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BHP's buyback - Eureka Report article

BHP's buyback

By Scott Francis
February 25, 2011

PORTFOLIO POINT: Investors in a zero tax environment will be able to make the most of BHP's $5 billion buyback program.

Earlier this week BHP announced the details of a $5 billion buyback of its shares, the structure of which will be welcomed warmly by a large number of Eureka Report readers.

The key feature of the buyback is that rather than being purchased on market, BHP will purchase shares from existing shareholders with a fully franked dividend. Although this will be an attractive proposition to the legions of DIY fund operators in pension mode, other shareholders in taxable environments will find it less compelling, as I’ll explain shortly.

The basic details of the offer are as follows:

  • BHP wants to buy back $5 billion of ASX listed BHP Billiton shares.
  • BHP will buy back shares at a discount of between 10% and 14% of their price.
  • Participants will receive a 28c payment and the remainder as a fully franked dividend.
  • The tender period opens March 21.
  • The tender period closes April 8.
Buybacks are generally viewed positively by the vast majority of shareholders. They are seen as a vote of confidence that a company is prepared to spend money buying back their own shares. This is the opposite of what we saw many companies do during the GFC, which was raise capital by issuing more shares at low prices, which had the effect of diluting shareholder earnings.

The benefit for investors is that as a company buys back its shares fewer shares remain on offer and therefore company earnings and dividends are split between fewer shares. Like most mining companies BHP’s dividend could be viewed as immaterial compared with the capital growth prospects. However, preliminary analysis on BHP’s earnings-per-share (EPS) suggests that when completed the buyback will lift EPS by about 2%.

The BHP buyback has the very Australian twist of a generous handful of franking credits thrown in with it. Investors in the 0% tax bracket such as SMSFs in pension mode will ultimately receive a tax refund to the value of the franking credits received.

Investors in higher tax brackets are often left wondering if they have been left out of the process, however, there is an additional benefit for those who don’t participate. Because the buyback is being completed at a discounted rate, BHP’s management is buying back its own shares relatively cheaply and shareholders will achieve a slightly greater benefit from future company earnings. But ultimately, deciding whether or not to participate in the buy back is all about tax.

Running the numbers

To illustrate this, it is worth putting some figures around the offer. These figures are only preliminary, as pricing details won't even be known until the end of the pricing period at the close of the offer – which is not until early April.

So let us make some assumptions to see how the maths stacks up. Let’s assume that the BHP share price in early April is $46.50.

BHP has said they will offer between a 10% and 14% discount to the share price. Traditionally these buybacks have been very popular meaning that the lower end of the discount is applied, which in this case is 14%. Working off that assumption, the shareholder will receive:

Breaking It Down
Capital Payment 28 cents
Dividend $39.71
Franking Credits $17.02

For the shareholder on a 0% tax rate – someone not paying any income tax or a superannuation fund in pension mode – the calculation of the benefit is straight forward. They don't have to worry about any capital gains tax benefit or acquisition cost and will receive the full a benefit of the 28c capital payment, a $39.71 fully franked dividend and $17.02 in franking credits – a total benefit of $57.01.

As we move up the tax bracket we find superannuation funds in accumulation mode paying 15% tax and the benefits become more marginal. This is because the fully franked dividend is now taxed at a rate of 15%, so the investor has to pay tax on the $57.01 gross value of the dividend (cash and franking credits), which comes to $8.51 of tax – leaving a total benefit after tax of $48.50. This is a much slimmer margin over our assumed share price of $46.50, and perhaps ultimately not work the risk.

Of course, there may be some additional tax benefits from selling BHP shares at a capital loss, investors sitting on capital gains for example.

Once you get to the 30% tax bracket and beyond, it becomes increasingly unlikely that participating in the buyback will make sense for you. Because the franking credits are paid at the rate of 30%, and your tax rate is also 30%, they cancel each other out and you would ultimately be selling your BHP shares at a discount to their final value.

The BHP buyback is an interesting one to watch. A $5 billion buyback shows a company with a reasonable amount of confidence in its future. Those investors for whom it makes sense are likely to find the offer has been extremely popular and face the prospect of having the number of shares tendered scaled back to a significant degree. However it’s important to note that the structure allows BHP to make full use of franking credits to boost its EPS line for all shareholders, which would have otherwise disappeared into the ether.