Growth Strategies

Dividends Rise Again

Their coffers bulging with cash, companies are increasing the once-out-of-favor common dividend.
Vincent RyanMarch 2, 2012

Cash-rich companies are paying dividends to shareholders again, in a big way. Dividends fell out of favor relative to buybacks in the past three decades, but postrecession, 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. And speculation is that computer giant Apple could call a one-time dividend as its cash and marketable securities climb to $100 billion.

Four hundred twenty-nine nonfinancial companies in the United States increased their common dividend by a market-cap-weighted average of 21.5% in the 2011 fiscal year, according to data provided to CFO by S&P Capital IQ. Only 18 nonfinancials cut their dividend, at an average of 2.2%. Compare that to 2009, when 131 nonfinancial firms cut dividends and did so by an average of 9.1%.

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“With two-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 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 stock back or distributing a dividend. And in this world of activism, many shareholders have no problem making their wishes known.”

But for a long time, 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].”

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 share price, however. In the 1980s and 1990s, 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 provider of tools and training for analyzing corporate performance. 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.

The looming danger for dividend-paying stocks is the possibility of U.S. tax reform. Among the strongest arguments against dividends had been that the dividend income an investor received was taxed as ordinary income. That rate was lowered to 15% with the Jobs and Growth Tax Relief Reconciliation Act of 2003. 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.”