More share buybacks on the way as companies swap equity for debt

Rio Tinto, the Anglo-Australian mining group, yesterday joined a growing band of companies seeking to buy back their own shares when it said it would seek authority from shareholders to buy in 10 per cent of its share capital. Peter Thal Larsen finds that institutional investors see no end to the trend of companies swapping equity for debt.

Rio Tinto, whose shares have taken a hammering in recent months as a result of the Asian crisis and falling metals prices, said share prices were a good use of the company's cash.

"Buying back shares, particularly in current market conditions, should achieve earnings per share improvement for the shareholders and enhance the underlying value of those shares which remain outstanding," said Robert Wilson, chairman of Rio Tinto plc, the group's UK arm.

Analysts said that given uncertain market conditions, the company was better off buying in shares than investing in new mines. A 10 per cent share buy-back would cost the company over pounds 1bn. But with an annual cash flow of pounds 2bn and a gearing ratio of 26 per cent, experts reckon Rio Tinto can afford it.

Shares in Rio Tinto Limited, the group's Australian arm, rose 8 per cent to A$18.30, while shares in Rio Tinto plc finished the day up 15.5p at 713p.

Peter Davy, an analyst with investment bank Societe Generale Strauss Turnbull, pointed out that Rio Tinto would not necessarily use the authority to buy back shares. "All they are doing is making sure they have the full set of tools available to get their balance sheet in order," he said.

Nevertheless, the fact that Rio Tinto is considering the move points to the growing fashion of companies distributing their spare cash to shareholders. In the past 18 months, British firms have handed back more than pounds 10bn in the form of share buybacks and special dividends. Recent converts to the trend include Bass, the hotels and brewing group, and electronics giant GEC.

But there is much more to come. NatWest Markets, the investment bank, reckons that share buybacks alone will reach pounds 7bn this year, up from pounds 3bn in 1997.

Underlying this trend is the belief that increased levels of debt will reduce a company's overall cost of capital. Since investors demand double- digit returns from shares, companies have to produce those returns from investments funded by equity. Debt, however, costs no more than the company pays in interest. With corporate borrowing rates at historically low levels, debt has become much more attractive.

Giving cash to shareholders is also seen as safer than pouring money into risky investments or acquisitions. "Buying back shares is like taking over a company where you know exactly what you're buying and you're not paying a premium," says one leading fund manager.

He points to utilities, insurance companies and the former building societies as obvious candidates to distribute spare cash. Other favourites include Associated British Foods, the food group which has accumulated a huge cash mountain, British Telecom and Marks & Spencer.

The trend towards share buybacks has been accelerated by recent tax changes. In the past, pension fund investors had a preference for equity because dividends came with a tax credit. When Gordon Brown, the Chancellor, abolished the tax credit in July, however, shares immediately became less attractive.

Mark Tinker, equity strategist with UBS, the investment bank, says British companies currently carry less debt on their balance sheets than businesses in the US and continental Europe.

He calculates that if UK debt levels rise to the same level as the rest of the world, British companies would be able to return pounds 100bn.

Generally, institutional investors encourage the trend. "When companies are generating free cash flow we are happy to see them buying in shares," says Mark Critchley, head of balanced funds at Gartmore, the fund management group.

"But we wouldn't expect a company to do it if it was at the expense of long-term investment in the business."

Nevertheless, other fund managers sound a note of caution about firms overstretching their balance sheets. "Incurring debt may involve putting a company's destiny in the hands of its bankers," says one. "Bankers aren't the shareholders' friends."

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