Buybacks, Debt, Placings and Profit Warnings

Q. Are there rules on when profit warnings have to be issued?

Over the last year I have experienced profit warnings on a few equity holdings I held - in several instances the results came in significantly below broker forecasts but no profit warning was issued in advance. Are there any rules on profit warnings?

A: The FSA does not have any particular rules on profit warnings but it does insist that insider information (or any event for that could influence the share price for that matter) such as changes in expectations of a company's business or financial conditions which include a company missing profit expectations by a significant amount has to be communicated to the market on time. Also, in the United Kingdom quoted companies are obliged to publish their results twice a year, and to provide trading updates twice a year as well.

Inside information is anything that could substantially affect the price of the stock and this includes profit warnings (generally defined as an annoucement where profits are going to be at least 10% below market expectations or more but this is not noted down anywhere). Additionally, directors are under tremendous pressure to disclose bad news and cannot delay public disclosure for weeks to decide the extent that it will affect their company's share price, but at the same time they need to be diligent not to make unnecessary alarming disclosures to the stock market as they could face legal action (from shareholders) if stock value are harmed through inaccurate statements. Disclosure has to be made using approved Regulatory Information Service and usually this takes the form of an RNS (Regulatory News Service) The vagueness of the UK rules creates problems with companies in some cases withholding price sensitive information from the market but the FSA does investigate cases where prices fall acutely - although admittedly rarely is follow-up action taken.

'..We are entering a world where 'Mr Market' sets the rules and takes no prisoners. The trouble is we private investors are not told what all the rules are when we start...' The sooner we realise that, the better able we are to protect ourselves. It's a bit like a game of Snakes & Ladders, in which some of the snakes are invisible ;o)'

Q.: What is a Placing?

National Grid dropped 11 pence at 674-1/2 as Citigroup placed 26 mln shares at 675 pence each, according to dealers. What is a placing?

A: A placing is when a company puts extra shares on the market. This usually happens when a company raises funds. i.e. the new purchasers buy the shares after which those shares are placed on the market which dilutes the value of the existent shares.

When a placing occurs it dilutes earnings per share and so the price drops. However usually it is a good signal especially if the offer was oversubscribed and if the company employs the cash raised in an effective way. Once the market knows how cash is deployed then the price will usually rise over the month after the placing. Only if the cash is deployed effectively though.

But just to let you know there are various corporate actions and other scheduled and unscheduled actions that can occur which can or will affect share price. Plus a range of actions from outside of companies. Meanwhile, one has to always take the various Rumsfeld "..unknowns..." into account when calculating what exposure to gamble on, as some of them can hurt a little or a lot.. Some are predictable in frequency and impact, others not.

Q.: What are the main debt considerations to consider?

A: In the nutshell the main considerations should be :
  1. Net Debt; which is worked out by substracting the 'Debt of a Company' (short term, long term and retirement benefit obligations) from the 'Cash and Cash Equivalents' (including assets held for sale and other investments). If the result is positive the firm has excess cash, it negative it has net debt.
  2. Gearing is worked out by dividing 'Net Debt' by 'Net Shareholders funds'. In general terms debt/equity of less than 100% is preferable but there is no cut-off point that is too high. As debt increases, shareholder profits become more volatile.
  3. Interest Cover determines whether a company is able to fund its annual interest payments and is calculated by dividing EBIT (earnings before interest and taxes) by Net Interest Paid. The lower the interest cover, the greater the risk that profit will become inadequate to cover interest payments. This is a better way of measuring the effect of debt on profits than gearing itself. A value of 2 or better is normally considered relatively safe but firms with volatile earnings may require even higher levels (on the other hand companies with stable earnings such as utilities may be safe at a lower level).
  4. Debt Covenants; aka as banking covenants are agreements between a firm and its creditors on the financial within which it must operate - these vary from one company to another but are usually based on a certain degree of gearing, a level of interest cover and/or free cash flow. A common covenant is net debt as a multiple of earnings before interest, tax, depreciation and amortisation (i.e. EBITBA).
  5. Debt Repayment Schedule; stipulate the repayment schedule at which batches of debt plus interest have to be re-paid and found in the report and accounts.

In a recession scenario it is advisable to steer clear of highly leveraged firms as heavily-indebted stocks will be the first to bear the brunt as they find it increasingly difficult to service their debt.

Q. Why do Buybacks work?

A: The obvious reason is that when companies buy back their stock, they reduce the shares outstanding and increase earnings per share. It is a fact that reducing the number of shares in circulation does have the effect of increasing a company's earnings per share. This is because when a company buys its own shares, each of your shares becomes more valuable and represents a greater percentage of equity in the company. What's less obvious is that companies typically buy back their shares at advantageous times; they know things that you or I may not. They're the ultimate insiders. Obviously, in an overpriced market, it would be foolish for management to purchase shares at all, even in itself.

The knock on buybacks is that they're for old or unimaginative companies with nothing better to do with their money. That misses the point because you can make money using buybacks as a selective tool (besides, a buy-back doesn't mean that a company isn't growing).

Companies also use share buybacks when they consider their shares to be undervalued. The theory goes on something as follows. If a company embarks on a buyback programme, the shares the firm buys will be cancelled, thus reducing the overall number of shares outstanding in the process. If profit levels are maintained at the same level, then future earnings per share will be enhanced, which may in turn generate a re-rating of the company by investors and ultimately boost the share price.

However, in general if the purpose of a buy-back is to boost a company's share price, returning cash to shareholders through raising the dividend may be a much more effective method of realizing this objective (this is from a study which US investment bank Morgan Stanley) conducted. This seems to contradict the theory that share buybacks are a more tax efficient vehicle since a 10% tax is applicable to dividend disbursements. However, from a retail investors' perspective, private investors are usually not able to take part in buybacks as the repurchased stock are normally acquired directly from the company's institutional investors. A buyback doesn't even guarantee that a stock's price will be supported. For a stock price to increase the company's rating has to be preserved meaning that the company retains its present price/earnings (PE) ratio, however if the firm is using its cash reserves to buy stock there's a possibility that the market might even de-rate the firm in view of it ending up with a lower cash pile. If a company does indeed embark on a buyback programme it is okay as long as this is done instead of a sizable acquisition and this is used to compensate against dilution from stock option issuance and complements rising dividends. But it can't be a good sign if a buyback is merely done to boost (EPS = net income/the number of shares in issue) earnings per share (as opposed to increasing the dividend) or leaves the company with a heavily indebted balance sheet. A buyback programme initiated to show that management feels that the current stock price for the company was undervalued or to thwart the attention of a predator wouldn't augur well.

So what to look for in buyback stocks?

  1. Look beyond corporate jubilance - measure stock price in relation to earnings and the value of a company's assets minus its liabilities.
  2. Look at how big the share repurchase is, how big the market value of the company is and whether the company has a history of creating value with buybacks.

Note: I keep getting questions from people who are frustrated as to why the respective share price of a particular company is going down when there is a share buy back. My opinion is that in the majority of cases, share buy backs add no value, just waste a company's cash because the directors know of no better way of spending any excess cash on hand. When this happens I much prefer a special one off dividend payment to return the excess cash back to me, the share holder.

Please do not reply if a share is worth 100p and 10% of the shares are brought back then the remaining 90% are worth 110p. It never works like that. Because if a share is worth 100p and 10% of the shares are brought back then the remaining shares at best can only be worth 100p. Because part of the 100p of the value of each share is also made up of the excess capital and this excess capital has been spent buying up shares. In fact it would make the company worth even less as once it has spent this excess capital it no longer has any excess capital in which to expand, the ability to expand would also have been included in the original 100p share price and therefore after any share buy back the share price falls to 90p and therefore the small private share holder loses out.

Q. Shares going into treasury, does that mean the total number of shares remains the same but shareholders hold an overall greater share of their own company?

A: Yes, the overall number of shares will stay the same. Shares in treasury are often used if directors want to pay incentive bonuses to managers as share options. In cases where shares are cancelled, the number of shares will of course be reduced but that is balanced out by company having less cash so the overall value of company won't change. For shareholders a special dividend is often better. A growth company should be using spare cash to grow not buying back their own shares. For instance I believe RIO in 2007 had a big share buyback which did reduce number of shares. Then to buy Alcan (at peak of market) it had to borrow loads of money. Silly management decisions!

Q.: What does it mean when a stock is said to 'Bounce'?

A: A stock 'bounces' when it moves away from the prevailing long-term trend i.e. it moves off a support or resistance level back to a minor correction resulting in short-term gains. You can take advantage of this by taking a position in the opposite direction to that of the prevailing trend. So if the share is nearing support from falling due to some brief market weakness, then by using say technical indicators you can wait for some confirmation and make a long trade from the bounce. Should the stock break through support it is likely that the stock will keep falling until a previous support level is reached (the last small support level that can be seen).

 ...Continues here - Housebuilders Priced below Book Value and REITS...

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