Share Buybacks - Good or Bad?

A recent article from Canada’s Globe and Mail ("Share Buybacks: The wrong way to reward shareholders") suggests that stock buybacks are - as a rule - useless.

The Globe article states that after a buyback program is announced a company's stock price usually declines anyway; that is, the buyback typically signifies a peak, and does not add any value to shareholders.  But is this correct?  How can buying back shares not add value to shareholders?

The Globe's simple look at the statistics ignores the rationale for doing buybacks. In fact, there are good stock buybacks and bad ones, and management’s reasoning makes all the difference.

Share buybacks can be the best way to reward shareholders. The fact that the market doesn't immediately recognize this and boost the stock price is irrelevant.

When a company's shares are trading at close to or below book value and at low P/Es, why would the company issue dividends or make acquisitions? Buying the stock of an underpriced company (their own) is the best choice. Every share bought back by the company means more earnings for remaining shareholders. For example, if a company has earnings per share of $.50 and you own 100 shares, your personal share of the earnings is $50.00. If the company buys back ¼ of its shares, your personal share of the same earnings is now $62.50. Eventually, more earnings per share = a higher stock price.

On the other hand, if a company's stock is overvalued either in terms of P/E or book value (or both),  then share buybacks are clearly a waste of money: why buy back overpriced shares when the same money could be used to make valuable acquisitions or pay a dividend? In this case, a share buyback doesn't make sense.

When management does a share buyback for the right reasons, people notice.  When Berkshire Hathaway, for example, announced in Sept of 2011 that it would buy back shares, BRK jumped 8% in a single day.

The Globe and Mail article notes that companies typically buy back stock when they are flush with cash but stock prices are high - which is the wrong time to buy back stock. At the moment, however, many companies are flush with cash at a time when their stock prices are low - the perfect time to buy back stock.

Good companies pay extra dividends or make acquisitions only when their stock is overvalued (or at least fairly valued).  When their stock is undervalued, buybacks are the best choice.

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"When companies purchase their own stock [at a discount to fair value], they often find it easy to get $2 of present value for $1."

Warren Buffett

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Stocks I Like - Baja Mining

IMPORTANT - See this important update as of April 23rd, 2012: Baja Mining.


Every once in a while, one notices a stock that seems to have all the qualities that allow the patient investor to make a windfall.  Baja Mining Corp. of Canada is just such a company.

Baja Mining (TSX: BAJ) is developing one of the largest copper mines in the world in Baja, Mexico.  Construction of the Boleo mine and associated port is well underway, and expected to start commercial operations in Q2-Q3 of 2013.  A great time-lapse presentation of the construction is available on their website.  The Boleo mine will have an initial 23+-year mine life.

So, what makes Baja such a great value?

First, unlike most companies that are still two years away from project completion, Baja is fully financed for construction, meaning it will not have to issue new shares to complete its project.

Once in production, the company is expected to have earnings of around $0.80 per share, which would give it a P/E of only 1.2 at today’s price of $0.92 per share.  Using a reasonable P/E of 10, Baja’s future price should be around $8.00 per share.

Finally, the company has hedged 50% of its initial 2 years of production at between $2.40 and $3.97 per pound, which will allow the company to remain profitable even if copper prices drop.

By all measures, Baja seems drastically undervalued.

I spoke with Baja representative Alex Macdougall regarding the company on Feb 1^st, 2012.  Following are some choice excerpts from that conversation.

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The Frost Report: “According to your corporate presentation, you are on track to start commercial operations in Q2 or Q3 2013.  Is that still correct?”

Macdougall:  “It should be Q2 2013.”

The Frost Report:  “It says (in your presentation) that 50% of your production is hedged at between $2.40 and $3.97 per pound…where in that range does the majority of your hedging occur?”

Macdougall:  “That I don’t know.  That was done by (Louis) Dreyfus - a very large metal trader like Glencore (see The Frost Report’s article about Glencore).  The hedging was required by the five commercial banks involved in the financing (Barclays, Standard Chartered Bank, HVB etc).  I would suppose that Dreyfus has sold various amounts of the first year’s production at varying prices…each commercial bank put up 20 million dollars."

The Frost Report: “Now, you have somewhat of a battle going on right now with Mount Kellett Capital Management…” (Mount Kellett alleges, among other things, that the CEO’s daughter is employed by the company at an extravagant and unnecessary compensation).

Macdougall: “Can I give you the history on that?”

The Frost Report: “Please do.”

Macdougall: “Mount Kellett was formed by former Goldman Sachs people.  The guy who really started it is McGoldrick (known as “Mark ‘Goldfinger’ McGoldrick”).  He was working at Goldman Sachs, specializing in distressed companies.  Goldman bought them and took them private, then brought them back out (took them public again).  He earned GS multi-billions of dollars.  He was offered a bonus of 70 million dollars, which he refused and said that he wanted 1.5 billion dollars.  I call that greed.”

The Frost Report: “He’s pointing out things like…the corporate secretary’s pay.”

Macdougall: “That’s misrepresented, by the way.”

The Frost Report: “It is?”

Macdougall: “If you go to SEDAR…it reveals Kendra’s (corporate secretary’s) to be $140K CDN a year base pay.”

The Frost Report: “So where did he get the total compensation of $725K from?”

Macdougall: “Using the Black-Scholes calculation for options.  But they are all out of the money.  They are (currently) worth zero.  It’s a red herring.  The only issue they have left is nepotism…having a family member be assigned an important position in the company merely because they are a family member.  But, John (Greenslade, CEO) did not hire Kendra.  Kendra was hired by Bill Murray, former President and Director of Baja…”

Macdougall went on to explain how McGoldrick’s firm has bought close to 20% of Baja.  He remarked that if one follows the history of Mount Kellett Capital Management, it seems reasonable to speculate that their plan for Baja is to take over this undervalued company at the undervalued price, keep it until mine completion, and then flip the shares back to the public at true value.  Obviously, this plan would allow the vast majority of the jump in value [from under valuation to fair valuation] to go to Mount Kellett Capital Management instead of existing shareholders.

As an aside to Frost Report readers, out-of-the-money stock options are a form of compensation - with a cash value - and are an expense to a company.

The Frost Report: “The company (Baja) is fully financed through to production.  I have seen in the past - unfortunately from my own experience – companies…as soon as production starts, issue a bunch of new shares.  What is the probability of issuing shares between now and production?  And, would there be any reason for Baja to go after acquisitions by releasing (new) shares after production begins?”

Macdougall: “No to both.  There is no chance of them raising monies before they complete construction.  Because of the agencies that have financed them…they (ex. the US export agency) are very demanding.  Every time they (Baja) approach the agency for an additional tranche (of financing), they have to prove exactly where all the money went, what was achieved, what the status of the program is, etc.  I think the stock is very undervalued…”

The Frost Report: “Well, I kind of like that part (the undervaluation)!"

For the remainder of the conversation, we bitched about program trading causing unusual valuations in the market, and about how retail investors are spooked out of buying equities, making it hard for venture companies to finance.

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During a brief (7 minute) follow-up conversation with Steven Lehner of Mount Kellett, he assured me that they are not interested in taking control of Baja, but merely ensuring the company does not burn any money unnecessarily.  If this is true, then we can expect Baja to reach its full intrinsic value in the hands of today's shareholders.  If Mount Kellett is covertly setting up a takeover (as Macdougall fears), then today's shareholders will likely get a premium on today's price, but not realize the full potential of the stock.

Baja Mining is an undervalued company with excellent potential for appreciation.  The fact that Baja is being stalked by an aggressive hedge fund shows how attractive Baja is at its current price.  And, having Mount Kellett as a large shareholder has arguably helped keep management accountable.

Benjamin Graham would love BAJ.

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Disclosure

Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.

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