyback.
In contrast, shareholders with 5000 shares on the 48.5 per cent MTR would have been worse-off by $2647 if they had participated in the buyback, rather than selling on the market at the close of the tender period. These differences remain the same even with varying cost bases.
Fosters
The brewers buyback closed on 19 December 2003. The market price on this day was $4.34, whereas the buyback tender price was $4.00. The buyback price comprised a fully franked dividend of $2.19 and a capital component of $1.81.
Using our model to analyse the best selling options for various shareholders, we found that sellers with an MTR of 31.5 per cent or less should have participated in the buyback rather than selling on the market.
Conversely, shareholders on 43.5 per cent and 48.5 per cent MTRs who wanted to liquidate their shares would have been better off selling on the market at the close of the tender period.
IAG
The insurance heavyweights initial buyback price of $3.18 was adjusted downwards to $3.05 to reflect the movement of the S&P/ASX 200 during the tender period.
The buyback price comprised a fully franked dividend of $1.27 and a capital component of $1.78.The market price on the day the buyback tender closed was $3.15.
As with Fosters, all IAG shareholders with a tax rate below 31.5 per cent who wanted to convert their shares to cash should have participated in the buyback.
A similar pattern also emerged for super funds and shareholders with higher MTRs.
Woolworths
Woolworths off-market share buyback involved the purchase of 46.7 million shares at around $532 million.
The market price was $12.28 on the day the buyback offer closed, compared to the buyback tender price of $11.40, which comprised a fully franked dividend of $8.52 and a capital component of $2.88.
Our analysis again reveals that super funds and shareholders on a MTR of 31.5 per cent or less would have been better-off accepting the buyback offer, while shareholders on higher MTRs would be better-off selling on the open market. For example, a shareholder with a MTR of 48.5 per cent would have been worse-off by 85c per share ($4246 for 5000 shares) had they participated in the buyback, representing a loss of 6.85 per cent on each share held compared to the closing market price.
Channel Seven
Sevens buyback provided an unusual situation with the share price dropping during the tender period, from $6.10 at the start (6 November, 2003), to $5.62 at the end (12 December, 2003). The buyback price at close of tender was $5.80, well over the days market price.
The buyback price comprised a fully franked dividend of $2.32 and a capital component of $3.48. In this case, all shareholders who wanted to liquidate their shares would have benefited from the buyback offer, regardless of their MTR. However, the gain per share was greater for taxpayers on lower MTRs.
Super funds would again be a big winner by participating in the buyback rather than selling on the market.
The trend that has emerged from the analysis so far reveals that the structure of the buybacks has been advantageous for super funds and individuals on low MTRs.
In contrast, shareholders on higher MTRs of 43.5 per cent or 48.5 per cent were better-off selling on the market, except in the unusual circumstance of Sevens buyback. All five of the buybacks studied occurred prior to the release of draft Taxation Determination TD 2004/D1. It proposes to reduce the tax benefits that have been associated with off-market buybacks of shares in listed companies.
Issued in January this year, TD 2004/D1 is contrary to previous ATO rulings given to some companies in regard to share buybacks and applies a special rule in the tax law designed to stop the artificial inflation of capital losses.
This determination will allow the ATO to decide the market value of the shares at the time of the buyback.
The difference between the market value and the final tender price will now be added to the capital proceeds of the buyback when calculating the shareholders capital gain or loss, thus reducing the tax benefit to the shareholder.
Commonwealth Bank
On 29 March this year, CBA announced the completion of its off-market share buyback.
The final trading price of CBA shares on the close of the tender period (26 March) was $33.22. The buyback price of $27.50 included a fully franked dividend of $16.50 per share and $11.00 of capital proceeds. In line with TD 2004/D1, the market value of the shares bought back for tax purposes was deemed to be $30.42.
For capital gains tax purposes, CBA shares were deemed to be disposed for $13.92; this amount being the capital proceeds of $11.00, plus $2.92 the amount by which the ATO determined market value ($30.42) exceeded the buyback price ($27.50). This additional $2.92 will reduce the tax benefit for individuals per share.
Performing the calculations for each MTR reveals that higher MTRs result in greater reductions of tax benefits. That is, a shareholders benefit in taking the buyback offer will now be reduced per share by 27c, 46c, 63c or 71c for MTRs of 18.5 per cent, 31.5 per cent, 43.5 per cent or 48.5 per cent respectively, due to the introduction of TD 2004/D1.
The reduced benefit for super funds is 29c per share or $1450 for a holding of 5000 shares.
The analysis reveals that all individual shareholders except those with a zero MTR would have been better-off selling their shares on the open market on 26 March at the closing price of $33.22.
Super funds still benefited from participating in the buyback, though only marginally (by $0.04 per share or $223 for 5000 shares). In contrast, pre-TD 2004/D1, super funds would have been better-off by 33c per share.
An individual shareholder with an MTR of 48.5 per cent who opted to accept the CBA buyback offer instead of selling on the open market would have been worse-off by the material amount of $5.15 per share, resulting in a loss of 15.5 per cent on each share held, compared to the closing market price.
The winners in this buyback offer would appear to be the CBA and its remaining shareholders.
The fact that the CBA was able to set a buyback price of $27.50, well below the market price, suggests that shareholders are not doing their homework.
The impact of this recent CBA buyback, together with the new tax determination, has shown that careful analysis is needed before shareholders sign up to be part of a companys buyback schemes.
IAG and Westpac have recently announced off-market share buybacks which will fall under TD 2004/D1.
Shareholders should watch the market during the tender period and apply a what if analysis leading up to the closing day of the tender.
Prudent investors should decide closer to the last day of the tender period before putting in a tender price for their shares.
Doing your own sums on the financial viability of a share buyback is crucial, as all offers are different.
Where a shareholder does not wish to liquidate their shares, then it may be beneficial for certain shareholders to ignore a share buyback and not sell on the open market, but rather keep their shares and benefit from the reduced amount of shares on issue, increasing earnings per share and the value of the shares.
The CBA buyback is the first buyback studied under the new rules.
Future buybacks will need to be investigated to further determine the impact TD 2004/D1 may have. It may be that as shareholders come to grips with understanding the potential gains or losses of participating in a buyback and the effect this determination can have on their decision making, then the cost to a company undertaking a share buyback may increase, as shareholders would be more likely to demand a higher buyback price to compensate for the reduced tax benefit.
This article was written by Kim Wyatt and Jarrod McDonald. Wyatt is a senior lecturer in the department of accounting and finance at Monash University. McDonald is completing his honours year in the bachelor of business and commerce degree at Monash University.
