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Woolies buyback windfall - Eureka Report article

Woolies buyback windfall

By Scott Francis
September 29, 2010

PORTFOLIO POINT: Even receiving a discounted price in the Woolworths’ buyback, DIY funds in pension mode can book a profit of up to 18%.

DIY funds in pension mode are in a unique position to take advantage of Woolworths' decision to buy back another $700 million of its shares.

The buyback is structured in a manner that will please a large number of our readers, being made up predominantly of a fully franked dividend. This structure creates additional value for investors on low tax rates (like super funds) and even more for those paying no tax (super funds in pension mode).

On one level the buyback can be viewed as another sign of confidence at a corporate level in Australia. On another, it represents an opportunity for astute SMSF trustees to collect a windfall of 18% of the shares’ current value on even the most modest assumptions.

Of course, buybacks create benefits for all shareholders. In this particular example, Woolworths is seeking to buy as much as 2.4% of all the shares on market and cancel them, which has the effect of redistributing earnings among the remaining shares on issue.

In fact it’s the reverse of what was happening during the GFC, when earnings were diluted by heavily discounted share issues. But before I explain how it works and how you can take advantage of it, here are the key dates.

  • Share sale facility opened Monday, September 20.
  • Tenders must be received by Friday, October 8.
  • Pricing and scale back details Monday, October 11.
The basic offer is that Woolworths will buy your shares back at a discount of 8–14% to the average trading price in the five days leading up to the close of the offer. It is prepared to buy back $700 million of shares, or about 2.4% of all the company’s shares.

This might not sound like a great offer but hear me out.

The capital component of the Woolworths payment is $3.08 and the remainder will be a fully franked dividend, which can be particularly attractive for investors on a 0% tax rate, such as self managed superannuation funds paying a pension.

Let’s take a look at the numbers.

As I write, Woolworths shares are trading around $29. Let us assume (and it is a relatively big assumption) that this is the average price for the five days leading up to the close of the offer. Woolworths will offer to buy these shares back at a discount of 8–14% to this final price.

Because the offer works very well for pension funds, let's consider a worst-case scenario and assume a 14% discount to the $29 trading price. This is a final price of $24.94.

Of this final price of $24.94, $3.08 is a capital component.

The remaining $21.86 is a fully franked dividend. This means that there is a cash amount of $21.86, and a franking credit of $9.37. To calculate the franking credits from the cash part of a fully franked dividend, you multiply by 3 then divide by 7.

The summary of what is received for the sale of Woolworths shares, assuming a buy back price of $24.94 and the maximum discount of 14% is:
  • A capital component of $3.08
  • A cash dividend of $21.86.
  • Franking credits of $9.37.
The total benefit to an investor on a 0% tax rate is $34.31. This investor faces paying no tax on the $21.86 dividend, and will receive a tax refund for the franking credits received. Basically, the value being offered for a 0% investor for the $29 Woolworths shares is $34.31 – producing a windfall of 18% on our modest assumptions.

If we assume that the investor wants to keep owning Woolworths shares and they continue trading for less than $34.31, then this is still an attractive offer. If the shares are bought back at a smaller discount than the 14% – which I think is unlikely – then the profit will be even higher.

• • • •

The next step is to consider the broad implications of the offer for a 15% investor; that is, a superannuation fund in accumulation mode. When we consider this scenario for an investor paying 15% tax, we have to take into account the tax payable on the fully franked dividend component of the buyback.

There are two tax differences to be wary of. The first is that selling the Woolworths shares for a capital amount of $3.08 potentially creates a capital loss that might be of use – especially if you have a known capital gain. However, because this will vary from circumstance to circumstance, I have not included the value of this in the calculation.

The second difference is that there is tax payable at the rate of 15% on the grossed-up (cash and franking credit) amount of the buyback – $31.23. At a 15% tax rate, this is a tax liability of $4.68. This means that the tax flow is the $4.68 tax liability less the tax credit of $9.37 – meaning a tax refund of $4.68.

For an investor on a 15% tax rate the summary of the cash flows are:
  • A capital component of $3.08.
  • A cash dividend of $21.86.
  • Tax refund of $4.68.
This is a total of benefit of $29.62 – or a profit of 62¢, assuming that you can still buy Woolworths shares back for $29. The 62¢ profit for the investor paying tax of 15% is much more marginal than the $5.31 profit made by our investor who pays 0% tax.

Indeed, assuming there are some costs involved in buying the shares back (brokerage), then this 62¢ per share profit will be even more marginal. The following table calculates the profit at the various levels of discounts assuming a 15% tax rate on the fully franked dividend:

Discount Profit per share
14% $0.62
13% $0.98
12% $1.33
11% $1.68
10% $2.03
9% $2.39
8% $2.74

The smaller the profit per share for investors on a 15% tax rate – such as self managed super funds in accumulation mode – the more speculative is the ability to sell the shares into the buyback and then successfully buy the shares back on the market at a lower price will be.

However, if you are a 15% tax rate investor and were considering selling some or all of your Woolworths shares anyway, this might be a great opportunity to get a little more than just the market price.

If your tax rate is 30% or higher it is very unlikely that it will make sense to participate in the offer. There might be a situation where the capital loss creates enough value for you to participate in the buyback – however at this stage it appears unlikely.