Capital Markets

Dividends Are Forever

CFOs come and go, but cash dividends stay -- and therein lies the problem.
Craig SchneiderMarch 1, 2003

Call it the gift that keeps on giving.

But first, a little background: In December, President Bush let it be known that, as part of his fiscal stimulus package, he intended to remove taxation at the individual level for corporate dividends. A few weeks later, during his State of the Union message, Bush reiterated his call to end the double levy on dividends and thereby “boost investor confidence.”

Despite heavy criticism from Democrats, shareholder rights groups generally greeted the President’s dividend present with huzzahs and handstands. After all, they argued, if stock prices are going to stay flat — or worse — shareholders might at least get some payback from their equity investments.

A fair number of economists (and financial columnists) also heaped praise on the plan, insisting that elimination of the dividend tax would stimulate the moribund stock market. What’s more, they argued the proposal would put more money into the pockets of investors — hence, priming the economic pump.

All of which has triggered a bit of a dividend stampede in corporate boardrooms. In January, for instance, management at Microsoft Corp. indicated the company might actually put some portion of its $42 billion cash-cache towards an honest-to-goodness dividend.

The Microsoft announcement was a real surprise. For years, the software giant has steadfastly opposed paying a dividend, choosing instead to funnel its capital into acquisitions, buybacks, and new projects.

Microsoft management’s decision to start paying a dividend — which it claims was not spurred by the Administration’s tax plan — no doubt had executives at other company’s considering a similar tack. Certainly, recent press reports indicate that a number of companies are considering adopting a cash dividend payout.

They may want to reconsider their considering. While shareholders tend to love cash dividends, such regular payouts increase a company’s administrative workload and reduce financial flexibility. At the very least, these critics caution, the decision to begin paying out a share of profits on a regular basis — what amounts to a fixed cost — should not be taken lightly.

Ira Zar, CFO of Computer Associates, which put a dividend in place two decades ago, says dividends need to be measured and evaluated against other uses of cash. Companies with underfunded pension plans, for instance, may have little choice but to plump up their retirement plans rather than funnel money back to shareholders.

Academic advisors also warn of conflicting cash interests. Gary Jacobi, adjunct professor of corporate finance at NYU’s School of Continuing and Professional Studies, says dividends can be a double-edged sword for any company that relies on issuing stock options to employees.

Since there’s an increased likelihood that stock options would be exercised because a company starts paying a dividend, Jacobi notes, “you’re more likely to have to come up with cash not only for the dividend [on shares outstanding], but also for any large number of diluted shares that are picked up on option.”

And that may be the biggest drawback to cash dividend programs — it’s hard to undo them. A payout plan launched when times are good can come back to haunt a company when cash gets scarce. And as many IR managers will note, once shareholders get used to receiving regular dividend, they’re not real eager to give them up.

That’s why some CFOs are wary of overly aggressive dividend payouts. Says Ken Goldman, CFO of Siebel Systems, “The key is to do it as a relatively small percentage of earnings so your company will be able to increase the payout rate over time. You don’t want to have to do a take away and decrease the dividend down the road.”

NYU’s Jacobi agrees. “[Decreasing or eliminating a dividend] is a little like waiving the white flag,” he says. “It’s not necessarily a last resort — but it’s darn close.”

What Is It Good For? Absolutely Nothing

Indeed, some old hands at dividend programs say maintaining a dividend payout can become a royal pain. Just ask Gordon Gillette, CFO of TECO Energy, who says that the cash distribution “becomes part of the cash planning and cash management cycle.”

And what a cycle it’s been. Management at the parent company of Florida utility Tampa Electric has spent much of the last year digging out from a failed joint venture with Enron Corp. and pulling back from an investment in merchant power. TECO’s construction in regulated and non-regulated businesses has also put the squeeze on cash.

In addition, TECO management has run into some plain old bad luck. The fact is, the entire energy sector has been hit with a sectorwide credit crunch, due mostly to Enron’s collapse, the failed deregulation in the California utility market, and low power prices in the wholesale markets.

Combined, those problems have led to stock market speculation (particularly from short sellers) that the company’s cash dividend — paid out for 43 consecutive years — would be cut or eliminated. “We find ourselves more challenged than ever before to maintain the dividend and complete an extensive construction cycle,” Gillette concedes. The company CFO admits that the construction initiative “has probably put more strain on the cash flows of our company than we’ve seen in the past.”

But reducing — or eliminating — its longstanding payout would likely send some of TECO’s dividend-dependent shareholders (read, widows and orphans) out onto high ledges. It would also be a huge defeat for the company’s management. Says Gillette: “I think we would be ill-advised to even think we’ve got to change our policy and therefore change a basic component for our shareholders, especially during this difficult time.”

Maintaining the company’s generous dividend policy won’t be easy, however. Over the years, TECO’s dividend payout has outstripped inflation and the payouts of its peers.

The jacking up of the company’s cash dividend has resulted in a $0.04 per share average dividend increase, which works out to a 2 or 3 percent increase in the annual dividend. TECO’s payout ratios have generally been in the 60 percent to 70 percent range, based on current outstanding shares.

All in, the dividend payout costs TECO about $250 million annually. That’s not exactly chump change, considering cash flows from operations have typically been around $600 million a year.

It appears, however, that Gillette and his finance team have been able to allay investor fears that TECO’s dividend payout might be lowered. Over the past few months, the utility’s CFO has raised more than 70 percent of the $900 million in capital needed for TECO to pay its dividend and complete its construction projects. But Gillette was only able to pull this neat trick by cutting costs, selling assets, and issuing more equity.

Not all TECO’s peers have been as fortunate. On January 24, CMS Energy’s management said the company was suspending its dividend. CMS is trying to reduce about $7 billion in debt through asset sales and cost cutting.

The suspension of its dividend will not likely sit well with investors, however. It could also force managers of some income funds to divest their holdings in CMS.

This is exactly why some critic’s rail against dividend plans, even well-intentioned ones. “If you lock yourself into a regular dividend,” says Al Ehrbar, partner at consulting firm Stern Stewart, “it reduces debt capacity and reduces financial flexibility, in exchange for which you get absolutely nothing.”

Small Yields, Big Problems?

Microsoft’s modest 8 cent dividend is likely to land it in far less trouble than CMS. With no debt and $42 billion in cash, there’s little question Microsoft can maintain the payouts. In 2003, for example, the cash dividend will cost the company $850 million. That’s less than one month of the software vendor’s positive cash flow.

And in theory, other technology companies — companies which have been battered by investors — could benefit from dividend plans. As Siebel’s Goldman points out, issuing dividends “could decrease the volatility of your stock and it could help put a floor on your stock.”

Market results seem to support that argument. Last year, for instance, 350 of the companies included in the S&P 500 paid dividends. According to Standard & Poor’s, the share prices of those dividend payers dropped about 18 percent in 2002, nearly half the 30 percent drop by non-dividend payers.

Historically, though, managers at high-tech companies have put excess cash toward share buybacks, arguing that buybacks are more cash efficient because they do not incur double taxation. If President Bush convinces Congress to go along with his tax proposal, that argument would be moot.

Nevertheless, managers at high-tech companies can start and stop repurchase programs at will, often without investor backlash. The same cannot be said of dividend programs.

Moreover, high-growth companies may risk losing their investment appeal if they start paying out dividends. “A high payout is a sign that it doesn’t have attractive growth opportunities,” says John Waterman, CIO of Rittenhouse Asset Management. “In the stocks we’re buying, the yield is going to tend to be low.”

If a company’s dividend yield is exceedingly low, it raises the obvious question: Why bother? Microsoft’s payout, for instance, works out to a 0.2 percent yield. “I’m not sure what they gained by doing this,” NYU’s Jacobi says. On a $50 stock, he expects at least a yield in the 1 percent range “to be meaningful enough to buy it for the dividend.”

Even a moderate payout could leave a tech company with too little cash to seize business opportunities. That, in turn, could send investors scrambling for the exits. “We look for techs with a little or no debt and excess cash on their balance sheet,” Waterman says bluntly. “And if paying a dividend causes cash to disappear or take on debt, we don’t want it.”

Here Come the Clawbacks

Certainly, companies with more volatile cash flows and earnings are ill-advised to consider high-dividend payout ratios. Siebel’s Goldman believes that companies with consistent earnings — and not strong cash positions — will be more likely to come out with recurring cash-dividend programs.

But some observers contend that most companies would actually be better served by offering a special dividend — that is, a dividend that’s nonrecurring and exceptional in terms of either size or date issued.

Making a one-time payment, they argue, will likely curry favor with investors. To be sure, companies that issue one-time dividends don’t have to worry about maintaining quarterly or annual payouts. And as Ehrbar notes, “lending agencies will not view a special dividend as a quazi-fixed-level obligation that reduces your ability to handle debt.”

Retail and institutional investors may not think much of a special dividend, however.

First off, sporadic dividend payments often send a message that a company’s management is not overly confident about earnings prospects. Moreover, investors looking for maximum wallop from President Bush’s tax proposal would likely seek out companies that pay recurring rather than non-recurring dividends.

That said, it’s not entirely clear which companies will actually qualify for the Administration’s double-taxation amnesty program. Under the proposal, a dividend can only be distributed tax-free after taxes have been paid on profits (the payout is based on something called an excludable dividend account, or EDA).

In fact, a recent study by Bear, Stearns & Co. found that only 11 of the 30 companies that make up the Dow Jones Industrial Average would be able to issue fully tax-free dividends under the Bush proposal. Six others — Alcoa, Eastman Kodak, Hewlett-Packard, Honeywell, IBM, and United Technologies — wouldn’t be able to issue any, on account of their EDAs.

Backers of the President’s plan concede that it’s complicated. Critics say it’s almost unfathomable.

The latter may be closer to the truth. Accountants are already speaking of bookkeeping machinations such as “basis clawbacks” and “cumulative net basis bumps.” One sure sign of murkiness: in late January, just days after the President’s dividend plan came to light, the Treasury Department issued a 12-page “technical explanation” with clarifications and adustments.

The Phantom Menace

Ironically, some observers believe Bush’s dividend tax plan — with its emphasis on excludable profits — may actually be intended to get corporations to pay more taxes.

Robert Willens agrees. “I think there’s a hope on part of the administration that companies will be better citizens, pay their share of taxes,” says Willens, Lehman Brothers’ tax and accounting analyst, “so they’ll have large EDAs. And that, in turn, will provide a large source of excludable dividends or deemed dividends.”

A number of tax experts say deemed dividends appear to be the real wild card in the Administration’s proposal. In essence, deemed dividends are the difference between a company’s EDA (a measure of the taxes paid on earnings) and its excludable dividend payout. That difference is then “deemed” reinvested into the company. (Read a more in-depth explanation of excludable income and deemed dividends.)

In return for all this deeming and reinvesting, investors get to report a smaller capital gain to the Internal Revenue Service when they cash out of equity investments. While the tax benefit to shareholders isn’t as substantial as tax-free cash dividends, it’s better than nothing.

Moreover, observers say that deemed dividends eliminate the need for companies to pay a large — or even a regular — cash dividend. “It almost doesn’t make a difference then for companies that want to go out and use cash for investments,” says Jacob Friedman, chair of the tax department at Proskauer Rose LLP.

Willens agrees, noting that a company that is a good tax citizen could offer shareholders the promise of deemed dividends combined with a share repurchase program. Arguably, the combination would more cost effective than a regular, tax-free cashdividend.

Of course, shareholders may not regard deemed dividends as highly as management. Friedman contends that the phantom share-price appreciation (the step-up in cost basis) works far better in concept than it might in practice. Further, he’s not convinced the average investor has the accounting skills — nor the patience — to keep track of the tax benefits of deemed dividends over several decades.

“I think the idea of tracking basis for years to come will not sit well for shareholders,” Friedman says. If Bush’s plan is passed, he predicts glumly, “we’re all going to become a nation of bookkeepers.”