Accelerated Share Repurchase / Buybacks (Home Depot Case Study)

Accelerated Share Repurchase / Buybacks – A share buyback, also known as a repurchase, means that the company purchases its own shares in order to reduce the outstanding shares in the open market. The reduction in the number of shares outstanding in the market eliminates any potential threats from the large shareholders who are on the lookout for increasing their control to significant levels in the company. Using a buyback, the company invests in itself, which improves the proportional share of earnings; this steps up the valuation of a stock.

As seen from the above snapshot, United Technologies entered into an “accelerated buyback” agreements with two banks (Deustche Bank AG & J.P.Morgan Chase) to repurchase $6 billion worth of company’s stock. Is Accelerated Buyback different from the Share Buyback from the open market? The answer is YES, and in this article, we look at Accelerated buybacks in detail.

• What are Accelerated Buybacks?
• Methods For Repurchase of Shares
• Reasons why companies should repurchase their own shares?
• Home Depot Accelerated Buyback Case Study
• United Technology Accelerated Buyback
• Advantages of Accelerated Buy Backs
• Disadvantages of Accelerated Buy Backs
• Accelerated Buy Backs – Accounting & legal requirements
• Effect of Share Buyback on market price
• How is the Buyback Ratio used for comparison?
• Conclusion

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What are Accelerated Buybacks / Accelerated Share repurchase?

An “accelerated” buy back is also known as an accelerated share repurchase (ASR). It is a practice that companies follow in order to buy back shares of its stock from the market. In traditional buy back methods, it may take weeks or even months for the companies to purchase shares from the open market. But in the case of an accelerated plan, the companies ask the investment banks to short the full amount immediately. When the companies purchase the shares that have been shorted by the investment banks, it agrees to bear any losses on the behalf of the bank. These shares, rather than being sold, are retired by the company. The buyback programs generally become a common phenomenon during the economic downturn when the stock prices fall down to typically low values.

In an accelerated share repurchase, the company buys its shares from an investment bank and the investment bank, in turn, borrows shares from the company’s clients. The investment banks are paid in cash by the company to buy shares in the open market. Since the investment bank has sold the share to the company to return the shares to its clients, they purchase the shares from the open market. At the end of the transaction, the company ends up receiving more shares than it initially had. While the returns on accelerated repurchases are positive, it is still less scalable as compared to conventional open market repurchase operations.

The main benefit of accelerated buybacks is that it gives a big short term boost to share prices of the company. At the same time, the company’s earnings get elevated and the profitability of the company increases on a per share basis. Such a method is also used by the management in order to alter the earnings figure for reporting reasons and incentive remuneration. This procedure can also sometimes seem to be a strategic move by the companies to shift the risk of stock buybacks to the investment bank when the company senses that the shares are undervalued.

Shareholders, very often, prefer share buyback programs, despite the risks involved because the ownership held by each investor expands when the number of outstanding shares floating in the market decreases. The company generates higher returns by making its shareholder value less dilute and spreading the same market cap over fewer shares than earlier. But realistically, in most cases, the ideal target is not achieved completely.

The share repurchase programs boost the earnings per share of the company and give a boost to stock prices as well. Apart from boosting earnings per share, buyback program reduces the value of the assets on the balance sheet. As a result of this, the shareholders’ funds, the return on assets and return on equity increase because the balance sheet has to remain balanced. Mostly, the repurchase programs target the short-sighted investors.

Methods For Repurchase of Shares

There are primarily four ways, using which the companies can repurchase their shares:

• Open market repurchases: Companies carry out buyback programs in open market over an extended period of time and may even have an outlined share repurchase program that buys back shares at certain times or at regular intervals.
• Tender issuing offers: Shareholders are presented with tender offers. The shareholders get the chance to submit all the shares, or some portion of their equity that they are holding, within a specific timeframe and at a premium over the current market price.
• Privately negotiated repurchases: Another method for the companies to buy back shares is by using privately negotiated repurchases. A privately negotiated repurchase provides a means for the company to repurchase a sizeable amount t of shares quickly.
• Structural programs: This type of repurchases has the accelerated share repurchase programs as one of its types. When considering the accelerated share repurchase programs, the company’s management has to decide if the share repurchase will be the most effective method for utilizing their cash. At the same time, the company also needs to consider the legal implications and the strategic considerations involved while going ahead with the accelerated share repurchase.

Reasons why companies should repurchase their own shares?

There are several strategic or other reasons why companies repurchase their own shares. The major reasons out of them are listed below:

• For returning a portion of the capital to shareholders in a tax-efficient manner rather than declaring dividends.
• Creating an impression in the market that the company’s share is not undervalued and thus are a source of good investment.
• Reducing outstanding share count in order to increase earnings per share or enhancing other performance metrics.
• Share repurchase dilutes the impact of merger and acquisition activity.

Home Depot Accelerated Share Repurchase Case Study

Since the inception of the Company’s initial share repurchase program in fiscal 2002 through the end of fiscal 2015, the Company has repurchased shares of its common stock having a value of approximately $60.1 billion.

• In 2006-2007, Home Depot agreed to buy back 289.3 million shares of its common stock for $10.7 billion.
• In 2014-15, Home Depot buyback in excess of $7 billion worth of common stock.

As we can see from the below graph, Home Depot prices have climbed from a low of approx. $20 per share in 2009 to a current high of $139 in 2017.

source: ycharts

Home Depot Shares Oustanding

We note that Home Depots Average diluted shares outstanding  decreased by more than 30% in the past 6-7 years. This is due the the buyback of shares.

source: ycharts

Sample Accelerated Share Repurchase Agreement – Home Depot

Below is a sample accelerated share repurchase agreement of Home Depot. this details the amount committed for buyback during each quarter, initial shares delivered, additional shares delivered and total shares.

source: Home Depot 10K Filings

United Technology Accelerated Buyback

At the end of 2015, United Technology entered into accelerated share buyback agreements with Deutsche Bank AG and J.P.Morgan Chase with each delivering $3 billion worth of stock under this program.

source: ycharts

This accelerated buyback was a part of $10billion repurchase planned for 2016. As per the Chief Executive Greg Hayes, this buyback takes advantage of the “big disconnect” between the company’s value and share price.

Advantages of Accelerated Share Repurchase

If the management of the company believes that the shares are undervalued, they repurchase the stocks and resell them when the price of the stock has been increased in order to reflect the precise value of the firm.

But for the meanwhile, the process of accelerated buy backs does serve some important purposes that are listed below:

• Accelerated share repurchase indicates to the investors that the company has enough money for economic crisis or for emergencies.
• Repurchase of shares increases the earnings per share (EPS), due to the reduction in the number of outstanding shares.
• Buybacks also counter unfavorable events such as hostile takeovers by preventing another firm from acquiring the company’s majority stock. The takeover target may buy back shares at a price, which is greater than the market value.
• Accelerated share repurchase stimulates the existing open market repurchase programs.
• Companies also consider buybacks for compensation reasons; at times, the company’s employees and management are rewarded with stock rewards and stock options.
• Share repurchases help in avoiding dilution of existing common shareholders.
• When the company spends the cash on hand on buying stocks from the market, it improves the overall performance metrics of the company.
• When companies carry out accelerated plans, they usually see that the company’s stock price is higher, yet the investors are not cashing on it because of being bullish on the company. In this situation, an accelerated buyback can kick start another rally of the company’s stock.
• Companies are generally able to increase dividend payments after doing an accelerated buyback as there is less number of shares on which the company has to pay the dividends.

Disadvantages of Accelerated Buy Backs

• Any share repurchase program serves as an easy cover up for the poor financial status of the company. The investors get a false impression about the financial situation of the company as the statistics improve drastically.
• Often, it has been observed that the company insiders take advantage of the stock exchange programs while not diluting the actual EPS number, which is reported in the books of the company.
• During the accelerated programs, the share repurchases are often not able to be completed. It becomes difficult to know the real impact of the repurchase on the market price.
• When the companies buy its own stock, it also creates a negative reputation of the company in the market.
• The buying of its own stock from the market also leads to poor utilization of the company’s capital because the company could as well employ the same dollars to fuel its business growth.
• Sometimes, buying the stock in the open market turns out to be a poor option for the companies. Because of flotation in stock market, the repurchase doesn’t prove to be a good use of capital.

Accelerated Share Repurchase – Accounting & legal requirements

In item 703 of Regulation S-K, it is stated that for all repurchases of equity related securities, the following information must be reported by the company in the form of tables:

• Number of shares that are repurchased.
• The average share price paid for repurchasing.
• The number of shares whose repurchase has been completed under the publicly announced program.
• The maximum number of shares (or approximate dollar value) that are remaining to be repurchased under the program.

Further, the company is required to disclose the above information for each month of the preceding fiscal quarter in the report of the next reporting period.

Additionally, for publicly announced programs, the SEC requires disclosure (in footnotes to the table mentioned above) of the following information:

• The announcement date.
• The approved number of shares or the amount by the board of directors.
• The date of expiry of the program if any.
• Whether any program has expired during the last fiscal quarter.
• Whether there is any program has been terminated prior to expiration or which the issuer does not intend to continue.

Generally, these disclosures are also included in the liquidity and capital resource section of the companies’ “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, which is an integral part of their annual and quarterly reports.

A company considering the share repurchase plan should consult an outside counsel and other investment advisors. When carrying out the accelerated buyback programs, the companies should review the limitations or restrictions on repurchasing the shares, some of which are listed below:

• Tax and accounting statistics related to share repurchase
• Any application requirement related to stock exchange on which the shares are listed
• Organizational documents including certificate of incorporation and bylaws
• Relevant laws related to state of incorporation
• Any agreements that may limit the ability to repurchase the company’s securities

Effect of Share Buyback on market price

A company’s stock has underperformed compared to its competitors for a particular financial year. In order to please the long term investors, the company plans to purchase a stock repurchase program. The company purchases 10% of the outstanding shares at the market price. The company had $ 1 million in earnings spread out over 1 million shares, equating to an EPS of $ 1.0. Since the value of its P/E ratio is 20, the share traded at $20. Now, if 100,000 shares are repurchased, the same earnings of $ 1 million will get spread over 900,000 shares, resulting into an EPS of $ 1.11. Assuming the P/E ratio to remain 20, the shares would trade up by 11% to $ 22.2.

Expanded share buybacks:

When there is an extension in the company’s accelerated share buyback program, it is called an expanded share buyback. The expansion in share buybacks leads to a faster contraction of the share float of the company. The more the amounts by which the expanded buybacks surpass the existing share repurchase plan, the better is the market reaction. The reaction effect of an expanded share repurchase depends on its magnitude.

Buyback Ratio:

Buyback ratio is the ratio of the cash paid for buying back its own common shares by the company over the previous year, to its market cap at the start of the period over which the buyback has been carried out.

The buyback ratio enables us to compare the potential impacts of repurchases across different companies. It also clearly indicates the ability of a company to be able to create value for its investors and return that value to them. This is because companies that engage in regular buybacks usually have a history of outperforming the market. Buybacks decrease a company’s number of outstanding shares, which results in an improvement in earnings and cash flow on a per share basis. Thus, share buybacks have a definite advantage over dividend disbursement by offering the management a greater flexibility.

How is the Buyback Ratio used for comparison?

Take, for example, a company, Company A buys back some of its common shares for $ 150 million over the last 12 months. Suppose that it had a market cap of $ 3.0 billion at the beginning of this period. By dividing the amount of buyback by the total market cap, the buyback ratio would come out to be 5 %. Similarly, if another company, Company B, buys back some of its shares worth $ 400 million over the same period and had a market cap of $ 16 billion at the beginning its buyback ratio comes out to be 2.5 %.

Therefore, Company A has the higher buyback ratio despite spending less than half of the amount spent by Company B on share repurchase. This is because of the much smaller market cap of the former.

Also, check out Restricted Stock Units

Conclusion

Many companies face and will continue to face critical choices regarding how to best allocate their surplus cash. An increasing number of companies, over the years, have chosen to repurchase shares of their own stock.

It is also important for a company to critically analyze the implications of share repurchases from a legal point of view, as discussed above in this article so that it can make an informed decision. If a company elects to implement a repurchase program, it should take great care to ensure that the individuals and the institutions, given the task of implementing the program, understand the relevant contractual restrictions and statutory requirements as well as the necessary processes required to ensure compliance.

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