We are joined this week by contributing editor Shawn Allen, who has been providing stock picks on his website at www.investorsfriend.com since the beginning of the year 2000 and has a great success record. Shawn is based in Edmonton.
Shawn Allen writes:
Opinions vary as to whether or not companies should buy back their own shares. Some would argue that it is almost always a good idea because, they contend, buybacks increase earnings per share. Others argue that it pushes stock prices up artificially in an unsustainable manner. Still others say that when companies buy back shares they are failing to reinvest for growth and are basically starving the economy of jobs and expansion. It has also been argued that share buybacks are effectively an additional dividend.
Warren Buffett (Trades, Portfolio) addressed this topic in some detail in his 2010 shareholder letter. Buffett said that he favored share repurchases when two conditions are met. First, there is money available for the repurchases with ample funds left over to take care of the operation and liquidity needs of the business. Second, the company’s shares are selling at a material discount to their intrinsic value, conservatively calculated.
Notice that Buffett’s criteria for repurchasing stock does not mention the impact on earnings per share (EPS). It is true that a stock repurchase will almost always increase EPS. That’s because it takes cash that is typically earning little or nothing and effectively invests it in shares that even at a p/e of, for example, 25 results in an initial earnings on the share buyback investment of 4%. And the buyback will likely earn more than 4% in the long term due to the growth in earnings that will no longer be shared with the former owners of the stock. But that still does not necessarily make the buyback a good investment, much less the best use of the cash.
A company can also increase its earnings per share by simply taking cash that is earning nothing and investing the money in a long-term government bond earning, say, 3%, even when that 3% will not grow. But that’s unlikely to increase the intrinsic value per share or to be the best use of the money.
If a company has excess cash beyond the levels that it can reinvest in the business or use to make acquisitions at good returns, then it should consider buying back its own shares. But, as Buffett pointed out, that should be done only if those shares are selling in the market at a price that is clearly below their intrinsic value. Otherwise it should consider paying out the cash as a dividend.
It has sometimes been argued that a company buying back its own shares is basically equivalent to paying a dividend. From the point of view of the company the two may be equivalent. Both actions can remove exactly the same amount of money from the firm.
But individual shareholders are definitely not indifferent to the choice of dividends versus share buybacks. A dividend distributes money to all shareowners in proportion to the amount of stock they own. A share buyback provides cash to those who sell into the buyback and leaves each continuing shareholder owning a larger percentage of a company that now has less cash than previously.
A share buyback effectively returns capital to former and now departed owners. In contrast, a dividend returns capital to the continuing owners of the company.
To the extent that the market is rational and efficient, it will not be “fooled” by share repurchases. A strategy that attempts to drive the share price up by repurchasing shares at extravagant prices is likely to fail. The market will recognize that this is a poor use of funds. The market also sometimes considers share buybacks to be a signal that the company has limited growth prospects.
Many companies have been in the habit of buying shares in order to “offset” the issuance of stock options. This may sound reasonable but it is fundamentally illogical. If issuing options to management is a good strategy, then it is a good strategy whether or not shares are repurchased as an offset. And if buying back shares is rational at their current price, then the quantity to be repurchased has no logical link to the amount of share options issued. A rational company tries to increase its true value per share rather than attempting to keep its share count stable.
The criticism by some that share buy backs “artificially” inflate stock prices is generally not valid. If stock is repurchased at attractive prices then the individual value of the remaining shares is legitimately higher. If the cash used to repurchase the shares would otherwise have languished earning little or nothing in the bank, then the earnings per share and the value of the remaining shares has increased. If, on the other hand, the cash could have instead been used to expand the business in projects with double digit return on equity (ROE) then that would likely have led to an even larger increase in the intrinsic value per share.
The criticism that companies should reinvest to grow the economy rather than buy back shares is also not valid. The economy works best when companies and individuals take those actions that are in their own financial self-interest. Encouraging companies to invest their money in uneconomic expansions is likely to damage both the business and the economy in the long term.
The bottom line is that share buybacks are neither inherently good nor bad in terms of their impact on share valuations and prices. It depends very much on whether or not the shares are being repurchased below their fair value and on what the alternative uses of the money would have been.
It should be considered to be a positive sign when companies follow a rational approach to share buybacks that considers whether or not the shares are undervalued in the market and the alternative uses for the cash. In the following updates I will indicate what the company has been doing in regard to share buybacks.
Canadian Tire Corporation Ltd (TSX:CTC.A, Financial)(CDNAF, Financial)
Originally recommended by Tom Slee on June 13/11 (#21121) at C$61.58, US$62.90. Closed Friday at C$131.63, US$109.05.
Recent earnings. Canadian Tire reported first-quarter earnings on May 14. I had expected that earnings might decline in 2015 for two reasons.
First, the company purchases most of its goods in U.S. dollars and the dramatic decline in the Canadian dollar in the past year would have increased their cost of goods sold, unless they had fully hedged for the currency risk.
Second, the company sold 20% of its lucrative credit card operations to Scotiabank effective Oct. 1, 2014. All else being equal, since some profits are now flowing to Scotiabank, this will lower Canadian Tire’s profit until such time as they can fully redeploy the proceeds received.
After adjusting for a gain on a land sale, I calculate that profits did decline by 8% in the first quarter, likely as a result of the two reasons mentioned above.
Same-store-sales (SSS) growth, however, was exceptionally strong. The Canadian Tire SSS was up 4.7%, the former Forzani Group stores figure was up 8.6%, and for the Mark’s stores SSS increased 5.5%. It was not clear if any of this was due to price increases as opposed to volume but in any case these figures are very strong.
Valuation. Analyzed at $131.87. The price to book value ratio seems reasonable at 2.1 but is materially higher than it has been in recent years. The dividend yield is modest at 1.6%, reflecting the relatively low payout ratio of 27% of adjusted earnings. The ROE is attractive, although not exceptional, at 12.1%. Earnings growth per share over the past five calendar years has been quite strong at a compounded average of 12.8% per year. Sales per share growth was quite good at a compounded average of 8% in the past five years. Trailing 12 months adjusted p/e is neutral in attractiveness at 17. Management has set its earnings per share growth goal at 8% to 10% per year.
Risks and outlook. Canadian Tire appears set for continued growth over the years. However, the sharply lower Canadian dollar is going to increase Canadian Tire’s cost of goods sold in 2015 and this seems likely to compress margins. Hedges are in place but only for an undisclosed and likely relatively short period of time. There is also, as always, some risk of more intense competition. Sales and profits will also be hurt if the Canadian economy weakens due to lower energy prices. Still, the company has been aggressively improving its sports stores, reinvesting in all of its stores, and has adjusted well to competition and the level of the dollar in the past.
Buybacks. In terms of share buybacks, Canadian Tire had for many years only bought back enough shares to offset the issuance of stock options. This was not an optimal strategy. That’s because, as explained above, if buying back shares was an attractive option the quantity purchased should not have been related to the issuance of options, which is a separate and unrelated matter. I was disappointed that the company did not buy back shares aggressively at the attractive prices available in 2011. However, in 2012 Canadian Tire began to buy back substantial additional shares over and above the amount to offset the issuance of stock options. This proved to be a wise use of capital as shares were repurchased at prices well below the current stock price. Canadian Tire is continuing this program, which suggests that management still views the shares as being undervalued.
Conclusion. Canadian Tire is a strong business that is well managed. Its stock price has more than doubled since the summer of 2011 but it is still reasonably priced given the earnings performance.
Action now: Buy for long-term growth.
Stantec Inc. (STN, Financial)
Originally recommended by Tom Slee on Aug. 28/06 (#2632) at C$10.24 US$9.23 (split-adjusted). Closed Friday at C$34.72, US$28.22.
Recent earnings. Stantec reported first-quarter earnings on May 13. Revenues per share were up 23% while earnings per share were up 13%. After adding back amortization of intangibles, I calculate that adjusted earnings per share were up 20%.
The company generates 43% of revenues from the U.S., 53% from Canada, and 4% from international clients. For many years, Stantec has very successfully pursued a business model of growth by acquisition (plus organic growth). Stantec recently acquired an engineering firm in Quebec that increases its total employee count (and presumably revenues) by 10%.
Stantec’s adjusted earnings per share growth in the past four quarters, starting with the most recent (first quarter, 2015) was 20%, 8%, 5%, and 18%.
Valuation. Based on my analysis price of C$35.26, the p/e ratio is 18.4, the price to book ratio is 2.9, and the dividend yield is 1.2%. The ROE is 17.2%.
Risks and outlook. The long-term outlook seems good as the company continues to target increasing revenues by 15% annually by continuing its growth-by-acquisition (and organic growth) approach. The company will suffer somewhat due to the oil and gas industry slowdown, although this could be offset by increased growth in other areas. The recent earnings trend is very strong.
After reaching a high of $38.14 last September, Stantec’s stock price had fallen as low as $28.78 in Toronto. This was no doubt due to fears regarding the impact on its business of lower oil prices. I think this fear was overblown given that about 43% of revenues come from the U.S. and that it has offices across Canada, not just in Alberta. Also, its practice areas include many segments not related to energy. With the strong first-quarter earnings, the stock price has now risen to $34.72.
Buybacks. In terms of stock buybacks, Stantec has done this to a limited extent at times when management felt that the share price was undervalued. Stantec’s approach has benefited shareholders in that it usually prefers to invest capital in growth but is willing to purchase its own shares when they are significantly underpriced.
Conclusion. Stantec has a long history of being an exceptionally well-managed Canadian company that has aggressively grown by acquisition. There is little reason to think that it cannot continue to do so. The stock is reasonably priced.
Action now: Buy for medium and long-term capital appreciation.
Toll Brothers (TOL, Financial)
Originally recommended on Nov. 11/13 (#21340) at $31.94. Closed Friday at $37.69. (All prices in U.S. dollars.)
Recent earnings. Toll Brothers, a U.S. luxury homebuilder, will report second-quarter earnings on May 27. Earnings have been rebounding in line with the recovery of the U.S. economy, American home prices, and new home starts. TOL’s adjusted earnings doubled in fiscal 2014 and revenues per share were up 40%.
Valuation. Based on my analysis price of $38.04, the p/e ratio is 17.7 and the price to book ratio is 1.8. Return on equity (ROE) is 10.75% and has been rising with the housing recovery. The stock does not pay a dividend.
Risks and outlook. The profit outlook is for modest but positive growth in the next few quarters as contracts signed in 2014 for houses to be completed mostly in 2015 were flat in units compared to those signed in the previous year. However, they were up somewhat in price. There is a lag of over one year before signed contracts become home sales.
Management appears to believe that the flat signed contract performance in 2014 was just a pause in a long-term growth trend and notes that growth in signed contracts did resume in the final quarter of fiscal 2014, which ended October, and into early fiscal 2015. Management expects an increase in signed deals in 2015, which would lead to an increase in profits in 2016 as those homes are completed and delivered.
Management’s optimistic view was confirmed by a report on May 19 that U.S. new home starts in April had surged 20% to an annualized level of 1.14 million units, the highest figure since 2007. U.S. new home starts had been at over two million units per year from 2004 to 2006 but declined to only about 500,000 units per year in 2009 to 2011.
Buybacks. In terms of stock buybacks, Toll Brothers has not engaged in this practice as it prefers to leave its capital in the company to fund continued growth.
Conclusion. The overall thesis in buying Toll Brothers is that it is a well-managed company selling at a reasonable price, which provides a way to benefit from the continuing recovery in U.S. home building starts and prices.
Action Now: Buy for medium and long-term capital appreciation.
- end Shawn Allen
