Cadbury Plc recently announced a scheme of Capital Reduction that will see the company cancel its share capital on a basis of 2 shares for every 5 held. This will result in a refund of about N12billion from their share premium account as well as part of the ordinary share capital. Each shareholder is expected to receive N9.5 per every share cancelled. The company’s decision was met with resistance by minority shareholders despite giving this excuse as reason for the capital reduction option;
Their options were retaining the capital for future use, deploying the capital immediately and returning the excess capital to shareholders. According to the board, the possibility of retaining the excess capital was ruled out because the excess capital would have to be invested in low-return, low-risk investments in the meantime, which will negatively impact on return on capital. The board noted that deploying the excess capital now without immediate value-enhancing opportunities may destroy shareholder value.
Directors of the company stated that they opted for the return of excess capital to shareholders because they reasoned that each shareholder will be in the best position to determine his risk-return profile as well as the most suitable investments to optimise the value of his capital.
source; The Nation
Now in an ideal world this makes for very good economics and sound corporate governance. Just like a share buyback, a company with excess cash and lack the ability to deliver improved returns will be pressured to buy back its shares. Unfortunately, this is not a buy back but a capital reduction the major difference being that share buy back involves the company paying for shares at market price unlike capital reduction which does not necessarily require the company to “buy” at market price. Also, whilst capital reduction leads to cancellation of shares, share buybacks do not. Rather, shares are retained as treasury stock. So let’s examine what this means for you if you are a shareholder of Cadbury. But let’s try to understand Cadbury’s position
Cadbury the Company
Cadbury claims returns on equity has not been as high as they expect despite posting good profitability margins. The company posted ROE of 25% in 2011 and 19% in 2012. On an average ROE has been 7% in the last three years. To put this into proper perspective, Cadbury posted an ROE (unaudited) of 18.2% as at September 2013 compared to Nestle with about 43% within the same period. Cadbury currently has no debt and had a cash balance of about N16.8billion. It also has a positive working capital of N8billion providing with enough buffer to pay short term creditors. The company indeed is financially sound.
In fact, if it goes through with its plans then adjusted ROE for 2012 will be about 28% compared to 19%. It is not hard to see why they want to do this.
Shareholders surely have a right to be wary. The company claims the this move does not affect the value of the shares as it will adjust in accordance with the outstanding shares. In fact, if this deal is done today the share price will increase from the current N62 to N103 per share (even though value remains the same). Despite this, shareholders are skeptical and really I do not blame them. Cadbury concluded a rights issue back in 2009 following the financial irregularities that threatened the company’s survival a year earlier. The rights issue raised N17billion apparently giving the parent company 75% holdings.
Therefore, there is bound to be a bit of apprehension from minority shareholders. The current deal also involves a pay out of N9.50 per share for the cancelled shares giving shareholders a total pay out of N11.9billion. Despite this payout shareholders are not happy with what has been presented to them. Some probably believe the cancelled shares is worth N77.5billion instead of the N11.9billion they are now being offered assuming they sell in the market. Some might also suggest the company increase dividend payouts if it feels it has a lot of cash rather than cancel shares. High dividend payout some believe will ride on the current bullish sentiments further driving share price higher.
Both sides do have valid points and this sort of protest by minority shareholders is overall good for the stock market. However, good reason should prevail. A an increase in dividend payout may well be a good option but to do that will grossly wipe out the reserves of the company. It is not an option they will want to take as the whole point of this exercise is to reduce share premium to the barest minimum. Share premium can only be paid as bonus in the alternative which increases shares and earnings per share. The company cannot also payback cash at current market price. What they are basically returning to shareholders is the excess share premium they do not need and not a share buyback.
Retaining Status Quo may seem like a logical option. However, current fundamentals do not justify the current price. Cadbury is trading at 8x book value, 37 P.E and 5.8x sales. All of this for a company without debt and yet posting an ROE of 19%. Surely, this is not an enviable position in an environment where Cost of Equity should be in the region of 30%. Soon the share price will thread downwards.
Another option I may want is for the company to increase invest in topline revenue growth which over the years should reflect on profitability. But when management says they lack the appetite for increasing investment, you have to take them seriously. Besides, should they need to invest they can borrow at a rate close to Return on Assets which may inch towards 14% following the sale.
Verdict: Reduce Capital