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Their coffers bulging with cash, companies are increasing the once-out-of-favor common dividend.
Vincent Ryan, CFO Magazine
April 15, 2012
Cash-rich companies are paying dividends to shareholders again, in a big way. Dividends fell out of favor relative to buybacks during the past three decades, but now, following the recession, issuers are raising their common dividends and declaring new ones. Even special dividends are being paid out, with such companies as Sara Lee, Boise, Diamond Offshore Drilling, and NYSE Euronext taking opportunities to return a portion of their free cash flow or one-time gains to stockholders.
In fiscal 2011, 429 nonfinancial companies in the United States increased their common dividend, by a market-cap-weighted average of 21.5%, according to data provided to CFO by S&P Capital IQ. Only 18 nonfinancial companies cut their dividend, by an average of 2.2%. (In 2009, by comparison, 131 nonfinancial firms cut dividends, by an average of 9.1%.) Nearly 60 companies either increased or declared a dividend in the first month and a half of 2012.
Duff & Phelps, a financial advisory and investment banking firm, has paid a dividend since 2009 and increased it the past two years. "We believe a dividend attracts a broader base of shareholders," says finance chief Patrick Puzzuoli. "Certain individuals wouldn't even look at investing in companies that don't offer dividends."
"With 2-year Treasuries at 30 basis points and the 10-year note at 2% or less, more and more companies have thought long and hard, and they have gone ahead and issued dividends for the first time or increased them, assuming they have adequate cash," says David Chichester, a partner at professional services firm Tatum and former CFO of Starbucks Coffee Japan. "If an investor can get a dividend yield of 2% to 4% plus the potential for the underlying stock to appreciate in price, that's very attractive."
Low nominal interest rates also mean corporate treasurers are earning scant yield when investing surplus cash, causing large cash balances to be a drag on earnings. "What is Apple going to earn on its cash — 20, 30, 40 basis points?" asks Chichester. "And [investing cash is] not the company's core business. So sooner or later there is a hue and cry about buying back stock or distributing a dividend. And in this world of activism, many shareholders have no problem making their wishes known."
For a long time, however, buying back stock has been preferred over dividends. It's easy to see why: once a company pays a quarterly dividend, shareholders expect it will continue unabated. Chichester is on the board of Central Garden & Pet, and he says the pet- and garden-product supplier has an active share-repurchase program, but has never paid dividends.
"I think it's unlikely that we would, because we don't want to set that precedent," Chichester says. "Boards like the flexibility of share buybacks: they approve an authorization level and it gets announced, but that doesn't mean the company has to buy back the stock [immediately or use the full authorization]."
But Duff & Phelps, for one, has welcomed the regularity of dividends, viewing them "as a means to creating some fiscal responsibility and financial discipline," says CFO Puzzuoli. "Every year we have to budget for these dividends and make sure we're committed to paying them."
Both buybacks and share repurchases are arguably a relatively low risk way to give investors a return on investment. If a company doesn't have a high-return internal project to allocate capital toward, after all, mergers and acquisitions may be used to fuel growth. But M&A transactions are high risk, as traditionally about 70% of them ultimately fail.
Neither stock buybacks nor common dividends may do much to increase a stock's price, however. In the 1980s and '90s, the general belief was that buyback announcements caused a stock's price to rise, says Al Ehrbar, an executive vice president at EVA Dimensions, a corporate-performance consultancy. But then the market became "jaundiced," he says, because many companies announced repurchases but didn't actually buy back nearly as many shares as they said they would.
Traditional corporate-finance theory says increases in cash dividends don't necessarily move share prices, either. But in the real world, they do send a very positive message. "Increases in regular dividends are interpreted by the market as a signal of the board's confidence that the company's performance will continue to be good or improve," says Ehrbar. "So it tends to have a positive impact on share values." Of course, a reduction in a regular dividend has the opposite effect.
Strategy Comes First
Before jumping into paying a regular dividend, though, management has to determine whether it fits the company's financial strategy, says Ehrbar. "How much debt does it want in its capital structure? What kind of cash balance does it need? How much unused debt capacity should it maintain for future expansion or acquisition opportunities?"
At ABM Industries, a provider of facilities-management services, a dividend is part and parcel of the company's thinking about value creation. The company has paid a cash dividend for 184 straight quarters, going back to the late 1960s. It has increased its dividend per share by roughly two cents per year since 2007, and forecasts doing the same for 2012.
"We really believe in sustained, long-term value," says James Lusk, finance chief at ABM Industries. "The combination of increasing dividends over time and a long-term view creates really good value for shareholders. We're not the kind of stock that is going to pop 30% in a quarter."
When a company is a consistent, long-term dividend payer, however, it has to spend the rest of its cash very wisely, says Lusk. When ABM acquires companies, which it does frequently, it looks for them to be accretive in the first quarter, for example. "We've had value investors say to us, 'We like the idea that you pay dividends because you are that much more judicious with the rest of your money,'" says Lusk.
Companies should also note that the possibility of U.S. tax reform is a looming danger for dividend-paying stocks. Dividend income had been taxed as ordinary income until the Jobs and Growth Tax Relief Reconciliation Act of 2003, which lowered the tax rate to 15%. But President Obama has proposed a return to taxing dividends at higher rates — as much as 40% or more for some investors.
"If Obama prevails, the relative advantage for repurchases will go back up," says Ehrbar, "and I suspect you'll see the tide shift back to repurchases over special dividends."