Capital Markets

Payback Time

As economic recovery begins, investors want higher dividends; CFOs want more investments to grow their businesses. Who wins?
Poul Funder LarsenMarch 18, 2004

The year 2002 was something of an annus horribilis for the media business, and Paul Richardson, CFO of global advertising and media services group WPP, faced his share of problems. After-tax profit at the £3.9 billion (€5.8 billion) group had slumped by nearly two-thirds, to £102m, amid the second year of contracting global advertising spending. With the war in Iraq looming on the horizon, stock prices were depressed and forecasts for media markets subdued. But when it came to declaring its dividend WPP and Richardson didn’t waver — despite weakened profitability the company hiked its dividend by 20%.

Priorities have changed at WPP over the last few years. Founded in the mid-1980s by Martin Sorrell, former group finance director of legendary ad agency Saatchi & Saatchi, the company grew rapidly for nearly two decades through acquisitions. Its share price also grew, culminating in a near tripling in 1999. With those kind of capital gains, investors were happy with a policy of paying just 20% to 25% of earnings as dividend. But, as with most high-growth media and technology stocks, the bubble burst and WPP’s stock fell long and hard. In 2002 alone it more than halved, from above £8 to below £4. But in the same year WPP paid out 71%, or £62.5m of the £88m profit attributable to ordinary stock owners.

For Richardson, the business downturn didn’t warrant a break with the company’s new strategy of steadily increasing the dividend. “Our margin was down, but the business is robust and the cash flow still good,” he says.

WPP’s new dedication to dividend growth is far from unique. Companies have responded to investors, who have learned to focus more on dividends in the low-inflation, bear market environment of the last three years, when “value investing” has made a comeback. Underlining this new awareness, a recent study by the London Business School entitled “Global Evidence on the Equity Risk Premium” explores, among other areas, the importance of the dividend to long-term returns, something that seemed to be lost during the bubble years.

The study shows that from 1900, more than half of investors total return in the world’s 16 largest markets came from dividend payments. That importance is greater during tough times. Since the bubble burst in early 2000, investors in the 20 highest yielding stocks in the UK would have earned a total return of 51%, while those investing in the lowest yielding stocks would have lost 64%. Comparable figures in most large European markets are less dramatic — return of high-yield stocks in Germany is 16%, in France 13% — but the pressure for dividends is growing.

A strategy of raising dividend payments, however, risks restraining capital investment and the capacity for acquisitions at a time when the business cycle is starting to turn. “Investors aren’t always very rational,” says Markus Pertl, a Munich-based managing partner for Europe with consultancy Stern Stewart. “You ask the company to pay out more cash in bad times, while you’re happy to leave them with excess cash in good times.”

Corporate finance theory says that companies should take into account a number of factors when deciding on dividend payments, such as future investment needs and the level of capital the company will need to retain for the dividend to be sustainable in the longer term. But theory and practice part ways when investors get restless. “Investors have been losing confidence in management forecasts and want to see cash now,” says Neil Kissel, a consultant with Marakon Associates in London.

Striking a Balance

For companies, it is a matter of striking a balance, something that is high on the agenda of Karsten Poulsen, CFO of ISS, a Copenhagen-based DKr38 billion (€5 billion) cleaning services group. In a bid to become the major pan-European player in its industry, ISS embarked on an acquisition spree in the late 1990s, which meant the company gobbled up scores of small and mid-sized firms across Europe. In 1999, for example, ISS made 32 acquisitions, including Europe’s then second largest cleaning services company, Abilis of the Netherlands. In that process ISS boosted its sales by more than 40% a year in both 1999 and 2000, chiefly due to the acquisitions.

This aggressive growth strategy had implications for the dividend policy too. “For several years we chose not to pay a dividend, one of the reasons being that during that period we created a pan-European platform leading to rapid growth,” Poulsen says. At the time, this was fine with shareholders. “We felt that investors were very focused on growth, and that overshadowed their interest in dividends.”

But over the past two years, ISS’s expansion drive has slowed considerably, while sales growth fell below 10% in 2002. Free cash flow, however, has more than doubled since 1999 to reach DKr1.7 billion in 2002, and last year ISS moved to reinstate its dividend. It paid out DKr2 per share, or roughly one-third of its DKr246m net profit for 2002.

Poulsen says the strong cash flow allows it to pay investors while leaving enough ammunition for future growth opportunities. “There’s room for value creation through acquisitions, while paying dividends too,” Poulsen says.

Dividends Galore

Indeed, reintroducing, or increasing, dividends can make good sense for growth companies that are finding it hard to put cash to good use in the current sluggish climate, says Kees Cools, vice president with the Boston Consulting Group and professor of corporate finance at the University of Groningen in the Netherlands. “Now that their growth opportunities have strongly diminished, companies show that they aren’t investing in unprofitable projects or acquisitions by giving the money back to investors,” he says.

ISS and WPP reflect the broader trend. The average payout ratio for European companies is close to historic highs of more than 50% of earnings, compared with around 40% three years ago. For FTSE 100 companies, the ratio was 49.2% for 2002, while for the Paris Bourse’s CAC 40 payouts were at 34.8%, a 20-year high, according to research conducted by Cools. The same tendency applies to the US, where payouts have received a boost from President George Bush’s lowering of the marginal tax rate on dividends last year. For the Dow Jones Industrial Average the payout ratio stood at 46.7% of earnings in 2002, the highest level since 1980, according to Cools. After steadily losing importance throughout the 1980s and 1990s, when average dividend yields for European companies fell from around 6% to some 2%, the slump in share prices has sent yields back up again to over 3%, levels not seen for a decade.

There is no doubt that investor pressure has helped this trend. “When stock prices went down, dividends suddenly became a larger part of shareholder returns,” Cools says.

Another factor is that many companies have more cash on hand than two or three years ago. According to Goldman Sachs, free cash flow at European companies rose to an estimated €153 billion in 2003, nearly double the level of €86 billion two years earlier.

Tricky Trade-Off

But while investors are calling for higher dividends, some finance chiefs are pushing back. When Philip Hampton, CFO of Lloyds TSB, left his post in January, a major issue underlying his departure, observers say, was a long-running debate over whether the UK bank which has a stratospheric yield of over 7%-should give priority to growth over maintaining its dividend.

Yet companies wanting to limit payouts in order to finance capital investment or acquisitions find themselves in something of a Catch 22. On one hand, “companies don’t want to lower dividends because it’s a bad signal that will send its share price lower,” says Cools. On the other, paying too much could undermine their financial health and long-term growth prospects.

And if economic trends persist, many companies will soon need to increase capital investment, which as a percentage of company spending has been sliding since a peak in 2001. According to Goldman Sachs, the capex of European companies is now at “unsustainably low” levels.

Paying too much attention to what shareholders want in terms of payouts can distort corporate priorities. “Often finance departments are bowing to near-term demands from [investors], rather than stepping back and looking at the long-term interest of shareholders,” says Kissel of Marakon Associates.

Richardson at WPP sees it differently. He made a point of consulting with major investors before setting policy. “We sat down with a group of some 5 to 10 investors and laid out the options.” He maintains that there is room for both raising payouts and financing investment and says the growth years are far from over at WPP-he points to 2003, when the company made more than a dozen acquisitions, while still returning cash to shareholders.

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