A risky business

A risky business

Share redemption is like a double-edged sword. The very advantage associated with it can backfire and become a major disadvantage

The recent announcement by the Gas Authority of India Limited (GAIL), pertaining to its share buyback worth over Rs 1,046 crore as it looked to return surplus cash to bondholders the biggest being the Centre is perfectly in tune with the Government’s efforts to raise funds for containing the rising fiscal deficit. The company’s Board approved repurchase of the Rs 6.97 crore dividend, which is about 1.55 per cent of the total paid-up capital, at a price of Rs 150 per share. The Indian markets may see similar announcements by other Public Sector Undertakings (PSUs) like Coal India Limited, National Thermal Power Corporation Ltd and National Mineral Development Corporation in days to come. GAIL has also declared an interim dividend of Rs 2.50 per share for the coming year. This share buyback forms a part of the target set by Finance Minister Nirmala Sitharaman for raising Rs 2.1 lakh crore from the disinvestment of PSUs in 2020-21. Share redemption is the process by which companies buy their own dividends which are traded on the bourses at the market value, and in addition to its stock, is a preferred way to repay cash to the shareholders. Paying dividends to bondholders is an expensive affair as it increases the cost of equity. Therefore, paying off shareowners through buybacks is less expensive and reduces the overall cost of the capital. Since 2016 through 2018, it was one of the most favoured ways of returning excess cash to bondholders. In 2018, Indian stock markets witnessed bond repurchases worth Rs 54,600 crore. This run was somewhat stalled in 2019 by the Government’s decision to tax these transactions. As many as 70 companies announced share buybacks to the tune of Rs 35,460 crore in the first half of 2019. In the 2020 Budget, however, the new tax regime made share buybacks lucrative once again.

 There are several reasons why firms buy back shares. First, to consolidate their stake as diverse and numerous policyholders or owners make it difficult for the company to take an undisputed decision, as numerous stakeholders with voting rights indulge in a power tussle. By redeeming shares, companies increase their voting rights and exercise more control over governance. For instance, OYO’s share buyback from Sequoia and Lightspeed in 2019 increased the stake of Chief Executive Officer Ritesh Agarwal from a meagre 10 per cent to 30 per cent, increasing his say in decision-making. Second, by redeeming its shares, a firm sends positive signals about its future prospects and growth potential. A company may also believe that the current stock price is undervalued and takes it as a good opportunity to increase its bondholding keeping in mind future prospects This is known as the signaling effect. Third, share repurchase is one of the best uses for any idle cash reserve companies might have, especially when there are not enough chances to invest the excess money.

However, share redemption is like a double-edged sword. The very advantage associated with it can backfire and become its disadvantage. While competing in a high growth industry, buyback may not be considered a positive step as it may give an impression that the firm does not have enough avenues to invest its idle cash reserve. Long-term investors respond to such share buybacks by selling their stakes. For instance, IBM’s buyback announcements between 1995 and 2000 made investors apprehensive about the company’s ability to bring out new products and services. Further, share repurchase is not an isolated event and has to be always viewed in conjunction with other performance parameters. For instance, it will not send a positive signal about the future growth potential to the investors if profitability is declining or the financial outcomes are showing otherwise.

Basically, there are three ways in which companies buy back their shares. Open market repurchase is the most common buyback mechanism in which firms announce redemption of a certain number of bonds through a Press release but do not give details of price, timing and execution of the deal. In fixed-price tender offers, companies invite shareholders to sell their dividends to the firm at a fixed price, generally at a premium rate to the prevailing market price, within a given time frame. While in auction-based tender offers, firms disclose their willingness to pay a premium and seek tenders from owners for certain portion of shares. It is the responsibility of the shareholders to respond to the company about the quantity of shares to be sold within a specified time period. Studies on the impact of share buyback have found that share redemption boosts operating performance due to an increase in earnings per share, return on equity and return on assets, rise in stock prices and shareholders’ value. But negative effects of share repurchase on the stock prices of the firms have been reported, too. Although buybacks bring a positive sentiment to the bourses, their attraction for firms and shareholders depend on factors that are unique to each case. The management has to decide the proper use of its funds — either to reinvest in its business or return cash to the shareholders — creating a balance between future growth and stockholder’s value creation.

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