The symptom is worse than the disease

So, DLF goes about the mock play – sorry buyback.

Earlier I had concluded that such false bravado is a symptom of DLF management being new to the listed public market. That explains why they try to zig and zag with the price action in the markets. Markets dance to a non-rhythmic rhapsody, not a synchronized symphony. Company managements can't keep pace with it without breaking down. Stock prices may go up or down in public markets, but management’s priority should be effective supervision of operations. By announcing a Rs.1,100 crore buyback when stock prices sag while having plans to raise QIP of Rs.10,000 crore in hardly six months down the line, they betray impulsive overreaction. As I said before, DLF may be a large enterprise; but they lack the maturity required to stay put in that bracket.

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Wait until they mop up

More on DLF buyback.

Realty and infrastructure is a capital intensive industry that is badly mauled by the global liquidity crunch. With demand for high end luxury homes and commercial complexes waning, the focus is on low margin budget buildouts. Even as realty companies conserve every rupee they can to meet the resources crunch, DLF worried about the falling share price (down by more than 50% from its peak of Rs.1225 in Jan 08) and announced a Rs.11 billion buyback (at price not exceeding Rs.600/- a share) to reassure itself and its minority investors.

Now is that a wise decision at this crunch time? As a long term shareholder I can’t care less. Know why? This whole buyback exercise is a temporary prop. Remember what happened to Ranbaxy stock recently? Even institutional shareholders like LIC and GIC tendered their entire holdings in the offer and the stock fell to Rs.450 levels from Rs.580 post buyback. So if you are a long term investor and want to pick up asset rich DLF cheaply, just wait for the mop up exercise to be over. Even after a recent downgrade, Deutsch Global values DLF NAV at Rs.532 a share.

Not bad. The news is that after the statutory cooling period of six months (for fresh capital issues) is over, DLF has plans to raise Rs.10,000 crore by way of private placements. When the market knows this, the buyback offer is just false bravado... The problem is DLF may be a sizeable enterprise; but its management is new to public markets behavior. So when the stock price falls because of market's general indifference towards the realty sector, DLF management is overreacting.

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They too will learn...!

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Say No to DLF buyback at Rs.600/-

So, why is everybody questioning DLF buyback?

As per filings before NSE, the company will spend close to Rs.11 billion ($255 million) to buyback 22 million equity shares at price not exceeding Rs.600 per equity share. Giving in to the babble around the expediency of this bold decision, I ran a check on the DLF data.

The company had revenues of Rs.60.58 billion and an EBITDA of 31.18 billion for FY 2007-08. So the EBITDA margins are in the range of 51.47%. The company has an interest outgo of Rs.4.48 billion during the period. DLF is an industry leader, let’s assume its cost of funds at an average of 14%. That means it has a debt of about Rs.32 billion in its books (Rs.4.48 billion x 100/14). Now if you imagine 14% funds getting deployed in a 51.47% margin earning business, it is a no-brainer to decide in favor of its retention in the business.

Why is then DLF bent on spending Rs.11 billion to buyback just 1.18% of its equity? Bravado? Why don't they retain that cash and plow it back in business?

I think it has to do with the high promoter holdings in the company. First off, in a buyback, even as the company forks out funds to buy its stock back, it is the promoter who gains in individual wealth since his % stake goes up. The SEBI formula - six months’ average of daily highs and lows or the last two weeks’ average, whichever is higher – comes as a blessing in disguise now that DLF prices have declined by over 50% of their all time high. So if the stock price is not kept propped up, the founder K.P.Singh’s family holdings of about 88% will have to be eventually valued lower. Being a high beta stock, DLF price will revive faster when markets improve and the founders know it only too well. That’s when the promoters stand to gain if they choose to dilute their stake and cash out.

So it pays to think like a promoter. I see a clear 50% upside from current valuations in about six months when the current turbulence fueled by oil price surge and political tempest settle down and the realty sector looks back up. What say you?

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Stock buybacks - value capture or management swagger?

Why do buyback announcements fail to boost stock prices?
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Typically if a company has generated surplus cash from its operations and is of the opinion that the cash cannot be profitably redeployed in the business in the near term, it may choose to distribute such cash amongst its investors by way of dividends. Further, if the company has built up a war chest anticipating large capital expenditure and because of adverse market conditions it decides against expansions, then its management may decide in favor of using the cash to mop up equity from stockholders desirous of cashing out. It also sends out signals that in the opinion of the management, the intrinsic value of the business is not adequately reflected in its stock price.

When a company buys back its shares and cancels it, the residual stake held by existing holders goes up. Each residual share gets a larger claim to the earnings pie (the numerator) since the number of shares (denominator) has gone down. As a result there will be fewer claimants to its equity and distributable profits (numerator) in future. Lower investor base brings down annual servicing costs. So even at a time when business prospects are not so buoyant, the surplus resources are not allowed to clog the arteries of business since overcapitalization is more dangerous than under capitalization. The business runs with optimal capital – and no excess flab.

But recently we’ve been noticing consistent decline in stock prices of companies that announce the buyback. Is it that investors don’t read the signals? Or is it that they read it only too well?

Notice the times. Liquidity is hard to come by and managements would do well to keep money in the bank than apply it towards stock buyback. If they need it later, how sure are they of raising it? If sure, at what cost? That is why investors see buyback announcements made by companies as management swagger, not backed by seriousness of purpose with an intention to capture value. Not the least when interest rates are going up and raising debt is way too expensive. Especially if it comes from companies that are already reeling under huge interest burden such as Reliance Infrastructure or DLF Limited that face a double or triple whammy - with large unfunded capex plans, bruised by economic headwinds and wading through a tardy business cycle.

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Wanting it all back

When our markets were doing an encore throughout last year, the PE deals soared. Promoters were busy diluting their stakes and there were takers and takers. Now the market has ebbed and the promoters are back with a vengeance – they want it all back.

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Boys cancel capital; Men own treasury stock

Not too sure whether I could stomach this. Share buybacks in India totaled $1.1 billion from nine deals so far this year. True spunk in times of inflation, crude price spiral and liquidity concerns. Boards must be having wholesome breakfasts I guess :)

Besides the recently concluded Madras Cements buyback, the others that have been lined up are of Reliance Energy, Great Offshore, Mastek, Patni Computer, Gujarat Flurochemicals, JB Chemicals, Sasken Communication and Goldiam International.

But I wonder why Indian laws mandate "cancellation" of shares bought back. Is earnings beef-up (because lesser no. of shares now stake a claim to enterprise earnings) the only motive? I think that's a very myopic outlook because you are compromising on long term resources. It betrays a lack of enterprise long term vision. Is there a guarantee that the company could raise capital in future at a lesser cost than the portion that got canceled? What about time taken to raise it? Will opportunities wait till you raise capital? Enterprise is all about sudden opportunities. Capital adequacy helps swift exploitation of an opportunity. The shareholders (both existing and those cashing out) may be enriched in the short term but they are also giving up quite a bit of future capital productivity.

So why can’t companies be allowed to hold at least a part of capital bought back as Treasury stock in their balance sheet?

The significant advantage could be that treasury shares have the potential to restore the distributable profits used when shares are bought back. The distributable profits used to buy back shares are lost when the shares are cancelled. Purchases into treasury still count as a reduction in shareholders' funds but, on the sale of shares out of treasury, the sale price will replenish the distributable reserves up to the amount lost on their acquisition. Any profit made by the company on a sale of treasury shares must be credited to the share premium account. This ability to recreate distributable profits, not available on a share buyback and cancellation, means that it is likely that shares bought back in future will be held in treasury up to the permitted levels.

Just as in the laws of UK, allow it with some restrictions –

- seek shareholder approval

- prevent companies from buying shares into treasury during close periods or when they are in possession of unpublished price-sensitive information, other than in certain limited circumstances;

- express ban for insiders to buy or sell stocks from or into treasury portfolio;

- prescribe ceilings based on net worth

- treasury stocks are denied the right to vote, dividends but are entitled to bonus shares;

Another benefit from treasury holdings is that these shares can be later applied towards employee stock options to reward talent. In the U.K., transfer out of treasury stock towards Employee stock option programs are exempt from stamp duty unlike employee stock option trusts where the company has to bear the trustee fee besides bearing the burden of stamp duty on transfer of shares held by the trust.

SEBI chief C.B.Bhave is known to be a man of action. I suggest he should check out procedures with UK Listing Authority for allowing treasury stock treatments. I hate the expression “cancel”, especially if it is used in relation to capital - not so easily found nowadays :-)

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