On 15 October, CSL Limited (ASX: CSL) announced an A$1 billion share buyback, the largest in the companies history and its ninth share buyback in 10 years.
Shares of the global biotherapeutics company are currently trading around $94 and the buyback would allow the repurchase of 10.6 million shares – around 2.3% of CSL's issued share capital.
But, is this the best use of shareholders assets?
Over the past 5 years, CSL's debt has increased from $190 million to around $3 billion and a large amount has funded its buyback program. In FY14 and FY15, the company bought back around $800m of shares and each year around $400m used borrowed money.
Share buybacks can be a good use of cash if company shares become significantly undervalued – but it is hard to argue that is the case for CSL.
Sometimes, even if the shares are fairly valued, buybacks can be more efficient than dividends for returning excess cash to shareholders. This may be true for CSL – because 90% of its revenue comes from international sources, its dividends aren't franked and will be taxed at shareholder's marginal tax rate.
However, borrowing to repurchase fairly valued shares will not increase shareholders wealth. In fact, it adds additional interest payments that the business has to pay each and every year.
The buyback versus the debt repayment is modelled as a series of simplified cash flows.
Buyback Vs Debt Repayment
Some of the information below comes from CSL's FY15 financial statements, and the rest are my calculations.
| Share buyback | Debt repayment | |||
| CSL FY15 Net profit (US$m) | $1,379 | Debt repayment value (A$m) | $1,000 | |
| Share price | $94.0 | USD/AUD | 0.72 | |
| Shares outstanding (m) | 465 | Debt repayment value (US$m) | $720 | |
| FY15 earnings per share | $2.97 | Average interest rate | 3.1% | |
| Buyback value (A$m) | $1,000 | Interest saved (m) | $22.3 | |
| Shares bought back (m) | 10.6 | Tax shield @ 20% | $4.46 | |
| Shares outstanding after buyback | 454.4 | Earnings after repayment | $1,396.9 | |
| Earnings per share after buyback | $3.04 | Earnings per share after repayment | $3.00 |
Buyback cash flows
The table below shows the cash flow information assuming the A$1 billion buyback is completed.
Assumptions: EPS remain constant and represent annual cash flow, WACC = 8.0%.
| 2016 | 2017 | 2018 | 2019 | 2020 | 2021 | 2022 | 2023 | 2024 | |||
| Debt Due | $100 | $200 | $150 | $250 | $150 | $150 | |||||
| Earnings | $1,379 | $1,379 | $1,279 | $1,179 | $1,229 | $1,379 | $1,129 | $1,229 | $1,229 | ||
| EPS | $3.04 | $3.04 | $2.81 | $2.59 | $2.70 | $3.04 | $2.48 | $2.70 | $2.70 | ||
| NPV | $1,277 | $1,182 | $1,015 | $867 | $836 | $869 | $659 | $664 | $615 | $7,984 | NPV |
| * All values are in US$m except earnings per share (EPS) | $17.57 | NVP/share | |||||||||
Once the share buyback has been completed, earnings per share increase 2.3% from $2.97 per share to $3.04 per share. The important thing to remember is that the company will have to repay the existing debt in the future, resulting in additional cash outflows which affect shareholder value.
Net present value = $17.57 per share
Debt repayment cash flows
The table below shows the cash flow information assuming the A$1 billion is used to repay debt.
Assumptions: EPS remain constant and represent annual cash flow, WACC = 8.0%.
| 2016 | 2017 | 2018 | 2019 | 2020 | 2021 | 2022 | 2023 | 2024 | |||
| Debt Due | 130 | 150 | |||||||||
| Earnings | $1,397 | $1,397 | $1,397 | $1,397 | $1,397 | $1,397 | $1,397 | $1,267 | $1,247 | ||
| EPS | $3.00 | $3.00 | $3.00 | $3.00 | $3.00 | $3.00 | $3.00 | $2.72 | $2.68 | ||
| NPV | $1,293 | $1,198 | $1,109 | $1,027 | $951 | $880 | $815 | $684 | $624 | $8,581 | NPV |
| $18.45 | NVP/share |
Once the debt has been reduced, company earnings increase by around US$18m (the amount of the annual interest saving) and remain constant.
Net present value = $18.45 per share
Foolish Takeaway
The repayment of debt (NPV = $18.45 per share) compared to the share buyback (NPV = $17.57) appears to provide around 5% more value for shareholders.
The share buybacks will effectively increase earnings per share (EPS growth comprises 50% of CSL's long-term incentive plan), but will not improve the fundamental performance of the business.
Debt-financed buybacks create additional interest costs that reduce shareholder value and also reduce the future financing capacity of the business. This debt capacity should be used for future investments, like CSL's recent US$275 million Novartis influenza acquisition.
Next time your company starts buying back shares with borrowed money (or paying dividends with debt) consider whether it is truly beneficial for the business.
