The Reece Ltd (ASX: REH) share price is up 3% today (at the time of writing) after the company increased the size of its on-market share buyback by $50 million to a new total target of $85 million.
The market clearly loved the announcement but beyond the share price reaction, the decision raises a bigger question for investors: Why would management choose to buy back shares and should investors turn bullish on Reece shares?
Image source: Getty Images
Why buy back shares?
At its core, a share buyback is a capital allocation decision. Reece management are effectively saying that, at current prices, buying the company's own shares offers a better risk-adjusted return than alternative uses of capital such as acquisitions, branch expansion, or accelerated investment in growth initiatives.
The move also implies that management believe that Reece shares are currently undervalued. Even after today's 3% rise, Reece shares are still down 42% year to date and down 11% over the last 5 years.
For shareholders, buybacks can be attractive.
All else equal, buybacks reduce the number of shares on issue, which can lift earnings per share, support valuation metrics, and signal management confidence in the underlying business.
The flipside of share buybacks
That said, buybacks aren't always an unambiguous positive.
When a company chooses to return capital rather than reinvest it, it can also imply that management sees fewer high-return organic growth opportunities available right now. In other words, Reece may believe its best option is to optimise its share price using financial engineering rather than organic growth.
Of course, its never that black and white and in reality, management could be pursuing both organic growth and and buybacks to optimise their capital allocation mix.
Another thing for investors to take note of is that Reece is funding the buyback from existing cash and debt facilities.
There are plenty of situations where increasing debt to buyback equity makes financial sense (e.g. debt is typically a cheaper form of financing than equity partly because it is typically tax deductible), but some investors may still be uncomfortable with increasing debt for this purpose.
So how should investors think about it?
For long-term investors, the expanded buyback builds confidence that management view the current share price as undervalued and an opportunity to reduce the total number of shares outstanding, increase earnings per share, and ultimately increase the value of the shares for shareholders.
However, it's not a substitute for growth and ultimately, the share price over time will still depend on Reece's performance in its core residential and commercial markets, particularly in Australia and the US.
For now, the market clearly sees value in Reece backing itself.
