Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.
Last week, Calgary-based oil service company Xtreme Drilling Corp. announced the result of their substantial issuer bid, also known as a Dutch auction. With a market capitalization a little over $150-million and a typical trading volume of 20,000 shares a day, it is understandable that the press release did not attract widespread attention. This is unfortunate, as a Dutch auction is a fair and effective way for a company to distribute excess cash and deserves wider recognition.
The process is quite straightforward: A company simply states the maximum amount of cash available for a share buyback and the maximum price (or price range) that it is willing to pay for those shares. Investors can choose whether to tender some or all of their shares and the minimum price at which they will sell. After the deadline has passed, the company takes up all of the shares offered at or below their maximum price until the cash balance is depleted – with all shareholders receiving the same price. This final tweak means it is possible that some shareholders who tendered at a low price will receive a better payout than anticipated, while no one sells below their minimum price.
A Dutch auction is more time-consuming, but preferable to a special dividend as a means of distributing excess cash for several reasons: The receipt of an unexpected dividend along with the associated tax bill may not be in the best interest of all shareholders; it provides liquidity for large shareholders in a thinly traded stock; only those shareholders who wish to recognize a realized capital gain or loss need respond; and it shrinks the number of shares outstanding so the earnings per share of the continuing company should enjoy a boost going forward.
In theory, a normal course issuer bid could achieve the same objectives over time, but it faces limits on the permissible dollar amount and trading volume. As a result, it doesn't offer liquidity for large investors or a transparent price-setting process.
Turning to Xtreme Drilling as an illustration of the process, the company was blessed with an abundance of cash because it sold its coiled tubing assets to Schlumberger in April, 2016, for $205-million. The corporate cash balance as of June, 2016, was $122.2-million. As a result of operating losses over the past three quarters, the cash had diminished to $90-million by March, 2017. The Dutch auction announced in April invited offers between $2.40 and $2.80 a share up to a maximum cash purchase price of $25-million. The stock at the time was trading in the range of $2 to $2.20, so this was a modest premium, sufficient to flush out large investors needing liquidity and investors with a negative outlook for the energy sector. After the buyback, the company would still have $65-million in cash and a debt-free balance sheet. With a book value per share of $3.88, any shares purchased in the proposed price range would automatically increase the book value of the remaining shares.
As an investor in Xtreme Drilling, I was surprised that the offer was oversubscribed at the minimum price so that 10.4 million shares will be taken up at $2.40 for a total of $25-million. This reduces the number of shares outstanding from 85.1 to 74.7 million and raises the book value per share from $3.88 to $4.09.
I chose not to tender to the auction because I am favourably disposed toward managements which return surplus cash to shareholders rather than make hasty and ill-advised acquisitions. In addition, the company still has (as of last quarter, anyway) about 86 cents a share in cash, a clean balance sheet and, while it is losing money, the quarterly revenue trend is showing sustained improvement. The outlook for the oil service sector remains cloudy, but Xtreme Drilling appears to be a survivor and I am a patient investor.
Robert Tattersall