Friday, June 08, 2007

Following the Buyback Crumbs

Since buybacks could have positive effects on valuation metrics, where does this leave investors? Perhaps investors should abandon all stock selection screens and simply take long positions in stocks which announce buyback plans. In neither the Callaway Golf nor QLT cases that were described in the June 5th post entitled “Buyback Brouhaha” does it appear that using cash for a buyback is going to impede future growth.

On this hint of potential, I decided to follow the buyback crumbs to test the buyback indicator as a way find promising small caps.

Within the Crystal Equity Research coverage universe, Basin Water, Inc. (BWTR: Nasdaq) recently declared its intentions to repurchase up to $10.0 million in common stock. Of course, our Buy rating precedes this decision. We like the company for its ground water treatment technology and its innovative service offering for water owners. Basin Water staged an IPO in April 2006 at $12.00. The stock soared to $17.00 but floundered as the company’s growth plans have unfolded slower than expected. Management is also taking time to revamp business practices so that is service contracts with customers can be executed profitable. In our view, the buyback is more or less a public relations effort to placate disappointed shareholders. Yet the financial commitment probably will not impede growth as cash resources - $51.0 million at March 31, 2007 and mostly remaining from the IPO - are more than adequate to carry out Basin Water’s strategic plans.

No great signal value for BWTR since the business opportunity remains intact whether there is a buyback or not. However, the appearance of BWTR on a list of companies with buyback actions in place, could alert a few more investors to the opportunity.

Goldman Sachs has been given the nod to buy back up to $150 million of the shares of Semtech Corp. (SMTP: Nasdaq), the semiconductor company. At a price of $16.00 this represents approximately 9.4 million shares or 13% of the outstanding shares. Semtech directors are not likely concerned about a floundering stock price or undervaluation. The stock is trading near its 52-week high and at a price-earnings multiple of 42.8 times trailing EPS. So it is necessary to dig deeper to find the motivations and the potential impact on the stock price if the authorization is fully executed.

In a repurchase shares are taken out of the market and, the number of outstanding shares is reduced. Well, that is not always the case. Most companies with buybacks underway, including Semtech, continue to issue other shares and derivatives. In the fiscal year ending January 2007, Semtech took in $2.2 million dollars from the exercise of 287,953 options. That is an average of $7.78 per share, well below the prevailing stock price. During FY07, the Semtech repurchased 790,700 shares for $14.2 million or about $18.00 per share. That does not seem like much of a bargain. I do give Semtech some credit for reissuing 113,820 share of from treasury stock valued at $906,000 or $7.96 per share. At least that was cheap money!

Anyone looking at the Semtech buyback has to look closer at the company’s options. Although Semtech issued only 648,000 options in FY07, it has handed out options by the bucket over the years - 1.9 million in FY06 and 2.7 million in FY05. Even though the company is now using a teaspoon to dole out options, options are getting exercised by the bucket. Only 804,000 shares were exercised in FY05, but 2.2 million and 1.2 million have come back in the last two years.
At the end of January 2007, Semtech had 10.3 million options outstanding at an average exercise price of $14.16 per share. This means most options are in the money and likely to be exercised. The number of shares outstanding is on the rise.

There must have been shouts of “incoming” in the Semtech boardroom and the directors have launched their countermeasures - a stock buyback. Here is how it will work. If all those shares were exercised Semtech would take in about $145 million and shares outstanding would increase 10.3 million. If the repurchase is fully executed, Semtech would use $150 million in cash and taken in our 9.4 million shares into the treasury. This means there would be a net outflow of $5 million in cash and a net increase of 900,000 shares, give or take.

No great signal value for SMTC. The valuation impact of Semtech’s buyback is really not as compelling as some might think, just looking at the 10% reduction in shares outstanding.

My suggestion to investors is to follow the buyback trail of crumbs, but look carefully before picking anything up. It may not be an acorn!


Neither the author of the Small Cap Copy web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein. Crystal Equity Research has a Buy recommendation on BWTR.

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