Weighing the pros and cons of launching a dividend
Only two years ago utilities that paid dividends as steadily as a Treasury bond were derided as old-fashioned mom and pop investments and were swallowed by Enrons offering growth. However last year the tide began to turn.
Suddenly the financial media paid attention again to phenomena like the Dogs of the Dow: the plodding companies that kept making money and sending it to their shareholders in the form of dividends as opposed to companies that kept making promises while giving out huge option grants. Then in January President Bush proposed a tax break on dividends, which threatens to take away the rationale many companies had used for buybacks as opposed to dividends – that they were fiscally more efficient. Apparently companies are getting the message. Also in January Microsoft made tech stock history by announcing a new dividend.
A year before Ralph Nader, of all people, had berated Microsoft for not sharing some of its $40 bn cash hoard with shareholders. Microsoft says that neither Nader nor President Bush inspired its change of tack. Curt Anderson, Microsoft's director of investor relations, instead credits 'the resolution of a significant portion of US and State antitrust matters.' He adds that this 'reduced some of the uncertainty around future long-term capital requirements.' According to Anderson, the board now feels Microsoft is able to meet its long-term capital requirements and provide a distribution to shareholders in the form of a dividend.
Nader's main charge, gathering credence among investors, was that share buybacks benefited executives by paying for their options, leaving dividendless stockholders whistling. Bala Dharan, professor of accountancy at Rice University, says, 'The academic community usually thought buybacks were generally good, but not everyone realized that in recent years they were used mostly to fund stock options.' According to Dharan, options and buybacks are great ideas, but combined – and without proper governance controls – they create opportunities for abuse by management.
Lining pockets
Although some are beginning to notice this flip side of buybacks, Dharan notes that 'not enough portfolio managers have got the message that stock options pour enormous amounts of wealth to executives rather than giving any benefit to shareholders and by implication, buybacks do as well.' In fact, Dharan points out that Microsoft's buyback program, at around $6 bn, almost exactly equals options granted last year. Anderson candidly admits that Microsoft has 'traditionally purchased its own stock as a way to manage dilution and it will continue its share repurchase program.'
Still, 'It is the case with almost every major company in the technology sector that their buybacks are to compensate for options and they have damaged shareholder [returns],' adds Dharan.
In declaring a dividend, Microsoft, in a sense, locks itself in. Once you have a dividend, 'It's difficult to go back,' says Ken Goldstein of the Conference Board. 'If you combine that with the idea that officers have to sign off on the financial reports, and they have to disclose if they buy or sell shares but cannot sell while they are officers, it makes it difficult to do a U-turn.'
Microsoft, however, does not feel tied down by its decision. According to Anderson, despite 'an intent to pay a recurring dividend, the board will continue to reevaluate whether to pay a larger or smaller dividend on an annual basis.' The board's decision 'will be based on the company's long-term capital requirements related to research and development, investments and acquisitions, dilution management and legal and business risks faced by Microsoft,' he adds. A reduced dividend, however, would send a signal to the totemistic markets similar to reduced earnings.
New or hinted-at dividends from options-heavy companies like Microsoft, Cisco and Oracle are still exceptions. Income stocks may have gone out of fashion but they never went extinct. 'More and more institutional investors are seeing that companies paying dividends have a more stable stock price,' insists Professor Dharan.
His regret is that some still accept tech companies' arguments of the ballooning 1990s that the more growth they have, the lower the dividend. In Microsoft's case, he asserts the company couldn't grow faster, and those billions of reserves pose a moral hazard to management who could be seduced into high risk and speculative investments. For example, he says, 'Xbox requires billions of up-front investment with returns coming six or seven years down the line but not guaranteed.'
Bowing to pressure
Gordon Fines, a portfolio manager at American Express Financial Services, thinks new dividends are a side effect of Enronitis. 'Companies have to appease shareholders in the wake of Enron and Tyco, so paying dividends is a way for managements to say, Look, we are a real company. We really are making money, and we are not doing it to line our own pockets.'
Fines says it's a myth that there was ever a trend away from dividends. 'Companies that traditionally paid dividends carried on doing so. It was all these high-tech companies and dot-coms that came in and felt they didn't have to. And, as we discovered, some of them didn't because they didn't have anything to pay.'
Even so, he worries that there may be a little bit of a game going on – penny wise, pound foolish. 'Those that survived are being pressured to pay out, but it's precisely the high-tech companies that need to hold onto money, because they missed one whole cycle of investment. If money goes out the door in dividends, that means less money to reinvest to catch up, or less to pay down debt.'
'There is a certain logic in buying back shares now while they are cheap,' Fines adds. 'But making sure shareholders stay on the reservation and keeping the banks off it is probably more important.'
Fines breezily discounts the effect of Bush's proposed tax relief on dividends. 'It won't be enacted,' he claims. 'When you have the chair of the tax writing committee saying he's not sure it's a good idea, this thing is as dead as a door nail.'
Dharan, on the other hand, discounts the effect of a possible tax change for another reason. 'At most it will take away an excuse companies had for not paying dividends,' says Dharan. 'But it was never a very good excuse, because dividends have so many other benefits, especially the disciplining mechanism on managements.' So management lacked the cash for – and commitment to – dividends because their benefits came from stock options.
With three decades of perspective on stock buying, veteran money manager Arnold Schmeidler is more sanguine about the prospects of dividend tax relief. 'It'll draw money into common stocks that have good yields, and will move companies to raise dividends rather than buy back stock,' he suggests matter-of-factly. Schmeidler relates the dividend trend to macroeconomics: 'With interest rates below inflation, and over $2.7 tn in money market funds, investors are looking for income returns in interest or dividends.'
'Paying out dividends sends a message that these are real companies with real money, which is not going into management's pockets,' concurs Fines. 'In the face of shareholder suspicion, there's no going back to business as usual; no free ride. High-tech or not, if they have money it is going to be paid out this way.'
Dividend IR
Steve Baruch, an IR consultant with GA Kraut Company, points out the implications for companies that start paying dividends. 'They are going to have to target new
institutions that are more focused on total return,' he says. 'There are a lot of pension funds and institutions that are forbidden from buying stocks unless there is a total return of both yield and growth. And they are probably far more influential than they were five or six years ago.'
'Dividend-paying companies could be ripe investments for other investors, and it will be incumbent on IR people to find out who,' adds Baruch.
This idea hasn't escaped Microsoft. 'Certain mutual funds and pension plans haven't been able to purchase our shares because they are limited to purchasing dividend paying stocks. Paying a dividend may now allow them to invest in Microsoft,' remarks Anderson.
In light of Microsoft's landmark decision, other cash rich tech companies are weighing the pros and cons of dividend payment. In November 2002 Cisco's shareholders voted down a proposed dividend. The company's board did not support the proposal and CEO John Chambers has long sung the praises of buybacks and acquisitions, so the no-vote was not surprising. Given a second opportunity, the results might be different.
For investor relations officers embroiled in a dividend decision, Baruch says that it's crucial to consider how institutional investors will respond. 'It's a matter of what kind of stocks they like overall, what's on your balance sheet, and what your cash flow looks like,' he says. IR professionals need to target investors who best suit a company's investment profile with or without a dividend, he adds. Companies with cash also need to consider their long-term ability to pay out a dividend.