Excess Cash and Shareholder Payout Strategies A Summary Neeti A++ Dixit This article discusses, unarguably, one of the key principles of finance i.e. extra cash and its treatment by companies. After chalking out positive NPV projects that beat the hurdle rate for a firm, companies look for financing sources. There are two possible sources, Debt and Equity. Depending on the type and stage of the business, companies choose their relevant financing mix (percentage Debt + percentage Equity). The free cash flow generated at the end of the first two key activities, after clearing contractual debt obligations, is the excess cash that ideally belongs to the stockholders. If a company cannot find an investment with returns exceeding the hurdle rate, stockholders should receive the cash back (it is not mandatory). The company could choose to hold back some cash as a cash balance and return in the forms of dividends or stock buy backs. Referring to MM propositions, dividends do not matter to an investor based under certain assumptions such as there are no taxes, no transaction costs, and all financial transactions are zero NPV thus leaving out the possibility of arbitrage. In reality, the world is not smooth as assumed by MM propositions. Mr. Black attempted to analyze the concept and the rationale behind dividends and payout policies and this article looks at the technology sector and tries to comprehend the behavior of technology bigwigs, Apple, Microsoft, and IBM as anecdotal evidence and an overall look at companies as empirical evidence. Anecdotal Evidences Apple (AAPL): In 2012, Apple CEO Tim Cook along with CFO Oppenheimer announced the following:
Quarterly dividend of $2.65/share in September quarter Share re-purchase programs for $10 billion of stock commencing in December to be executed over the next three years To summarize Mr. Oppenheimer, the rationale behind this was threefold; first, to reward Apple s current shareholders with some income; second, to attract new investors to purchase their stock; and third, to reduce dilution that was created by employee participation in equity programs Microsoft (MSFT): In 2003, Microsoft announced a small dividend and a 2-for-1 stock split. Summarizing Mr. Connors, CFO, the dividend and the stock split issue was keeping in mind the large cash surplus Microsoft had garnered and should be shared with the shareholders. The action was to attract new shareholders and reward existing ones. A share split usually generates positive reaction and causes the prices to go up as it becomes more affordable to an average investor. However, the prices went down by about 7% (market adjusted) as it was probably perceived as Microsoft s business model as aging and reaching maturity. In the same year, Microsoft doubled its annual dividend to a quarterly payout of $0.08 (after revision), announced a special dividend of $3 per share, and announced a buyback worth $30 billion shares. This move lead to a positive response from the market with a market adjusted return of 3.88%. The example shows that Microsoft, with a cash balance ranging from $20 billion to $60 billion, acted as follows: issue dividends (to reward its existing shareholders) 2-for-1 stock split, (to make its share more affordable and attractive to new investors), and simultaneous special dividend with a share buyback (to protect its employees holding equity options from a decline in share price) Special dividends are a smart act by companies without creating illusions to their shareholders about possibilities of future dividends but also signaling a good run or a sudden surge of cash. However, Microsoft signaled that
shareholders need not worry as the company had positive NPV, cash flow generating projects in pipeline with sustainable dividends for next four years. MSFT continued with a string of dividends and buybacks in 2006 and 2008 of similar tunes to 2004. In my personal opinion, I do not look at it as a bad news because the company had large amounts of extra cash and chose to share it with its shareholders. Post equalizing of dividend-income tax rate with capital gains on stocks, MSFT issued its first dividend along with buybacks, which shows that the company is not averse to sharing the profits and kept investor sensitivity to taxes in mind. According to the article, further buybacks signal that the company gracefully entered the mature stage. However, the actions show a strong corporate management that took decisions keeping the investor in mind. The article also comments on a lackluster performance of MSFT stock post the buybacks but I believe counting only stock performance as a measure of performance is a myopic view. IBM (IBM): IBM started with its stock buyback program as early as 1980 for its business model was under pressure followed by a larger repurchase program in 1994. It seems a good corporate governance wherein the income is shared with stockholders as dividends were subject to heavy income taxes. In 2003, after dividend-income tax relaxation, IBM s dividends showed a smooth and gradual ascent. Again, there are arguments of IBM stocks lackluster performance but that is only if stock price movement is the one measure of performance. Empirical Evidence Figure 2 in the reading highlights four key points: Buybacks and dividend payouts have usually mirrored their movements till 2003 where dividends show a smooth ascend post equalization of tax rates on buyback and dividends During the Great Contraction period (2008-09), stock buybacks show a plunge reiterating that companies can switch minds rather swiftly
when it came to letting go of cash for a purchase while reluctance in altering dividends shows the discomfort in altering policies as this could convey negative news Large US companies are able to maintain enough liquidity for their dividend payouts regardless of boom or bust economy, again reiterating that changing dividend policies is not a preferred move Buybacks have reflected the state of the economy post 2003 As noted by Ms. Dittmar, companies buying back their shares in boom reflects that they are doing well and the motive is purely to share prosperity with shareholders in terms of buybacks is the most tax-efficient way (the aim isn t to inflate the stock price) Payout strategies by Industry Groups Regular dividend payments denote maturity of a company and usually are from sectors such as utilities and telecom. They generally do not horde cash and innovate. On the other hand, growth sectors such as technology usually innovate and hence usually prefer to buy back shares. This is visible from average dividend yields of 4.4% and 5.3% of utilities and telecom companies respectively vs median of 2.4% of S&P 500. There payout ratios also exceed 60% vs median payout of 32.4%. Digging deeper in each sector, AT&T and Verizon (mature telecom) with divided yield of ~5% and buybacks as low as 1% prove that regular dividend payouts is a characteristic of mature companies. To show dominance of buybacks, we can look at technology and consumer cyclical business sectors with bigger associated risks. For example, JC Penney boasts a buyback payout ratio of 246.9 while N/A for dividend payout (under the presumption that they did not ever pay dividends); HP showed a dividend payout ratio of 12.7% while a buyback worth $10,117 million with a ratio of 121%. Cash Required by a Company
From the traditional Keynesian economic perspective, companies tend to hold cash for the following three possible reasons: Transactional demands to manage the day-today, routine expenses, working capital Precautionary demands holding money for contingencies Speculative demands cash required to make investments to take advantage of a positive NPV opportunity Technology sector illustrates a high speculative demand and hence retention of cash (as seen for MSFT and AAPL). Such companies would retain cash for RnD and future M&As. Economic volatility affected Tech companies hoarding tendencies as seen below: Top three Cash-holding Tech Companies (Barron, 2012) Company P/E Net Cash ($, billion) Dividend Yield MSFT 10.7 56.7 2.7 Cisco 9.1 32.1 1.9 Qualcomm 15.5 26.7 1.7 Other than Keynesian point of view, companies are also affected by macro factors such as change in taxation policies, uncertainty in future demand. Taxation policy of US is a key factor that has made companies retail large amounts of cash and it specially holds true for R&D with investment heavy sectors such as Pharma and Technology. With high overseas sales, these companies would not want to repatriate cash from low tax zones to the US (taxed @35%) as the income is already reported overseas. The economic factors are uniform for all companies and large industrial establishments have shown tendencies to horde cash during or post-recession as S&P 500 industrials held average cash about 10-12% of their market cap from July 98-2001. Post the dot-com bubble, the average jumped above 20% of their market cap. Guiding Principles for Crafting Payout Policies
To avoid landing in financial distress or bankruptcy, companies should have enough cash for their working capital and contingencies Achieving optimal-leverage while equity provides freedom and flexibility, debt brings about control responsibility. Deciding an optimum D/E ratio is important because if a company pays dividends, it decreases the degree of financing of equity capital from internal sources, and it might require external financing sources Any cash retained for investment activities should have an expected return other projects Companies should thoroughly evaluate potential projects and only distribute cash when they run out of positive NPV projects Unless the company specifically wants to signal growth or change in business model etc., company should assess the payouts of its peers and act accordingly Special dividends are a safer way to distribute extra-cash (usually through a non-recurring event) without raising hopes for investors for regular dividends in future. As visible from Sara Lee issuing a $3 special dividend post its division into two publicly traded companies. The dividend was funded by its sale of North America Fresh Bakery business Buyback as an option is usually executed as per the following criteria o Share buybacks are expected to increase EPS o The distribution of cash should not land the company in financial distress i.e. the share price should not go too low as it could lead to existing shareholders sell their stakes Personal Opinion A company should first see that it has enough cash to carry out its demands of cash activities. While devising a payout policy, a company should look at its capital structure while setting the framework. A company could borrow debt or decrease debt by retiring it. A payout policy of any kind should also be inline with the peers and industry best practices unless the company wants to
send signals. Understanding the future positive cash flows is extremely important to decide on dividends otherwise it is a better move to buy back shares (provided the management is confident of no stock price decline in future). Also important is the understanding of your investors. If the investors are not dividend friendly then dispensing cash via buybacks is a better plan. For e.g., pro-risk investors in growth companies like Uber are not looking for dividends per se. Retirees as investors look for investments in incomecompanies as a regular stream of cash. IS the D/E ratio optimal? Yes No Increase or Decrease Leverage Does company have +ve NPV Projects? RoC >Cost of Capital? Yes Retain and invest No Do your investors like Dividends? Yes Pay Dividends No Buy back Stock