Trading Strategies: Buybacks bring in the cash - but at what price?

Nearly 40 European companies have announced or completed share-buyback programmes so far this year, including AstraZeneca, Barclays, BAT, BT, Centrica, Diageo, GlaxoSmithKline, GUS, Imperial Tobacco, Next and Shell.

In most cases, shareholders aren't receiving cash directly, but existing shareholdings will represent a greater proportion of the firm's ownership.

In theory, a buyback will enhance earnings per share, because the fewer the number of shares in circulation, the bigger the slice of cake for each share. The perceived virtue of a buyback is that the management is investing in what it knows best and concentrating on its core business. Companies often come unstuck when they embark on new ventures with which they share no synergies. But a boardroom that recommends a buyback is unlikely to be full of fantasists with impossible expansion plans.

Think of BAT, now sticking to its knitting and producing excellent returns. It was not always so. In the past, the management frittered away its lucre on a hotpotch of ventures, from paper mills to cosmetics, life assurance and convenience stores.

Vodafone is another company that in the 1990s used its highly rated shares as a currency to buy businesses, but could not make them work. Today the mobile-telecom king is back on course. It is spending £5bn on 3G and other network capital expenditure, and £4bn on its buyback, but it still expects loose change of £7bn in the current financial year.

The big argument against a buyback is that it may signify a paucity of ideas for new capital projects. Can the management really think of nothing worth building for the company's future? Surely, the argument goes, Shell would be better off using the funds earmarked for additional oil exploration, while Mitchells & Butlers should open more pubs and National Express should put on additional coaches.

Buybacks are prevalent in the current economic cycle because companies built up unusually high cash mountains in the years dominated by the dot.com crash and geopolitical uncertainty around the Iraq War. Meanwhile, the fall in inflation has focussed attention on the selection of capital-investment projects that will genuinely yield a decent return. For the UK's high-dividend companies, such as BT, a buyback can also make a substantial immediate saving, because they no longer have to pay out dividends on the shares repurchased.

But there are other reasons boards are quick to recommend a buyback: a company's earnings per share is often the measure used to benchmark performance in executive share-option packages. Some boards are simply desperate to please the City, and some need a distraction from poor operating figures.

Certainly, share prices almost always bounce on buyback announcements. Research suggests the average hike is 2 per cent, but that masks a wide range of outcomes hinging on whether the market judges the move a sensible use of excess cash or an attempt to support the share price.

Companies that have continued to slide despite their buybacks include Boots, Burberry, Dixons, Rentokil, Weir, internet-security company SurfControl and corporate adviser Evolution Group. Boots announced a £700m buyback last spring, stunning the City, which could not quite understand where it had got its cash. The high-street chemist's shares jumped over 50 per cent as investors welcomed the decision, despite a rare move by credit analysts Standard & Poor's to cut its rating two notches to A-minus, further downgraded to BBB-plus earlier this April.

At Dixons, the departure last summer of finance director, Jeremy Darroch, who left to join BSkyB, was an inauspicious start to the electrical retailer's buyback programme. Shares in the Currys and PC World owner are under pressure as consumers spend less on big-ticket items and more at the supermarkets. The company has been running presentation days for analysts at its Nottingham HQ, possibly another sign that it is trying too hard.

Burberry, part of GUS Group, is a strong company, but is struggling for growth, particularly in Japan, while its new clothing range has apparently met only with a muted response in the US. All three companies have lost their finance directors: telling, because the FD generally has the best seat in the house when it comes to watching a company in pantomime.

A fourth, Emap, whose FD Gary Hughes quit earlier this month, is also facing tough conditions, particularly in its French market where sales of its TV-listings titles are in decline. The board is contemplating a buyback to soak up the cash that was originally earmarked for the acquisition of Scottish Radio Holdings.

Share buybacks are great amplifiers, and they are usually price-enhancing. The management of BAT, for instance, believes that the tobacco company's buyback accounts for as much as one quarter of its 10 per cent EPS growth. But if a company is in trouble, a buyback will do nothing to stem the tide once the back-slapping stops.

cash@independent.co.uk

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