The #1 factor that proves management believes its stock is cheap

The longer I invest money, the less I listen and the more I watch. As the grey hairs increase and the battle scars mount, I have grown an aversion to sharp talking management teams who promise the world and deliver an atlas. Instead, I have become more of a student of history. To look at what has actually transpired. Talk truly is cheap. I’m no longer interested in what’s going to happen. I want to see a demonstrable track record. What has management achieved.

In this same vein of seeing action over words, it’s time that Australian Boards caught up with their US counterparts and more critically examined the role and merits of share buybacks. After all, when management commence a buyback, they’re not just telling the market their stock is cheap, they’re acting on it.

A buyback is not appropriate for most companies

Let me begin with a statement that flies in the face of the introduction: in the majority of situations, a buyback is not appropriate. It is a sad reality, but for most companies, it simply does not make financial sense to buyback and cancel shares. Put simply, most companies find themselves in one of the following situations:

1. Too much debt
2. High capex
3. Poor free cashflow (perhaps low cashflow conversion)
4. Declining earnings
5. Significant earnings uncertainty
6. High Stock valuation.

In the case of the first 5 points, these are all clearly negatives and should garner caution and closer examination. In the case of the final point, this is a terrific situation to find oneself in. And management should capitalise on the opportunity by turning their focus to using their overvalued script proactively. For example through M&A or actually raising capital for ‘future opportunities’.

A buyback is a special vote of confidence

So because a buyback isn’t appropriate in most situations, where it does occur, it should be seen for the special signal that it is. By definition, more often than not, a buyback indicates that the company has a strong balance sheet, modest or low capex, strong free cashflow generation, stable and transparent earnings and is trading below intrinsic value – often by a long margin.

Of course, I write ‘more often than not’, as I have seen examples of management trying to ‘con’ the market by initiating a buyback where it was clearly inappropriate. But on the whole, a buyback is a strong signal that management is a true believer in the outlook for their own company.

Why a buyback makes so much sense

In the current market, there are many companies trading on single digit Price to Earnings Ratios (PERs); some considerably lower as we shall see below. If we consider a company trading on say 9x earnings, then the maths is compelling.

On 9x price to net profit after tax, buying and cancelling shares will yield a return on every share purchased of 100/9 = 11.11% return – AFTER TAX. That equates to 15.87% ROIC pre-tax.

And that is a guaranteed return. No ifs or buts. In coming years, as the company’s own earnings grow, the ROIC on the cancelled shares will also increase. Less shares to divide profits amongst. Less shares to distribute dividends to. The benefits will flow into perpetuity.

Valid rationale or excuse?

Many companies that are (super) cheap, have good cashflow and a strong balance sheet, make the decision NOT to genuinely assess a buyback.

The most common excuses I have encountered are:

1. Uncertain times ahead or lack of earnings transparency

2. Stock is too tightly held / illiquid

3. Higher return elsewhere – through organic or inorganic growth

Each of these reasons may actually be valid under certain conditions, but often they are not.

For example, in the 1st instance, during times of extreme market dislocation, this may make sense and in fact be prudent. But if this reason is used repeatedly over a period of time, then management really need to fess up. Either they lack an understanding of their business, or their earnings really are volatile and outside of their control.

Similarly in the 2nd instance, it may make sense to look to promote liquidity where, for example, the stock is on the cusp of moving into a new index. But this is rare and is also a bit of a misnomer, because turnover is based on the value of stock not the number of shares which trade. For example, 100 trades in a $1 stock is the same as one trade in a $100 stock. As an investor, what is important to me is the value of my holding, not how many shares I own. I would be more than happy to see the value of my holding rise, because there are not enough sellers (read ‘poor liquidity’) and the buying causes the price of the stock to appreciate.

In the third situation – where management want to ‘keep the powder dry for other opportunities’ – this also may make sense. But a full and proper examination needs to take place. For example, as we saw above, if a stock is generating a 12.5% return after tax GUARANTEED, then in assessing growth opportunities this needs to be the benchmark. And it needs to include a margin for uncertainty. 12.5% today in our own stock which has a high degree of familiarity and confidence, may be equivalent to getting 16-18% in another company where there will always be a higher level of uncertainty. If the ROIC on a growth option is not notably higher than a buyback, then the question must be asked ‘is management trying to build an empire or do what is best for shareholders?”

#1 Buyback Candidate

We rate the management team at Pepper Money Limited (ASX: PPM), and that perhaps as much as anything is why I believe that they are a compelling candidate to initiate a buyback. Even allowing for an inevitable earnings downgrade, PPM is trading on a PER (price to net profit after tax) of 5x FY24 earnings. For conservatism, let’s assume a further 20% hit to earnings above and beyond that which has already been provisioned. In approximate terms, this leaves PPM trading on a PER of 6x. At 6x, the ROIC for buying and cancelling a PPM share is 16.67% after tax, or a whopping 23.81% on a pre-tax basis. There are not too many acquisitions that can ‘guarantee’ that return.

And the impact of successive buybacks has a compounding effect on returns. For example, a 10% buyback year on year, produces a ROIC of 18.52% in the second year and 20.58% in year 3. On a pre-tax basis, this equates to 26.46% in year 2 and 29.40% in year 3; even without any growth in underlying profits.

PPM is generating strong free cashflow, has large cash reserves, is trading below book value and has an EPS CAGR of 21% over the past 8 years. And as I said, the management are first rate in our assessment. So why wouldn’t they back themselves by buying and cancelling shares?