Apple recently announced huge share buyback program picking up 10 Billion of its stock. Apple earned piles of profit and this could be the right thing to do for a company which is very cash rich, hugely profitable and does not know what else to do with cash stacks. It is certainly better than many cash surplus companies that diversify from the core business into new ones only to erode shareholder value. We can recall many such instances closer home of very profitable businesses who failed to manage such huge piles of cash. They went on to diversify only loosing share holder’s wealth. When a company buys back its own shares from market with the surplus profits, it actually reduces the equity shares outstanding in the market. The earnings in subsequent years can be shared amongst lesser equity holders and boost earnings per share (EPS). When the EPS goes up, at similar valuations (P/E ratio), the share price goes up. It also puts more money in the hands of lesser equity holders by way of dividends. This is the best thing to do for a profitable company rather than haphazard diversification.
The previously very profitable Future group learnt it the hard way, when it’s reckless and loosely made diversification (to deploy its huge profits) backfired. They then let go of the profitable Pantaloon to retire some of the debt. Huge profits and troves of cash is a happy problem to have but history has shown that not much management is successful in managing this situation well.
The combination of Overconfidence in our capability, competence and feeling that 'I cannot go wrong this time’ coupled with disposable surplus cash is a deadly & potent concoction for disaster. This tendency is seen in the companies that we invest too that diversify recklessly especially those that had a history of success and healthy cash flows. These growth pangs are a happy problem that many companies dabble with limited success and damage shareholders wealth.
In my previous blog I wrote about how future group diversified into financial services and lost their sheen. The stock price of FCH at time of listing in Feb 2008 was around Rs 765 and now is Rs 150. Videocon, a successful consumer Electronics Company entered telecom and made a hash of it. The very successful Marico which makes parachute brand oil had lost money diversifying into Kaya skin clinic. Inebriated with success, the UB group diluted its potency by flying into aviation business with Kingfisher. Similar examples dot the corporate landscape. The very successful telecom service provider Bharti made so much cash they wondered how to spend it only to diversify into insurance and Mutual fund. 5 years later, they had less than 1% of the life insurance premium underwritten by the industry as a whole. All these companies had diminished the valuations of their core business. Unitech's diversification into telecom or RIL’s foray into retail has only caused severe loss to share holders. Reliance is faced with the biggest challenge of having to manage an ever growing cash pile. It has been unable to acquire or diversify in a manner meaningful to the shareholder displayed by stagnant earnings.
Managements have the responsibility of judiciously investing shareholder’s money, deploying it in a manner that earns returns for its shareholders that trusts them. How much such management we can trust to invest our money prudently and how much premium are we willing to pay to have such management will decide the returns we make. As we see having too much cash and being profitable is a challenge.
An efficient company makes more money than they spend. Such companies re-invest excess cash generated into their business, which is already generating a lot of cash and produce even more profits. This cycle may not continue endlessly. There could be circumstances when the company is unable to put the cash to good use. In such times, it would be ideal for them to pay it back to share holders as dividends or buy back their own shares if market conditions are favorable. Apple has stayed focused on its core business deciding to reward shareholders by way of share buyback that will result in higher Earnings per Share. There is a caveat though: a few dubious managements use buyback program to increase the wealth of their top executives by buying their stakes at an unrealistic and high price.
The European concerns have been bothering the world economy. The story can be different each time but the cycles of economy and business continue to turn. A deep crisis of confidence is an opportunity. As they say, never let a good crisis go waste.
