In companies such as tobacco groups that generate large amounts of surplus cash, how should this cash be best employed? The choice boils down to:
Investment in current businesses. Tobacco companies like British American Tobacco (BATS) have already invested heavily in vaping, e-cigarette and “modern oral” nicotine brands. Despite a health scare about vaping in the US in 2018, and a ban being threatened on flavoured e-cigarettes, BAT now has 16m consumers of non-combustible products, and aims to triple this number by 2030. BAT’s aim of reducing “the health impact of its business by offering a greater choice of enjoyable and less risky products” is an appeal pitched towards impact, rather than ESG, investors.
Acquisition of another business. This can be risky. During 2018, whilst BAT was still absorbing Reynolds America, which increased the group’s US exposure to 40 per cent, its share price halved under the threat of a ban on menthol cigarettes, which form about a quarter of the group’s sales. And investors are backing the takeover of Vectura by Philip Morris despite reservations about the wisdom of an inhaler company that aims to improve health being owned by a company that sells health-threatening products.
Paying down debt. The interest rate BAT pays on average is 3.6 per cent, and by the end of 2020, it had reduced its net debt to £41.7bn. It expects repayments to accelerate before interest rates rise.
Increasing the dividend. This is BAT’s strategy, and shareholders currently receive annual dividends worth £2.16 a share. These cost £4.75bn in 2020, about double the amount by which it reduced net debt. In contrast, Imperial Brands (IMB) has cut its dividend so that it can repay more borrowings.
Buying back shares. BAT shares sunk to a low of £25 in early 2019 and were only £27 by the end of 2020, although in between they had hit a peak of £35. With such a stubbornly low share price, the yield is over 8 per cent. If instead, the group bought back and cancelled its own shares, the share price would go up, but it would open executives to criticisms about gaming the payouts from their long-term share awards. How valid would these be?
Gaming pay?
In 2020, adjusted diluted earnings per share (EPS) growth in 2020 enabled 19.9 per cent of the top team’s 2018 share award to be released. A further 32.7 per cent came from other performance conditions. For Jack Bowles, BAT chief executive, these shares were worth £786,000, or 15 per cent, of the £5.1m that he received in total for 2020.
Suppose that instead of paying a dividend, BAT had bought back shares in each of the three years since these shares were awarded. About a fifth of the shares in issue would have gone out of circulation, and since earnings would have stayed the same, the EPS would have increased. In most scenarios, it’s fair to assume that this increase would be sufficient to satisfy the EPS performance condition in full. More shares would be transferred to executives and the share price would go up too, although the price rise might be moderated by BAT losing its status as an income stock.
But there’s a negative too: if buybacks replaced dividends, dividend shares would no longer apply. These are additional shares thrown in to compensate executives for the dividends that would have been paid had they had owned the released shares since the day they were awarded. They are also added to the shares bought from half of their annual bonus, which also have to be deferred for three years. In 2020, dividend shares increased the number received by each executive by about a quarter – so while buybacks would increase the value of each share, this would be offset by significantly fewer shares being transferred in total.
Different gainers
These conflicting consequences suggest that for executives, any gain from buybacks would be muted. But there would be some surprising gainers: participants in the company’s Sharesave scheme. This is an option scheme that encourages eligible employees to save, and then to use these savings to buy BAT shares at a discount from the price at the start of the savings period. Sharesave ignores dividends: all that matters is the share price, so it doesn’t work so well in high-yielding companies – buybacks would generate higher gains.
In general, whether or not buybacks really do game executive pay depends on a number of factors such as: the extent to which they replace the dividend, the size of the dividend, the prominence of EPS as a performance condition of share plans; whether a dividend share policy applies, and how the share price responds when investors are deprived of a dividend. It’s ironic that in some companies, buybacks might game the value of share plans – but not so much for those of the top executives. It would be the ordinary employees in Sharesave who would be the winners.
