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Analysis of BHP Billiton’s share buyback

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Following the sale of its US onshore oil assets, BHP Billiton (BHP:ASX) has announced the return of US$10.4bn to shareholders. Half of this amount, US$5.2bn (approximately A$7.2bn), will be returned to resident Australian shareholders through an off-market share buyback. The other half will be via a payment of a fully franked special dividend in January.

BHP’s decision to offer an off-market share buyback will be welcomed by SMSFs.

Deciding whether to accept an off-market buyback is a pretty straight forward decision. If you are paying tax at a high marginal rate (34.5% or higher), it is unlikely to appeal based on the example calculations I’ve outlined later in this piece. If you are paying tax at 0% (such as an SMSF in pension or an individual with income under the tax free threshold), then this looks like a good deal. If you are somewhere in between, such as an SMSF in accumulation, then it will generally make sense to accept depending on the tender discount and your ability to use any capital gains tax loss.

Of course, if you sell some or all of your BHP shares in the buy-back, you will then need to decide what to do with the cash.
 

What’s special about an off-market buyback?

There are 2 types of buybacks. An on-market buyback is conducted on behalf of the company by a broker purchasing the shares on the ASX.

The other type is an off-market buyback which is usually conducted through a tender process, and provided it is an equal access scheme, allows a company to distribute surplus franking credits to its shareholders. It is this distribution of franking credits that makes the off-market buyback very special. Part of the sale proceeds is treated as a franked dividend, with the other part treated as a capital component.

Effectively, the shareholder gets a franked dividend with imputation credits, and materially reduced sale price for capital gains tax purposes. This is what makes off market buybacks so advantageous to some shareholders, and because shareholders are keen to accept, it means that the company can purchase the shares at a discount to the market price.

BHP’s off-market share buyback

Shareholders will be offered the opportunity to participate and tender all, some or none of their shares, with the tender closing at 5.00pm (AEDT) on Friday 14 December.

The tender will be at a discount to the market price, ranging from 10% up to a discount of 14%. Because the buyback is capped (the A$7.2bn represents about 7.5% of the issued capital of the ASX listed BHP Biliton Limited), BHP will accept tenders from those shareholders offering to sell at the lowest price (highest discount), and reject those offering to sell at a higher price (lower discount).

The buyback will comprise two components – a capital component of $0.38 and the balance as a fully franked dividend. If the market price of BHP shares is (for example) $34.00 and the tender discount is 14%, then the buy-back price will be $29.24. This will comprise a capital component of $0.38 and a fully franked dividend of $28.86.

The buy-back price will be the same for all tenders – so if the tender is cleared at a discount of 12%, shareholders who nominate discounts of 12%, 13% and 14% will be successful and receive the price at a 12% discount. Rather than nominate a % discount, shareholders can also tender ‘final price’ (take whatever the market clears at). As a scale-back is probable, BHP has also announced some priority rules – to clear successful shareholders who are left with a residual parcel of 65 shares or less, and a minimum allocation to successful tenderers of the first 165 shares.

The market price will be determined by calculating the volume weighted average price of trades on the ASX over the 5 trading days immediately before the closing day, i.e. from 10 December to 14 December. The announcement of the buy-back price and any scale back will be made on Monday 17 December, with payment to successful tenders by Monday 24 December.

Shareholders worried about BHP’s share price during the buy-back period can also set an overall minimum price. If your tender discount is successful (this also includes ‘final price’ offers), you will only be accepted if the buy-back price is equal to or above your minimum price.
 

Should you accept?

The premise is that you should accept the buyback if your effective sale price (after tax) is higher than you could achieve by selling the same shares on the ASX.

Let’s compare the two alternatives – selling your shares on market at $34.00, or selling your shares in the buyback.

We will do this from the perspective of an SMSF in accumulation (paying tax at 15%), and a SMSF supporting the payment of a pension (paying tax at 0%).

We will also make a few other assumptions:

  • For the on-market buy-back, the deemed tax value is also $34.00 (this is determined by the ATO and won’t be available until after the buyback is completed). The sale price for CGT purposes is the deemed tax value less the buyback price, plus the capital component. In the examples below, this is $3.78 if the tender discount is 10%, or $5.14 if the discount is 14%;
  • Purchase price for your BHP shares - in the first 2 examples, $15.00, and in examples 3 and 4, $40.00;
  • A tender discount of 14% (the maximum), and also the minimum of 10%.

Four examples are shown:

  • Example 1: discount of 14%; original purchase price of $15.00;
  • Example 2: discount of 10%; original purchase price of $15.00;
  • Example 3: discount of 14%; original purchase price of $40.00;
  • Example 4: discount of 10%; original purchase price of $40.00.

In Example 1, the market price is $34.00. Applying a 14% discount, the buy-back price is $29.24, which comprises a capital component of $0.38 and a fully franked dividend of $28.86.

For a fund in accumulation paying tax at 15% (columns 2 and 3), the after-tax proceeds from selling the share on market would be $32.10. If the shares had been sold via the buy-back, the effective after-tax price is $35.43. There is also a capital loss of $9.86, which is potentially worth another $0.99 (15% tax rate, one-third discount) if it can be applied to offset a capital gain on another asset. This takes the potential effective selling price to $36.42.

For a fund in pension (columns 4 and 5,) the buy-back return is $41.61 per share, $7.61 higher than if the shares were sold on market.
 

Example 1 – Discount 14%, Original Purchase Price of $15.00, Market Price $34.00

* Value of losses can only be accessed by applying against other capital gains
 

Example 2 – Discount 10%, Original Purchase Price of $15.00, Market Price $34.00

* Value of losses can only be accessed by applying against other capital gains
 

Example 3 – Discount 14%, Original Purchase Price of $40.00, Market Price $34.00

* Value of losses can only be accessed by applying against other capital gains
 

Example 4 – Discount 10%, Shares Purchased at $40.00, Market Price $34.00

* Value of losses can only be realised against other capital gains
 

My concluding comments

In pension, the outcome looks very attractive. At a discount of 14%, you are $7.61 per share better off – and at the minimum discount of 10%, you would be $9.55 per share wealthier.

In accumulation, it is still going to make sense to accept in most situations, more so if you can utilise the capital loss.

BHP has conducted off-market share buybacks in the past and they have been heavily oversubscribed. This is larger and represents 7.5% of BHP’s Australian domiciled shares. It will, however, be very popular as the franked dividend component is very high. As all successful tenders receive the same sale proceeds, if you want your tender to be accepted, either tender ‘14%’or ‘final price’.

And if you want to review the outcome for a high marginal taxpayer paying tax at 47% (45% plus 2% Medicare Levy), see Example 5 below. Even at the most favourable tender discount of 10%, a shareholder, after taking into account the value of the capital gains tax loss, is $3.63 per share worse off.
 

Example 5 – 47% taxpayer, Discount 10%, Market Price $34.00, Purchased at $15.00 or $40.00

* Value of losses can only be realised against other capital gains

Paul Rickard is co-founder of the Switzer Super Report. This information was produced by Switzer Financial Group Pty Ltd (ABN 24 112 294 649), which is an Australian Financial Services Licensee (Licence No. 286 531). All prices and analysis at 12 November 2018. This material is intended to provide general advice only. It has been prepared without having regard to or taking into account any particular investor’s objectives, financial situation and/or needs. All investors should therefore consider the appropriateness of the advice, in light of their own objectives, financial situation and/or needs, before acting on the advice. This article does not reflect the views of WealthHub Securities Limited.