February 2012 Feature: Bowser 101: Share repurchases

The different types of share repurchases and what they mean for investors

Every once and a while, a Bowser Company of the Month will make a decision that causes confusion among a few of our Buckaroos. Right after the January issue went to print, Tucows Inc (A:TCX) reported the results of a Dutch Tender Offer—one of many types share repurchases.

What is a share repurchase (or buyback)?

A share repurchase is exactly as it sounds. A company uses its capital resources—often times cash on hand—to literally buy back an allotted dollar amount or number of common shares.

Why buy back shares?

There are a number of reasons why a company would repurchase shares. The first and most idealistic reason is to reward shareholders. To use an example, assume an imaginary company has 20 million shares outstanding. Over the past year, this company has reported a net income of $5 million—or $0.25 earnings per share (EPS*).

*To calculate earnings per share, divide the net income (earnings) by the number of shares outstanding. This is a measure of shares’ value often used by analysts to determine how much a company’s stock is worth.

The company then buys back 5 million shares to leave 15 million shares outstanding. Even if the company reports the same $5 million in earnings, its EPS has gone up from the original $0.25 to $0.33. So, the value of each share, from an earnings perspective, has increased $0.08 or 32% without increased financial performance.

Not only EPS will increase, however. All per share metrics will see increases. For example, if this imaginary company maintained $60 million in shareholder’s equity, before the repurchase, its book value would be $3.00, but $4.00 afterwards. Once again, there is no financial performance driving these increases.

Some believe that share repurchases are a better use of the company’s capital than cash dividends. Why? The value is still increased, but there is no capital gains tax paid like there would be on dividends.

That sounds great! Is there a negative side?

Unfortunately, as we said, that was the ideal reason. There is a more selfish reason for companies to buy back their shares. In this case, a company issues its executives stock options.**

**Stock options are incentives for company employees. They give these employees the “option” to purchase the company’s shares at a predetermined price.

When an employee exercises his or her options, the number of shares outstanding increases, diluting the per share metrics. When the number of shares goes down, each share becomes more valuable, but when the number of shares goes up—as with the exercise of options—each share becomes less valuable (supply and demand).

So, how does a company ensure that its shares maintain their value? They buy them back, decreasing the total shares outstanding.

What’s so bad about that? It sounded good before!

First, company executives are profiting by buying the shares at a lower price through their options and then selling them at the higher market price, pocketing the difference. Second, when executives and employees exercise their stock options, the company receives a tax break. Third, the benefits of the repurchase just reset the company’s metrics to previous values. For example, if a company’s executives exercise 5 million shares worth of options and then the company repurchases 5 million shares, the metrics would remain the exact same. See the table below for a visual representation.

So, after the options and buyback, the EPS (and other per share data) returns to its original value. The benefits of the first reason no longer have the same weight.

How can I safeguard against this move by management?

The best way is to find companies with morally sound management that look out for the best interests of the company and its shareholders. This can be a daunting task. Sometimes self-interested management is obvious, other times not so. Doing your homework is the best way to tell.

Beyond that, exercising options is not the worst thing that a company can do. Sure, it negatively affects the results of a share buyback, but it also means that a portion of management’s income is performance based—the better the stock performs the higher their pay (they are shareholders).

As long as the options are not too enormous, increasing the total shares outstanding by some extraordinary amount, there is not an excessive amount of harm done.

How does Tucows’ repurchase fit in?

TCX’s buy back represents a mix of the two scenarios. Over the past year, there have been ten different occasions that a director or officer has exercised options. The total number of shares exercised in those transactions is 327,915. Of all the options exercised, only twice did that same insider turn around and make a large sale at a higher price. Both times that officer repurchased the same number of shares at the same price, and in the same day. So, TCX’s officers are holding their shares, which inspires confidence in the company’s management.

Also, only 327,915 shares were exercised compared to 4,114,121 shares repurchased. The company has been steadily decreasing it shares outstanding, now at 40,215,688, down from 70,356,013 in 2009—a 43% decrease.

What are the different types of share buybacks?

1. Open market repurchase: a company can buy back its shares in the open market. There are certain limitations on how many shares can be bought back over certain periods of time, however.
2. Tender offers:
   1. Fixed price: the company contacts its shareholders offering to buy back a number of shares at a fixed price. Typically, they are seeking a certain number of shares to buy back. If more than that number accepts the offer, the company will select which to buy back on a pro-rata basis.
   2. Dutch auction (the method TCX used): the company contacts its shareholders offering to buy back shares within a range of prices. The shareholders then declare the price at which they are willing to sell their shares. Then, the company lists the offers from least to greatest. The company works down the list until it has reached the number of shares it wished to repurchase. The highest price at which the company will buy back is the “qualifying price,” meaning that price and all below it qualify for repurchase.

Example: Company A offers to repurchase 1 million shares between $1.00-$1.50/share. 10 shareholders respond for a total of 2 million shares. However, 1 million are below $1.25. So, the company purchases those 1 million shares between $1.00 and $1.25 (the qualifying price).

What happens to the shares that are bought back?

The company has two options: (a) put the purchased shares into its treasury, or (b) retire them. Shares put in the treasury can be used for stock options or in future acquisitions. They aren’t included in the shares outstanding figure, nor do they receive dividends. Retired shares are no longer available to the company.

There are mixed feelings when it comes to buybacks. What is most important is each company’s specific situation. It’s easy to over-generalize a managerial decision like a buyback, but applying knowledge to these decisions makes for smarter investing.