Why Share Repurchase Matters?

I remembered watching a TED video about James Randi about homeopathy. On stage, he swallowed a whole bottle of sleeping pills. However, the pills are much more diluted than the actual medicine, and even ingesting the whole bottle of pills does not have any fatal consequences.

You can watch that TED video here: https://youtu.be/c0Z7KeNCi7g

The company’s shares can have the same effect. If the company keeps issuing new shares, this will dilute the net profit that each share provides.

As such, I will prefer to the company does the opposite; reduce the number of outstanding shares. Thus each share will get a large net profit in the future. This is usually called share repurchase or share buyback.

Benefits

Like eating medicine or supplement, we are expecting some form of benefits for our health. There are benefits to share repurchase for the shareholders.

Can only be done by using Cash

A company that generates a lot of cash can do a lot of things to improve its business or it can return value to its shareholders.

A dividend is the most direct and tangible way to provide value to the shareholders.

Share repurchase is another way to return value to their shareholders too, but it isn’t so directly.

Regardless, to buy back their shares from the open market, they have to use cash.

In this case, how they get their cash is important. I will look out at their operating cash flow and their free cash flow. If the company has a lot of operating cash flow and free cash flow, this means the company’s core operations are generating cash for the company.

There are other ways to generate cash, for example, borrowings or raising more capital by issuing more shares. These methods of generating cash aren’t sustainable in the long run.

Improving the Metric

This is kind of technical. Let’s imagine a company has the following:

·         1000 shares outstanding

·         Net profit $1000 for the year 2000

As such the Earnings per share (EPS) for the year 2000 is $1 (Net profit $1000 / 1000 share outstanding)

Then in 2001, this happened:

·         900 shares outstanding

o   The company brought back 100 shares with cash

·         Net profit $1000 still for the year 2001

Then in 2001, their EPS will become $1.11 (Net profit $1000 / 900 shares outstanding)

Despite the net profit does not increase from the year 2000 to 2001. However, the EPS has improved simply because the company brought its shares back.

This affects Return on Equity (ROE) and Return on Asset (ROA) metric too.

Investors use these metrics, EPS, ROE, and ROA to evaluate the company.

Compounding Effect

The previous section demonstrates how buying shares improved the metrics like EPS.

Let’s see what will happen if the company keeps doing that over a few years. The table below shows that if the company keeps buying at 10% of the outstanding shares.

 

Assuming that the net profit does not increase over the years, just decreasing the outstanding shares improved the EPS over the years.

If the company can prosper and increase its net profit, the effect of compounding is more potent. The below shows that if the company manages to increase its net profit yearly just by 1%.

This shows that as long as the shareholder keep holding on to their shares, the shares will be more valuable in the future.

Scarcity

As the company buys back its shares, there is a lesser amount of shares in the open market.

This means that whoever keeps holding on to the shares will have a larger percentage of ownership of the company.

Usually, if there are lesser sellers in the market, the buyers will have to buy at a higher price for the share. As the demand is higher than the supply, the price of the share may rise.

Shareholders don’t have to pay a cent!

The company will buy back its shares with the company’s cash. The shareholders are not required to pay for this action.

That being said, that doesn’t mean this action is free, just that the company is paying for it, reducing their cash for shares.

Tax?

As the company buyback their share, it isn’t a payment to the shareholders, unlike a dividend. As a Singaporean Investor in USA-listed companies, the dividend is taxable. At the time of writing (17/6/2022), there is a 30% withholding tax on my USA company's dividends.

Which isn’t an income to the shareholder; as such there isn’t a tax on it.

Drawbacks

Although supplements are good for health, overconsuming certain vitamins may have negative health outcomes.

Similarly, companies can benefit from buying back their shares. But it isn’t an action that can be used every time and in every situation. There are drawbacks if the company applied share repurchase inefficiently.

Can only be done by using Cash

If the company is unable to generate excess cash, it may not consider this action. Improving their business operation should be their focus.

If the company uses loans to buy back its shares, I probably have to listen carefully to its rationale. This course of action is usually considered unwise. If I am not satisfied with the reason, I will skip this company.

Not at any Price

The company will benefit more if it buys the share at an undervalued price.

However when comes to intrinsic value, it can be subjective. As everyone values the same investment differently.

As such, if the company management is ridiculously optimistic about their company share, they may just buy the shares recklessly.

This may reduce the efficiency of their money.

For example:

A company has allocated $ 1 million to buy back its shares.

That company’s Book Value per share is $100 per share. For simplicity’s sake, let’s take that as the company’s intrinsic value.

It also has 10 million outstanding shares.

Assuming the company’s net profit is $10 million.

As such, depends on the Price to Book (PB) value the company brought the shares:

As such, the table shows that as best as possible, if the company can buy their shares as cheap as possible, they can buy more shares back. The effects of their share buyback will be more effective on the EPS.

As such, it isn’t a good idea to just buy the shares at any price. Buying it cheap against the intrinsic value is more efficient.

However, there is more than 1 way to valuate a company. If the management wants to buy the shares back, they can easily justify with a very optimistic valuation and then buy back the shares.

Summary

The share buyback is a good sign for the company in general. The company must have the cash to buy back shares. If the company is generating a lot of cash from its operations, this can compound to those shareholders who still holding on to their shares.

What price does the company buy is the issue. However, even if the company pays a high price for its shares, it is still in favor of the shareholders. Just that it isn’t that efficient.

As best as possible, the company should buy its shares back as cheaply as possible. Of course, life isn’t as smooth as we wish to be. We can only prepare for the good and bad things to come. 

Taking a Peek at Utility

I am taking a peek at Utilities Companies in USA and Singapore.

Why so? It isn’t going to grow or prosper like those sexy tech companies. Nor does it have the hype either. Unless Elon Musk tweets about those companies out of the blue.

But in theory, at least some people believe that the Utility sector has some advantages:

·         A defensive sector

·         Produce goods and services with inelastic demand

However, because of the Utilities’ characteristics, they do have some problems:

·         Very heavily regulated

·         Very Capital intensive

Defensive Sector

In theory, the Utility sector underperformed when the market rallies. However, when the market falls, the Utility sector remains relatively resilient.

From Gurufocus, this is the overall performance for the past 10 years. VOO is the ETF for S&P500, while VPU is the ETF for the Utility sector.  

How do I know if this theory is true or otherwise?

Maybe I just need to look at the recent months. Thanks to the Fed’s rising interest rates, the overall market share price is dropping.

Well… looks like the Utility sector (VPU) doesn’t fall as much compared to S&P 500’s VOO.

What about a rally?

I am using 1/1/2020 to 1/1/2021, a recent rally and it does show that while VOO is improving by 51%, VPU was only 18%.

Although I only did a comparison for the recent times, it does seem Utility is kind of resilient.

Inelastic demand for their products and services

What is Inelastic demand?

It is when the demand or consumption of a certain product or service remains relatively the same even when the price has increased.

For example, 30 eggs were priced at $6.50 back in Feb 2022. However, in April 2022, it has become $7.05. But customers still bought relatively the same amount of eggs daily. (At least for me though.)

Although in May 2022, some supermarkets' 30 eggs prices had gone down to $6.75, I still consumed roughly the same amount of eggs monthly.

Thus, my demand for eggs is pretty inelastic.

The Utility sector products and services have similar characteristics. They provide electricity, gas, and water. Not only are they difficult to give up, but they are extremely difficult to adjust our consumption without resulting a big impact on our daily life.

Very Heavily Regulated

Because the Utility’s products and services are inelastic, in economic terms. This results in 3 important implications.

Not sensitive to income growth or economic activity

Usually, when the public becomes wealthier, they may indulge more. For example, dine out in the restaurant more often, or buy the latest luxury watch.

The utility may not able to enjoy a lot of this additional spending from their customers. Drinking more water probably is the last thing in their mind when they strike a lottery.

Vice versa, if the public received a pay cut, they may spend less. Instead of dining out, they may cook at home, which is cheaper. However, the utility may not suffer a huge reduction in their customer demand. The customers may consume lesser, but there is a level of consumption needed to maintain their basic needs.

Thanks to this factor, the Utility sector is relatively resilient during an economic downturn.

Natural Monopoly

Utilities are a fine example of a natural monopoly.

Natural monopolies can appear when one company is much more efficient than other competitors in providing the goods or services to the market. Even without unfair business practices that company will over time become a monopoly due to the market conditions.

This may happen in two ways:

1.       The company takes advantage of the industry’s high barrier to entry, thus creating a “moat” around its business operations. One example is the high cost involved. A water utility needs a lot of machinery, and a pipe network, to satisfy the water safety requirement set by the government and hire a large number of specialists, engineers, and technicians.

2.       The company is producing at a scale so large that it is so much more efficient than small-scale production. And that company satisfies all the available market demand. Thus, the small-scale producers can’t compete due to cost.

Utilities tend to be a natural monopoly thanks to the high cost involved and it doesn’t make sense to have another company compete against it. Sooner or later, one company will remain either the competitor bankrupt, give up or merge with a superior company.

Regulations

As Utilities will naturally become a monopoly, they may abuse their unique position and may raise prices without control. Thus, the government will have to step in to ensure there is no such abuse. As Utilities are essential, almost irreplaceable, and vital to the economy, as this gives the government a very strong reason to regulate them. To ensure the utilities are reliable, cost-effective, and still affordable enough for everyone.

But are Utility companies good?

Whether a company is good is subjective. However, in my case, I look for a company that can is it:

·         Profitable?

·         Good cash flow generation?

·         Able to grow?

I take references from the utilities in the USA first. And let’s see if we can find any patterns. Sadly, there are too many utilities listed in the USA, I just use the top 4 market cap and see if I can learn anything from it.

In this case, I will be looking at NextEra Energy (NEE), Duke Energy (DUK), Southern Co (SO), and Dominion Energy (D).

USA Utilities: Profitability?

The overall trend looks like the companies are growing their revenue.

But their net profit doesn’t grow as much as their revenue. But profitable MOST of the time.

USA Utilities: Cash Flow?

Looking into their cash flow from operations can give us an idea of how much cash it generates from their operations.

Most of the time they are generating an increasing flow of cash into the companies.

However, their free cash flow is another story… as Free cash flow is the reminding cash after cash flow from operations deduct from capital expenditures, this shows that to remain in business, utilities need to re-invest themselves. Re-invest itself… Heavily. 

USA Utilities: Growing?

This is a bit tricky… what metrics show that the company is growing?

Maybe let’s look at their cash.

The result is a kind of mix, SO’s cash is growing over time. D’s cash is maintained at a certain range. But overall, most of their cash has wide volatility.

Let’s look at other areas, like their property, plant and equipment. They need these to provide their utility service to the public. 

Well… this assets liner is increasing over time. Generally speaking for all the companies.

Retained Earnings are another way to check whether the company is growing.

Looks like only NEE has a good growth in its retained earnings. While the others are still growing, but not as explosive as NEE.

Singapore Utilities

Philip Securities newsletter email has sent me some suggestions, I will be looking at SembCorp Industries Limited (U96), Keppel Infrastructure Trust (A7RU), China Everbright Water Ltd (U9E), SIIC Environment Holdings Ltd (BHK), and lastly Union Gas Holdings Ltd (1F2).

Now in Singapore, let’s see if we can find any insights. Same as the USA’s Utilities, I will be looking at their profitability, cash flow and whether can they grow.

I will be showing 1 chart with all 5 Singapore utility companies, and 1 chart without Sembcorp Ind (U96). The reason is that I would like to compare all of these companies together, but U96’s data is larger than the other companies, which distorts the chart for the other 4 utility companies. So I will show another chart without U96 to have a better view of the other companies.

Singapore Utilities: Profitability?

Let’s look at their Revenue first.

While Sembcorp (U96) has had huge swings in its revenue over the years, it is the largest out of the 5.

Apart from Union Gas (1F2) seems to grow its revenue the slowest. Otherwise, the rest seems to be quite ok. They can grow their revenue.

Although U96 has the biggest revenue, its net profit doesn’t seem to match its revenue size and suffer a loss in the year 2020. Keppel Infrastructure Trust (A7RU) has also suffered losses in the recent 2 years too.  Otherwise, these companies usually are profitable.

Singapore Utilities: Cash Flow?

Unable to see a clear pattern, but there are times some companies will have negative cash flow from their operations.

Their free cash flows show a similar pattern as their operating cash flow.

Singapore Utilities: Growing?

Again, let’s have a look at the cash

While U96 has the most amount of cash, the rest of the companies (most of them actually) manage to increase their cash in hand.

 

All of them increased their property, plant and equipment, but U96 and A7RU increased their property, plant and equipment more than the rest.

 

Only BHK’s retained earnings are performing well. A7RU is getting worse and worse. Weird… A7RU is profitable but its retained earnings aren’t accumulating.

Observation

Singapore Utilities and USA Utilities are different.

USA Utilities are performing in their operating cash flow, able to invest in themselves and grow their retained earnings.

Singapore Utilities, although their operating cash flow isn’t consistent, can increase their cash in hand. They do invest in themselves, but their retained earnings aren’t that consistent.

Well… recently I learned that, if it isn’t obvious then stay away.

I guess for Singapore Utilities, I probably stay away. It isn’t obvious to me that these companies are prospering.

But for the USA Utilities, there are more than what I just found. Maybe I can spare some time to search for some interesting companies that might be worthy of deeper research.

Your Humility,
Manferd