What should investors make of Diageo’s (DGE) decision to resume its £4.5bn capital return programme? The prospect of special dividends is a welcome boost, but there is more to consider when it comes to buybacks.
On the face of it, buybacks mean a bigger share of future profits for holders of the stock still outstanding but with Diageo’s shares expensively valued, there are reasonable doubts about the value investors are getting.
Furthermore, Diageo has a reasonably high quantity of debt on its balance sheet, although CEO Ivan Menezes announced the company expects to be within the top end of the target leverage ratio by the end of June 2022. That target is for adjusted net debt to be between 2.5 and 3 times adjusted earnings before interest, tax, depreciation and amortisation (Ebitda).
The positive interpretation of the capital return programme is that it’s a confident gesture by management in anticipation of better times. Should the ‘Roaring Twenties’ materialise, the strong portfolio of drinks brands will do well, raising the prospect of earnings beats to make the current share price look better value.
Relatively expensive by historic standards (shares are currently priced at roughly 26 times forecast 2022 earnings per share), Diageo has been less sensitive to inflation fears than other quality shares.
It hasn’t been on anything like the multiples seen for, say, US tech stocks. Of course, that’s not comparing apples with apples, but there is enough upside uncertainty to entice investors beyond the announced distributions, even with discount rates jumping around due to inflation expectations.
Juggling wider stakeholders' return expectations
Other companies’ capital return policies have the potential to be more controversial. In the United States, the resumption of buyback activity could be in anticipation of higher corporate taxes under the Biden administration.
Using cash now to buy back stock means earnings have to increase by less for the per share figure to look impressive. In other words, buybacks pre-empt the tax drag effect. Of course, it doesn’t take long for the opportunity cost of using cash in this way to affect profits growth.
Still, although under-investment in capex may be felt in two to three years, buybacks can flatter figures in the next 12 months. With a post-pandemic boom in the offering, the attractions for chief executives is obvious.
Buybacks also have the advantage of being easier to control than dividends. Pausing repurchase programmes causes less of a ruckus with shareholders than cutting pay-outs. Still, as chief executives’ bonuses are often based on eps, the debate on whether capital management decisions are being made in the best interest of all stakeholders will continue.
Companies benefitting from the rotation to value stocks and into cyclical industries face the same questions. Miners and oil & gas producers have always had to juggle managing their debt funding, the need to reward shareholders and committing to adequate capital expenditure.
Resource companies are now also under pressure to consider the type of capital expenditure they make. Net zero carbon commitments by oil majors were met with scepticism and the many climate NGOs have pilloried the likes of Royal Dutch Shell (RDSB) for their capex being overly focussed on fossil fuels.
In fairness, given the impact the pandemic had, there was always likely to be a need to invest in traditional core activities building back. Still, the level of longer-term spending commitment to help shift the energy mix of products from hydrocarbons towards renewables will remain under scrutiny.
Could buybacks plus debt destroy shareholder value?
Money returned to shareholders could be a future battleground. Sustainability activists will insist on the composition of capex being geared towards net-zero carbon commitments and such greener capex being prioritised over dividend and buyback policy.
Across all industries, finding good projects that meet sustainability requirements and can generate adequate returns on capital is the challenge for management teams. If the response is not to try and instead to fund buybacks, investors should watch out.
Shares that are already expensive, especially need profits growth to justify that rating. Where debt is also a consideration, and interest payments must be made, there is even more of a need for caution. Buying back shares that disappoint on growth can diminish the value of total equity, as the company has just squandered its cash assets repurchasing equity that had been overpriced by the market. The debt, however, stays the same.
It seems far-fetched to suggest that a business such as Diageo could fall into such a trap. But, if the post-pandemic bounce doesn’t deliver enough positive surprises, shareholders may question management not giving them more of their cash back as dividends.
