Share buy-backs – especially big ones like Telstra’s (ASX:TLS) – do a lot to stir the pot of public debate. To some they’re a case of Santa come early, showering gifts on shareholders; to others they’re a sign of a company down on its luck, bereft of imagination and opportunities for growth; and to still others, they’re a way of making a balance sheet ‘more efficient’ to somehow conjure up additional returns.
The truth is more prosaic. A share buy-back is simply a means of giving shareholders back a chunk of their own money, and whether it makes sense or not depends on whether it's best for shareholders to have the money or for the company to keep it.
|– Telstra will buy back $1.5bn worth of shares|
|– Only makes sense for certain shareholders|
|– Use Telstra's calculator and/or seek advice|
The effect of a share buy-back is almost identical to that of a dividend, except that instead of returning cash to all shareholders and all shareholders maintaining the same interest in a slightly reduced pie, the cash is only returned to those shareholders that wish to take part, whose share of the pie is proportionately reduced.
Herein lies the magic, if there is any. Because all shareholders are different – particularly in terms of tax – it makes more sense for some to get their money out than for others, and an off-market share buy-back enables them to do this. For those not participating, they will maintain their investment, which will be a slightly larger share of a slightly less valuable company.
It gets even better when the buy-back is conducted off-market via a tender, because the keener some shareholders are to take part, the bigger the discount they’ll accept, and the more the non-participants will see their proportionate share increase. So the tender process should spread the benefits on offer more fairly among all shareholders.
But we’re getting ahead of ourselves. Before we consider whether it makes sense to stay or to go, let’s run through what’s actually happening.
With its recent sale of Autohome shares for $2.1bn and continued strong free cash flow, Telstra now has surplus capital that it wants to give back to shareholders.
In addition to paying out around $3.8bn in dividends this year, management has decided to return another $1.5bn by buying back shares. This is comprised of a $1.25bn off-market share buy-back, followed by a $250m buy-back of shares on the market.
The off-market buyback will be conducted via a tender process, and holders of shares bought on or before 17 August 2016 will be eligible to take part. The forms will need to be received back by the company’s registrar (Link Market Services) by 7pm on Friday 30 September. Tenders can also be lodged online via Telstra’s buyback page (you'll need to click on 'here' and go through a brief verification process).
Under the tender, shareholders can submit a price at which they’d be prepared to sell their shares. The offers will be accepted from the bottom up, until the $1.25bn target is reached, so that those accepting the biggest discounts are more likely to have their offers accepted.
You can also select a minimum price at which you’d be prepared to sell your shares, and/or you can opt to have your shares bought back at whatever is the final price that would make that possible.
The price paid by Telstra will be the same for all shares bought back and will be the lowest price at which it can buy back shares worth $1.25bn, taking all the different tenders into account.
Should you take part?
So should you take part? Here’s where it gets difficult because, as we’ve noted above, everybody is different (particularly in terms of tax) so there is no one-size-fits-all answer. The way it works is that the price eventually paid for the shares is split between a capital component (which the ATO has indicated will be $1.78) and a dividend component (the rest of the price).
On the dividend component, you’ll pay tax at your marginal rate offset by a full franking credit, as with a regular dividend; and on the capital component you’ll be subject to capital gains tax (CGT) on the difference between the cost of the shares and $1.78 per share plus an adjustment based on the difference between the market price and the final buy-back price (see section 4.1 of Telstra’s Buy-Back Booklet). The CGT discount will be available if you’ve held the shares for more than a year and if you make a capital loss then it can be used against capital gains in the current year or carried forward to future years.
So the buy-back is likely to be more attractive to people (or super funds) on low tax rates, and/or who stand to make a capital loss on the shares and can make good use of it against gains elsewhere. And, of course, the lower the discount on the buy-back price, the more attractive the deal will be.
|Marginal tax rate||0%||Super
|Assuming market price = $5.00; Discount = 10%; cost base = $4 *|
|Buy-back price ($)||4.50||4.50||4.50||4.50||4.50||4.50|
|After-tax proceeds of buy-back ($)||5.67||5.25||5.03||4.62||4.49||4.18|
|After-tax proceeds of sale on ASX ($)||5.00||4.90||4.90||4.83||4.81||4.76|
|Profit/(loss) for Buy-Back and replacing shares on market||0.67||0.25||0.03||(0.38)||(0.51)||(0.82)|
|Profit/(loss) for Buy-Back vs selling on market||0.67||0.35||0.14||(0.21)||(0.32)||(0.57)|
|* This also assumes zero brokerage, that the Telstra shares have been held for more than a year, and that capital losses can be used against gains held on shares that have also been held for more than a year.|
|Note that these are illustrative examples only, based on Telstra's Buy-Back calculator; we recommend making your own calculations and/or speaking to your tax adviser.|
All of this is explained in greater detail in Telstra’s Buy-Back Booklet, available from its website. In particular, in Section 4.6 (on page 19) there’s a table setting out how the proposal might pan out for people on different tax rates. We've reproduced parts of this in Table 1, but with the market price lowered to near-current levels ($5).
It’s important to note that the prices and some other details will change, but it provides a good basis for working through the various possibilities. Telstra also provides (via the same link given above) a buy-back calculator, which you can use to test different scenarios.
Bear in mind that it might also be worth participating even if you don’t want to reduce your holding, because you can always buy the shares back on the market, but this is likely to be less attractive for most situations as you’ll have to absorb the discount. There are also risks to this approach as the price may change between the Buy-Back and when you replace the shares.
There is also a risk that the Tax Office might classify such a transaction as a 'wash sale' – where shares are bought and sold within a short period for the main purpose of obtaining a tax benefit. In such circumstances, the Tax Office might disregard the transaction and any tax benefits might be lost. So if you’re considering such an approach, make sure you consult with your tax adviser.
After extensive road-testing of Telstra's Buy-Back Calculator and while noting that we’re not able to provide personal advice, we’d say it’s hard to find scenarios where those on the highest tax rates will benefit from participating. At the other end of the spectrum it looks like super funds will benefit in most situations at least as compared with selling on market, and even when repurchasing the shares as long as the discount isn’t too big. In the middle, things get more marginal.
Everybody is different, though, so we’d recommend having a play with the calculator yourself, running through the methodology in Section 4.6 of the Buy-Back Booklet, and/or speaking to your personal tax adviser.
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