BusinessDay... the voice of business: Banks build up to another round of shares reconstruction

Banks build up to another round of shares reconstruction
================================================================================
Chinedu Dike on 06 February, 2008 01:00:00
 
A recent report by BusinessDay indicated that the new wave of share issues in
the banking sector is once again swelling outstanding shares of banks. The
implication is that the banks in carrying these large shares volumes may not be
able to generate enough profits to give good returns on investments.
Specifically, the report noted that total returns will either trim down or at
best be held at their current levels for any bank that is doing fairly well.
Worse still, the report said, is the fact that investors based on this may not
expect bonus issue from the banks in the few years to follow. And for the other
banks whose performance is less competitive, total returns including bonus
issues will be very marginal or even zero. The concern here is that in an
environment like ours where investors tie high returns expectations to bonus
issues, the market may witness strong resentment to banking stocks, at least in
the short run.
Trailing the first phase of consolidation which was concluded in December 31,
2005 was the shares reconstruction era. Some of the consolidated banks embarked
on shares reconstruction. The objective was to trim down the volume of shares
outstanding and gain higher market value for the shares.
Some of the banks that prosecuted their consolidation through mergers or
acquisitions came out with over bloated share volumes that if carried in the
books would significantly reduce returns to shareholders.
Specifically, companies may want to make their ratios look better. Performance
indices like price earnings ratio, earnings per share, return on assets, return
on equity, dividend per share and others can be pumped up by a stock buyback
program.
The share capital being the denominator, and since earnings is not likely to
grow at the same rate as the shares outstanding, it then means that the higher
the shares volume the lower the returns to the investors in terms of EPS and DPS
and so on.
To check such development, the banks have opted to reconstruct their
outstanding share capital. This they have found to be more comfortable to manage
as it does not require any cash outlay, but mere adjustment in the books of the
company.
On the other hand, the option is what most share holders have quarreled with
and raised strong objections. Their argument is that shares reconstruction
leaves the investor worse off at the end of the day, while the board turns out
results that look good on paper but offer nothing to the investors.
They have contended that rather than share reconstruction, the board and
management of the banks should have used the shares buy-back option to reduce
the shares outstanding. This option they said achieves the twin objective of
reducing the issued and paid up share capital for higher market value, as well
as returning some cash into the hands of the shareholders. This cash can go into
other high yield investment or help the investor attend to other current needs.
This is a good argument, but the question is whether these banks have such free
cash to pay out to the investors.
Stock buy back is method whereby a company buys back its own shares from the
market. An example of a company implementing stock buy back is Microsoft. The
firm is in the middle of a stock buy back program that will repurchase $40
billion of its stock by 2011. It feels that this is the best way it could apply
the excess cash at its disposal being that there is no pressing investment need.
Rationale for share buyback
And the question is why Microsoft or any company would buy its own stock off
the open market? There are several possible reasons, but the basic consideration
is what effect it would have on shareholders. Under most circumstances, stock
repurchase plans benefit stockholders.
The reason is that fewer outstanding shares mean the remaining shares are worth
more. This is seen as having weighty five pieces as against eight pieces of an
item. The company does not change, but the value of the stock does, because
there are fewer shares outstanding.
Off the market
Having so acquired the shares the company either cancels the shares it buys
back or puts them in the treasury. Which ever way, it is off the market and off
the street and no longer involved in the business.
Motivations for a share buy back
If the circumstance demands it, stock buy back is sometimes seen as one of the
best investment options for company’s money as at the time of exercising the
option. The reason is that rather than creating what appears to be a mirage, the
interests of the shareholders are actually wooed for the future growth of the
company.
Managers are charged with creating wealth for the shareholders. Part of that
responsibility is deciding what the highest and best use of cash is for the
company. The usual corporate explanation is that buyback was the best investment
of the money at the time and it provided shareholder with additional wealth by
increasing the value of their stock.
The minuses
While the above and more holds well for a stock buy-back option, it is not all
a fair game as there are some minuses. Shares buy back works for a company that
has idle cash. What this means vis-à-vis the banking consolidation is that the
option would certainly not work as the banks that have embarked on share
reconstruction actually need more cash strengthen their market position.
But the truth is that nothing has fundamentally changed about the company. If
there were weaknesses in the business model before the stock buyback, those
weaknesses will still be there after the buyback.
Another problem stock buybacks seek to cure is the dilution (too much stock on
the open market) caused by too generous stock option or stock compensation
plans. When stock options are exercised the number of outstanding shares
increase. This makes the company’s ratios look weaker – the opposite of what
repurchasing does.
In Microsoft’s case, the company has been sitting on a huge bankroll of more
than $34 billion in cash. With no major acquisitions in sight or legal
settlements pending, the company cannot, in good faith just let the money sit
there. It needed to either invest it in something that created wealth - an
acquisition, for example, or return it to shareholders in the form of a dividend
or stock buyback.
But whatever be the case, it is advisable that a close look is taken behind the
numbers for the real story before assuming that a stock repurchase is good for
shareholders or just window dressing.