Companies Buying Back Shares

It looks like share buybacks is back in the headlines again. My blogging life began officially in September 2005, and share buybacks was my very first posting. Seven years on, and the conclusions are still the same.
September 2005: Share Buybacks' Posting
What should investors’ opinion be of these share buybacks? Should companies make known their intentions?

We need to understand first why there is a stockmarket in the first place? First and foremost, it is there to allow companies to raise cheap funds to fund their growth strategies. Secondly, it is to allow for individuals and other entities to participate in the growth of these companies. Other reasons are secondary in nature. A company raises funds to facilitate corporate strategies, hopefully they will make money, preferably higher than the prevailing interest rate (if not, all funds should put money in the bank and close shop). Successful companies may keep accumulating profits to prepare itself for two general reasons: market down cycles, or in order to take advantage of opportunities when there is a market/industry correction/sell-down.

Companies should only indulge in share buybacks when accumulated funds are in excess for the above two reasons. This is because share buybacks will deplete reserves and may not be easily convertible to cash when there is a down cycle or market correction – the time when funds may be needed for those two purposes. Companies doing share buybacks must and should consider this aspect before embarking on the said exercise. Even then, the company can still decide on other options to do with the excess cash – give back to shareholders in the form of dividends or bonus – especially in a matured industry.



Companies raise cash for investing in growth, if they find no good investing opportunities after a prolonged period and cash flow is healthy, the funds should be returned to shareholders. Companies doing share buybacks are basically saying that that is the best way to spend their excess cash. To arrive at that decision, they must be convinced that their share is undervalued compared to their company's prospects. A company’s share price may not reflect its true potential – who knows the company’s fundamentals better than the people running them.

Then we have to look at why management is doing this – is it to improve share price via reducing the free float; and/or improve the earnings per share (but that only happens when they cancel the shares). If a company has to resort to improving their share price by reducing free float, it is usually not successful – a simple glance at the past 2 years' price performance of most of these companies will tell you that. By reducing free float, it is a futile exercise as the company will have to accumulate a significant amount to prop up the share price – that seems artificial no matter how you look at it as the only group really keen to own the shares is the company themselves.

Of course, share buybacks can successfully engineer higher share prices by massively reducing free float but they will have to meet regulations for minimum free float in the market place. The danger is that share buybacks can be taken advantage as “insider trading” by management as it involves market timing – hence the authorities must be more vigilant when it comes to the timing of share buybacks. If a company buyback the shares and do not cancel them, are they waiting to unload when price is higher? That is tantamount to trading in their own shares or having an investment portfolio. Is that part of the company’s normal course of business? Can this activity account for a substantial amount of profit for the company? How should analysts regard this profit – probably not enthusiastically as it is considered as a “one-off.”

It is safe to say that companies should make their intention known to the public when doing share buybacks – is it for future placements to institutions; to be cancelled, if so please state a time frame; not to be cancelled, but to be sold back into the market when price is higher; or to be disbursed as bonus. To me, that is vital information and I believe investors will rate the stock accordingly with the new information.



Bottom line, if it is not going to be cancelled, share buybacks are not really that big a positive in rating the company. Most times, companies who do share buybacks will not see significant improvements in their share price – investors do not rate a company higher because of that as investors are not buying the stock in the first place for various other reasons, and the free float is not really a major reason. Any worthy share buyback has to be cancelled for it to be effective.

Companies not doing that, need to ask themselves more questions as to why their share price is not at a level where it should be – are investors not happy with the management’s vision; is the company not communicating its plans effectively; has the company not been able to chart a credible track record; have the financial results for the company been haphazard or inconsistent; is the company too unfocused or too diverse that nobody even wants to follow/research the company; how is the management track record been in treating minority shareholders; have transactions or deals been really fair to all shareholders or been forced down investors’ throat (oops, getting too specific here) – chances are the stock will be rated properly if the above concerns have been addressed. Hence most share buybacks will not be entirely successful as it is fighting against the “enemy” when the “enemy” is really internal not and not external.

Notion Vtec's Prospects Reassessed

Following its corporate exercise the shares traded around RM2.60 and as the news began to filter that the 10% new share issue is to be placed out to one of the major clients, Nikon. Nikon has a commanding global share of the high -end DLSR market (circa 40%). As was reported through the Dow Jones Newswires:

http://malaysiafinance.blogspot.com/2010/01/dow-jones-newswires-report-on-notion.html

The full FY2009 (ended Sep 09) earnings per share amounted to 25.6 sen per share based on the consolidated 140.7 million shares of 50 sen each. The results were above the last earnings per share guidance. OSK projected that its 2010 net figure would jump to RM52.8m or a net EPS of 37.5 sen.

At a share price of RM3.30, that works out to be a quite ridiculous 8.8x PER for 2010 for a company that is showing double digit EPS growth trend. Why is that ridiculous, you might ask. One, the emergence of Nikon (if the news is correct) as a 10% shareholder will boost its image and secure its future order flows. Needless to say, the main reasons why Notion Vtec was picked by Nikon were their strategy, execution ability and relevance in moving up the value-chain. Their expansion into Thailand (funded by the share placement) fits in nicely with Nikon's plan.

Would the move alienate Notion's other clients? Most probably not, as there is no hint of a board seat for the new substantial shareholder. Moreover, Notion Vtec's attraction is their ability to deliver, and that is paramount to any clients.

Notion Vtec Bhd is the country's leading listed maker of precision components for hard-disk drives (HDDs), and have started making 2.5" HDD components for South Korea's Samsung Co. Notion will initially make up to 500,000 pieces a month for Samsung with an average selling price estimated at RM4 a piece, and the volume can go up to one million pieces per month by mid-2010. The qualification to produce for Samsung could be a significant earnings kicker going forward. Samsung is the world's largest maker of liquid crystal displays, would fit in nicely with Notion's existing customer base.

Notion's biggest cutomers by revenue contribution are Western Digital Corp,the world's second largest maker of HDDs; Hitachi Ltd, Japan's third largest manufacturer; and Nikon Corp, the world's second biggest camera maker. Currently, some 80 per cent of Notion's sales comes from the from the HDD and digital camera industries, while the remaining 20 per cent is derived from the industrial segment, particularly from electronic braking systems for the automotive industry.

Now that it has breached the RM3.30 mark, could there be further upside from here? The key is the 8.8x 2010 PER. Notion Vtec is being bought up by smart fund mangers even at present levels. If you do not do your homework, you would have just had a nice profitable trade and will probably miss out on the fat. Remember 3A! Of course I am not saying this is another 3A, but its going to look a lot like it because of one major factor - JCY HDD.

What is JCY HDD? .... JCY HDD is a wholly owned unit of JCY International. The group is one of the world’s largest HDD components manufacturers, with manufacturing operations in Malaysia (Johor and Penang), Thailand and China. The JCY group reported a revenue of RM1.76 billion and net profit after tax of RM207 million for the financial year ended Sept 30, 2009. The submission of JCY’s listing draft prospectus confirmed The Edge’s report that the HDD components maker was seeking to list on Bursa Malaysia and had appointed CIMB IB and UBS AG to work on its initial public offering. Both CIMB IB and UBS AG are also lead arrangers on extending the term loan to JCY HDD. According to a source familiar with the matter, the IPO exercise valued JCY at RM4 billion in terms of total market capitalisation - the next biggest IPO in recent times after Maxis.

As news of the pricing of JCY HDD began to flow out, it is apparently going to be around 14x earnings. If you put JCY HDD next to Notion, even though the former is bigger, Notion Vtec will win on many factors. Notion will have a lot more room for growth than JCY HDD owing to their relative size. Notion has Nikon, and seriously, Notion's production structure is more geared towards the cutting edge of technology. Notion is producing HDD for a few of the top rung global players. They are supplying digital cameras and LCDs for Nikon and Samsung, the two market leaders in their fields - these two sub sectors are the real growth sectors in HDDs, need I say more. JCY lags behind in terms of margin profitability, ROE and track record even.

Many smart funds are willing to accumulate Notion Vtec to at least revalue it closer to JCY HDD's 14x pricing.... and that's assuming JCY HDD does not perform very well on trading, if JCY performs well, that will only drag Notion Vtec along as it is in its slipstream. Even if you take a 12x PER for 2010, Notion Vtec is well supported at RM4.50.

Why the disparity? Its not that JCY is overvalued but rather its only in recent times that Notion Vtec has been on the radar, and that the latter is grossly undervalued. Now that there is JCY HDD in the frame, Notion looks like a princess, before, Notion was pretty but alone in the forest, now Notion has come to the city and shines brilliantly next to anyone.

After the consolidation there is just 140.7m shares. Which way will you be leaning to?

NOTE: The above opinion is not an invitation to buy or sell. It serves as a blogging activity of my investing thoughts and ideas, this does not represent an investment advisory service as I charge no subscription or management fees (donations are welcomed though). The content on this site is provided as general information only and should not be taken as investment advice. All site content, shall not be construed as a recommendation to buy or sell any security or financial instrument. The ideas expressed are solely the opinions of the author. Any action that you take as a result of information, analysis, or commentary on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

p/s photos: Lin Chiling