In late 2000, I became the laughing stock of a high-tech conference when I asked the 400 executives present whether their companies would pay dividends once they achieved their business plans and were making the zillions they predicted. ‘Retained earnings and growth through acquisition,’ one laughed as he patted me sympathetically on the head. ‘That’s the way to see your share price explode.’
Prophetic. The share prices of most of the companies at the conference have since exploded, though not in the way that particular CEO envisaged. And dividends are making a comeback. At the time of writing (early March), Microsoft has just paid its first-ever dividend, netting Bill Gates a cool $60 mn in the process. Lou Thompson, head of the National Investor Relations Institute in the US, says that during steep downturns, pressure grows for companies to pay dividends. The impetus comes from both investors and companies, who want to send stakeholders a message of financial health. ‘In an era when companies are trying hard to restore investor confidence, introducing or raising a dividend says they are confident in their ability to see out the rough times,’ says Thompson.
Of course it’s comforting to invest in a company with a strong balance sheet. A good cash position is a powerful indication that a company can ride out the storm while less well-endowed competitors see their credit quality deteriorate because of cash flow and liquidity problems. When ratings downgrades lead to higher interest payments, some companies can find themselves at risk of going belly-up.
Those with cash in the bank, on the other hand, are the ones best placed to make merry when the economy eventually recovers. They can build their businesses and invest in their growth areas while competitors struggle to restore their balance sheets or recoup market share.
This, at least, is the theory. But what if companies are perceived to have more cash than necessary to fund operations, acquisitions or other potential expenses?
The return of the dividend
According to David Kathman at Morningstar, many companies with cash in the bank are currently unable to generate a return in excess of their cost of capital. ‘Plenty of money has been wasted on ill-conceived mergers and projects when it could have been returned to shareholders to do with as they please,’ he notes.
Colin Melvin, director of corporate governance at UK-based Hermes Pensions Management, agrees. ‘When companies have excess cash which is not being employed and is not required for contingency needs, they should return that cash to shareholders,’ he says. If cash flows are predictable, adds Melvin, then this distribution could take the form of a regular dividend.
Some companies have, of course, been paying a dividend forever. Consolidated Edison, the giant US utility, has increased its dividend for each of the last 29 years and yields over 5.5 per cent. Jan Childress, director of IR at ConEd, says around 60 percent of his company’s stock has long been held by retail investors. ‘They’re very interested in the safety of a dividend, and are attracted to our long track record of dividend increases,’ Childress explains. ‘It reassures them about our financial stability.’
Nonetheless, Childress admits to having fielded ‘a ton’ of questions about the company’s leverage since the Enron collapse and because of the ongoing debt problems at certain energy companies. However, the company’s debt-to-equity ratio of just under 1.1 is not high for the sector, and its A+ credit rating and predictable cash flow also reassure investors.
The pressure grows
If successful, President Bush’s proposal to remove taxation on (most) dividends (which is seen as a form of double taxation since the corporation is already taxed on its profits) will put the pressure on many companies that do not currently pay a dividend. The Bush plan, unveiled at the beginning of the year, would save companies and investors an estimated $320-364 bn over the next ten years.
With $21.2 bn in cash and cash equivalents, Cisco at last opened the door to the introduction of a dividend last November, but shareholders defeated the proposal by ten to one, preferring more buybacks. The Bush proposals may change all that. John Chambers, Cisco’s CEO, has stated publicly, ‘If dividends were certain not to be double-taxed, we would look at it [sic].’
Vodafone, the world’s largest mobile telecoms operator, will soon come under renewed pressure to return some of its cash to shareholders. Ian MacLaurin, the chairman, hinted at the company’s annual meeting last July that Vodafone had plans to either make a major acquisition with the cash or to use it to pay a special dividend. The company’s subsequent €6.8 bn hostile bid for Cegetel (and the real target, the cash-generative SFR mobile unit) was blocked by Vivendi late last year, leaving Vodafone with plenty of cash on its books. If Vodafone sells its Japanese fixed line business, a move announced in early February, investors are likely to redouble their calls for some form of distribution.
What about buybacks?
Brad Pacheco, a spokesperson at Calpers, the giant US pension fund, says, ‘Although we do not have an official policy regarding cash on the balance sheet or retained earnings, our corporate governance staff and some of our active corporate governance funds closely monitor the cash positions of companies.’
He continues, ‘We don’t like to see companies stockpiling cash so they can ride out five years of a down market, or making acquisitions with cash that would be put to better use buying back stock.’
But buybacks don’t always have the effect of reducing the number of shares in circulation and thus increasing earnings per share. Intel has spent more than $23 bn on buybacks since 1998, but the number of shares outstanding has actually increased by 100 mn because of share options. It’s the same with a lot of options heavy companies; buybacks don’t so much return cash to shareholders as they do head off their grumbles about the dilutive effect of options. They might still complain, however, that the buyback is nothing more than a deferred wage bill.
A company can be stymied even if it has a sincere desire to return cash to investors through a buyback. Nokia, for example, has been under increasing pressure to distribute part of its $8.8 bn cash pile to shareholders, but a buyback risks tipping its debt-to-equity balance. Moody’s, which has an A rating on Nokia (on watch negative), has said it may downgrade the company if it launches an extensive share buyback program, which it is planning to propose to shareholders at its annual meeting in mid-March.
Antti Raikkonen, Nokia’s director of IR, confirms only that the company has been in extensive discussions with Moody’s over the possibility of a downgrade. He also notes that the company’s current cash position is very strong, and that, with total current debts of just over €900 mn, Nokia faces no immediate threat to its ability to run its operations or service its debt. The company’s strong cash flow should see its cash position continue to grow this year. Indeed, in late November one CSFB analyst estimated the cash pile could grow to €12 bn by the end of 2003.
Wolfgang Draack, senior vice president of European corporate finance at Moody’s, says he is wary of Nokia’s continued ability to generate cash, and that the negative outlook on the company is intended to reflect the business risks.
Moody’s latest outlook review for corporate Europe says company executives generally focus on shareholder value, in many instances at the expense of bondholder value, an attitude that likely hastened the decline in ratings for European issuers. Draack says the telecoms industry, in particular, provides lessons like Marconi, whose shareholders lost virtually everything when its debt burden forced it into restructuring. ‘A few years ago the core defense business was generating a huge amount of cash. Marconi’s balance sheet showed it to be a very cash rich company,’ said Draack. ‘But then it chose to distribute most of the proceeds to shareholders, raise debt and buy heavily into telecommunications at the peak of the market. The company concentrated too heavily on telecoms, neglecting its core business. The rest is history.’
David Frohriep, another Moody’s spokesman, affirms that ratings agencies are responding to an extremely volatile market environment with many more ratings downgrades than upgrades, and he admits there is now a stronger focus on liquidity and cash flow. The definitions of both, he says, have evolved since the start of the downturn in world markets, and particularly because of major corporate accounting scandals.
Keep your eye on the ball
While dividends and buybacks almost invariably make shareholders happy, a company should never lose sight of its cash needs. Look at the sad case of Cable & Wireless. Under lengthy pressure to return some of its huge £7 bn reserve to shareholders, the company finally gave back some £1.5 bn at the beginning of 2002 in the form of a 15 percent buyback and an extraordinary dividend.
Unfortunately, C&W Global’s operations were eating through cash, and coupled with various acquisitions that the company made in late 2001 and early 2002, there was a rapid deterioration in the cash position. That led to a ratings downgrade late last year which in turn triggered a £1.5 bn cash obligation, a tax indemnification clause that C&W had agreed to in mid-1999 on selling its One 2 One mobile unit to Deutsche Telekom. The company’s financial position now looks extremely precarious, and the share price has collapsed.
A word of warning to both companies and investors, then. Dividends and buybacks are a great way to keep investors happy; and they certainly inspire confidence in a down market. But companies are well-advised to keep a close eye on corporate contingency needs, and to make sure investors are aware of them, before they decide on the size or shape of any payout.
Activism, Tokyo style
Over the past three years, investors everywhere have been zeroing in on companies’ financial discipline. Yoshiaki Murakami and Kenya Takizawa, co-founders of Japanese asset manager M&A Consulting, see IR as essential in conveying company performance, and they maintain that companies can only satisfy shareholder expectations if they demonstrate operational and financial discipline along with boardroom transparency.
M&A’s web site proudly proclaims the company’s mission to ‘promote shareholder value in the Japanese market’ and ‘unlock value with effective corporate governance.’ It adds that its philosophy is ‘for the efficient use of capital, against the accumulation of capital’ which is probably why Murakami, an ex-bureaucrat, last year launched what became ‘the first post-war, all-Japanese proxy battle,’ in the words of Georgeson Shareholder chairman John Wilcox.
The target was Tokyo Style, in which M&A held an 11 percent stake. Murakami complained that despite having around $1 bn in cash and annual sales of $480 mn, the company’s market capitalization was only $890 mn. Yet its cash alone amounted to more than that. He blamed the problem on poor management performance and a lack of transparency and demanded a fat dividend. He was also critical of the company’s cross-shareholdings and real estate acquisitions that had little to do with its core business.
In Japan, Murakami is thought to have lost his proxy battle. But by forcing the company into a compromise, he achieved a significant victory. Tokyo Style had to win over undecided shareholders by offering them much better terms than those originally proposed, raising the dividend from the equivalent of ten cents per share to 15 cents, and substantially increasing investment in its core business.
In the end, M&A forced the company to demonstrate that it was using at least some of its spare cash to produce value for its shareholders.
