BHP buyback clock is ticking

PORTFOLIO POINT: With just a couple of days left on the BHP Billion share buyback, here’s what investors need to know.

Should I stay or should I go? That is the question BHP Billiton shareholders are weighing up with two days to go to the April 8 deadline to participate in the group’s $5 billion off-market share buyback.

BHP is one of several resource heavyweights using share buybacks to manage the mountain of cash they are mining from the commodities boom. The tax and other inducements of buybacks can be attractive to some investors, but not all sellers will end up winners so it is important to understand exactly what is on offer (we first reviewed the buyback on February 25).

Buybacks are simply an offer by a company to buy back some of its shares from existing shareholders, but each buyback is different and the details are far from simple. In an on-market buyback the company buys its shares on the ASX on a first come, first served basis.

In an off-market buyback, like the one from BHP, the company sends shareholders a document explaining the terms of the offer and how shareholders can participate. Sometimes the offer is restricted to selected shareholders, but the BHP buyback is an equal access scheme whereby the company offers to buy back the same percentage of shares from any shareholder who wants to sell.

BHP says it is using the buyback to return surplus capital to shareholders as part of an ongoing capital management plan. When companies increase profits there are several ways they can use the cash: they can reinvest in the business, make an acquisition, increase dividends or return money to shareholders in some other way.

BHP has been searching for major acquisitions without success so presumably directors think a share buyback is their next best option. As shares are bought back and cancelled, earnings per share (EPS) and return on equity (ROE) should improve, providing added support for the share price. The company is hoping for a hat-trick: a positive outcome for sellers, holders and the company.

So how does it all work?

Normally, when you sell shares at a profit you pay capital gains tax. However, in an off-market buyback the company can enter into a special arrangement with the tax office so that the bulk of the offer price is in the form of a fully franked dividend (which is not subject to capital gains tax).

BHP is offering to pay 28¢ a share as the capital component and the balance as a fully franked dividend.

For example, if the final buyback price is $40 you receive a dividend of $39.72 ($40–28¢). In other words, sellers are likely to end up with a large capital loss which they can use to offset capital gains elsewhere in their portfolio this financial year.

The capital proceeds of 28¢ could be adjusted if there is a significant difference in the movement of BHP’s share price on the ASX during the course of the buyback offer period and BHP’s share price on the London Stock Exchange.

BHP is offering to buy shares at a discount of between 10 and 14% to the prevailing share price in the five days before the offer closes. You can nominate the discount you will accept (at 1% intervals) or a minimum price or you can simply agree to accept the final buyback price.

You also elect how many shares you want to sell, but the exact discount and any scale-back of acceptances will be determined by the number of shares tendered. If previous buybacks are any guide, the final discount is likely to be 14% and the offer is likely to scaled back by 60% or more. In other words, if you tender 10,000 shares BHP may only take 4,000 or less.

Should I sell?

If you are happy with BHP’s performance and future prospects you may decide to hold on to all your shares. But if you have been thinking of selling some or all of your shares, then you need to weigh up whether it is better to sell into the buyback and save on tax and brokerage or to sell on market.

Buybacks are most attractive to shareholders on low marginal tax rates, such as the 15% tax rate that applies to self managed super funds or no tax for funds in pension phase. This means you can offset excess franking credits against other income or take the excess credits in cash (for more on this, see Scott Francis on BHP’s buyback).

The exact value of the buyback will depend on your marginal tax rate, the price you paid for your shares, whether you have held them for 12 months or longer and are entitled to the 50% capital gains tax discount and the discount used to set the final price.

It is difficult to work out your exact after-tax position until the final buyback price and scale-back is announced on April 11. In the meantime, you can test various scenarios with the tax calculator on BHP’s website by following the prompts.

Say you bought your shares for $24 five years ago and the final market price used for the buyback is $46, less a 14% discount. If you are on a marginal tax rate of 30% or higher you would be better off selling on market. If you pay 15% tax or no tax you stand to gain $5.82 a share and $10.62 a share respectively by participating in the buyback.

Barbara Drury is an author and business journalist. This article first appeared on March 31 in The Investing Times published by Lachlan Partners.