The number of publicly listed companies that have initiated capital reductions has been increasing, with 57 companies last year implementing reduction programs, compared with 40 in 2015. So far this year, more than 10 listed companies, including in the electronics, textile and real-estate sectors, have announced capital reduction programs to improve their financial structure, despite speculation that they are using the measures to bypass dividend taxes and health insurance supplement premium obligations.
In theory, capital reduction is the process of decreasing a company’s share capital, which usually boosts its return on equity (ROE) for shareholders. In practice, a company can reduce its capitalization either through share cancelations or with share buybacks to cut the nominal value of each share.
However, the rationale for companies to implement capital reductions varies, with some using the scheme to offset operating losses and some aiming to improve their balance sheet for a better shareholder value, while others simply want to make payments to shareholders as they are sitting on huge piles of cash.
Accordingly, capital reductions have different meanings for shareholders. First, loss-making companies are forced to implement capital reductions, because otherwise they would have no chance of achieving a recovery in earnings. While a capital reduction aimed at covering losses is typically followed by a cash injection to make up the financing gap, the implications of this scenario are that companies have operational difficulties and might still face risks if no dramatic changes are made to business strategy or product portfolio. Therefore, despite an immediate improvement in the company’s ROE due to the declining number of issued shares, sustainable growth is not ensured.
Second, there are companies that view a capital reduction as a feasible solution if they consider splitting their operations into different businesses, especially when tax considerations are involved in the process of a planned demerger. Under a well-orchestrated demerger, shareholders benefit from better net book value and earnings per share. They could also see an increase in their total wealth after a restructuring amid a bullish market.
However, there is always the possibility of a company using a demerger to create hype around their shares, so investors have to discern companies that genuinely attempt to create value from those wanting to manipulate stock prices.
Third, there are companies facing heightened scrutiny from investors about how their pile of cash should be utilized, and their answer is to return the cash to shareholders through capital reductions. Of course, shareholders greet the refunds cheerfully, but they would not benefit in the long term if companies reduce capital out of a conservative outlook on future business performance, which they might derive from either cloudy prospects for their industry, few new products in the pipeline, or uncertainty in the macroeconomic environment.
Companies might also want to deliver cash directly to shareholders amid cashflow uncertainties, insider interests and government regulation, but whatever the reason is, a capital reduction hints at limited growth potential.
The reduction fever is likely to continue for a while, as most investors welcome payouts from companies along with a potential boost to ROE and stock prices in the short term.