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Serving Up Dividends: The 2004 Free Cash Flow Scorecard

A new study of corporate cash flow shows that most of the nation's largest companies can increase dividend payments without jeopardizing their ability to grow.
Ronald Fink, CFO Magazine
January 1, 2005

See the CFO Free Cash Flow Scorecard

Recent trends in corporate cash flow suggest that U.S. companies are continuing to clean up their financial acts. In fact, they are increasingly in a position to initiate or increase dividend payments, even if they also begin to reinvest in their business or make big acquisitions.

These conclusions are drawn from a study of cash flow by the Financial Analysis Lab of the College of Management at the Georgia Institute of Technology. After adjustments for one-time and nonoperating items, the study found that cash flow from operations at the 86 nonfinancial companies that make up the S&P 100 grew 21 percent between 2000 and 2003. Meanwhile, their adjusted free cash flow — adjusted operating cash flow minus capital expenditures and preferred dividends — advanced by a robust 58 percent.

What's more, the big increase in adjusted free cash was not primarily the result of reduced capital spending, as this was cut collectively by less than half the gain, or roughly 20 percent. Nor was the elimination of preferred dividends from the free-cash calculation largely responsible, according to Charles W. Mulford, an accounting professor at Georgia Tech who directs the lab. Mulford says the study — presented here as the CFO Free Cash Flow Scorecard — shows that preferred dividends were a negligible factor, amounting to a "rounding error."

Instead, companies have improved their cash flow mostly by reducing overhead, shedding less profitable assets, and boosting operating cash flow. That means these companies are now on such a financially firm footing that they can, if they wish, put more money into dividend payments without sacrificing their ability to grow.

And in fact, that's what an increasing number of companies are doing. According to Standard & Poor's, more than half of the companies that make up the S&P 500 index expect to raise their cash dividend payout next year. That would continue the reversal of a decades-long trend away from dividends. Last year, there were 252 dividend increases by the S&P 500, and only 229 in 2003.

The scorecard suggests that this trend is sustainable, at least among the largest companies. While dividends paid by the 86 companies in the scorecard rose 12 percent from 2000 to 2003, from a collective $65 billion to $73 billion, their adjusted free cash flow has been growing even more dramatically. As a result, the proportion of adjusted free cash represented by those dividend payouts fell from 40 percent to 28 percent.

A New Perspective
What accounts for the increase in dividend payers? A number of plausible reasons have been advanced, such as the 2003 legislation that aligned dividend tax rates with capital-gains rates (15 percent), making dividends as attractive to shareholders as stock repurchases.

As Mulford sees it, the trend to higher dividend payouts reflects a fundamental change in perspective on the part of U.S. companies. "We saw an extended period, probably dating back through the long-term bull market that started in the early 1980s, during which companies gradually retained more of their earnings, lowering dividend payouts. Cash that was returned to shareholders was typically done so with stock buybacks, given the preferred tax treatment," he notes. "I think firms have found that they've reduced payouts about as far as they can, and there is a greater sense now that shareholders want increased dividend payouts."

If so, institutional investors in particular may be driving the demand, according to a recent survey of 384 financial executives by researchers from Duke University and Cornell University. The executives expressed two primary reasons for initiating a dividend: "a sustainable increase in earnings, and demand by institutional investors." Tax considerations, meanwhile, were secondary, according to a follow-up survey (see "Payout Policy in the 21st Century" by Alon Brav et al., at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=571046).

It's not surprising that the sustainability of payouts is a critical issue. But the Georgia Tech study, which was co-authored by Michael L. Ely, a financial analyst at the lab, with the help of research assistants Mario Martins and Amit Patel, suggests that most of the payouts by the S&P 100 can be sustained as long as recent cash-flow trends continue. "Companies with strong free cash flow are able to reinvest, have cash for acquisitions, and still pay dividends," notes Mulford.

Another issue is to what degree the trend to higher dividends reflects a dearth of opportunities to reinvest profits. After all, dividend payments come in lieu of retained earnings, and thus represent an acknowledgement on management's part that it can find no better use for the money. But fewer than half of the CFOs in the Duke/Cornell survey said that "the availability of good investment opportunities is an important or very important factor affecting dividend decisions."


The Free-Cash Spectrum
Individual results for the 86 companies in the CFO Free Cash Flow Scorecard vary widely. The financial condition of those such as Alcoa, Boise Cascade, Delta Air Lines, Lucent Technologies, and Sara Lee, for instance, is nowhere near as strong as that of others. Weak cash flow may force such companies to reduce or eliminate dividend payments if they haven't already done so, even if they keep a tight lid on spending.

At the other end of the spectrum (and in its own category) is Microsoft Corp., which has virtually no debt and voluminous free cash flow — an adjusted total of $14.3 billion last year, 155 percent more than in 2000. Yet the software juggernaut also enjoys fewer growth opportunities than it once did, and now compensates employees with cash instead of stock options. So Microsoft's announcement late last summer of a special $32 billion dividend payout came as little surprise, even though the company had initiated an annual dividend payout of 16 cents per share in January 2003. The new, lower-dividend tax rate was of obvious interest to Microsoft's high-income shareholders, including founder and chairman Bill Gates.

More typical of our scorecard is Williams Cos., whose former telecom and energy trading businesses exposed the Tulsa-based company to the knock-on effects of the meltdowns of both Enron and WorldCom earlier this decade. According to the Georgia Tech study, Williams's adjusted free cash flow was negative for three consecutive years starting in 2000. Not surprisingly, the company slashed its third-quarter dividend from 20 cents a share to 1 cent in July 2002.

But after cutting capital spending, shedding some $9 billion in assets and using the proceeds to reduce debt from some $14 billion at the start of 2003 to $7.9 billion at last count, Williams's adjusted free cash moved from a negative $2.3 billion in 2000 to a positive $237 million in 2003, and late this year the company increased its dividend fivefold, to 5 cents a share.

Yet Williams is also reinvesting in its core natural-gas business. Half of the new capital expenditure is going into exploration and development, but the company is also spending more on treatment and processing and on pipeline maintenance.

"There's always that delicate balance between reinvestment and a dividend," says Williams CFO Don Chappel. "In many cases, increasing the dividend isn't the right answer. In other cases, it is."

Deciding to invest instead of pay higher dividends requires as much discipline as it does analysis, and Chappel notes that Williams was one of many companies where such discipline was lacking during the late 1990s. "This company has been through adversity," he says. "And oftentimes the lessons learned during periods of adversity are priceless."

Twice as Nice
Another company in better financial shape, Viacom Inc., initiated its first dividend in 16 years in 2003 — 24 cents a share annually — as adjusted free cash flow almost tripled from $1 billion in 2000 to $2.9 billion last year. Earlier this year, the media company boosted its payout to 28 cents.

Intel Corp., which has been paying a dividend since 1992, doubled its quarterly payout this year, from 4 cents to 8 cents. Despite disappointing results from new product introductions, Intel's adjusted free cash soared from $319 million in 2001 to $8.2 billion last year, slashing its ratio of common dividend payout to adjusted free cash from 169 percent to 6 percent — which, of course, makes the higher payout vastly more affordable.

Despite tough business conditions, Mulford says many other companies among the S&P 100 have more than enough adjusted free cash to pay dividends for the first time, citing Amgen and Cisco Systems as examples. "Both companies are well positioned to initiate a dividend policy," he contends.

At the other end of the spectrum is Lucent, which suspended its dividend in 2001, when its adjusted free cash flow was a negative $4.2 billion. That followed a negative $2.9 billion in adjusted free cash for 2000 and preceded two more years of negative results. Despite a recent improvement in liquidity, Lucent's future remains decidedly up for grabs.

But the CFO scorecard paints a more positive picture for other companies that have suspended their dividends because of poor free cash flow. One example is AES, which suspended its dividend in 2001 when its adjusted free cash was running at a negative $909 million. Unlike Lucent's adjusted free cash, however, the Arlington, Virginia, energy company's results turned positive last year. If that performance continues, notes the Georgia Tech report, "the company would be in a good position to reinstate its dividend policy."

As a look at the accompanying tables shows, that statement also applies to a number of other once-troubled companies — another sign that the finances of Corporate America are on the mend.

Ronald Fink is a deputy editor of CFO.

See the CFO Free Cash Flow Scorecard




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