Corporate Finance

Columbia University

Prepared by: Bachhawat, Vivek Hadgis, Demetrios Tsoka, Katerina Uccellini, Jessica

Professor Charisa Asbury

Dividend Policy: The FPL Group, Inc. (FPL) I. Executive Summary A. Current Situation: In the spring of 1994, Merrill Lynchs utilities analyst downgraded their investment rating for the FPL Group, the parent company of Florida Power & Light, Floridas largest electric utility. The Merrill Lynch analyst downgraded FPL because he/she believed FPL was on the verge of cutting its dividend for the first time in 47 years. Reacting to this news release, Kate Stark, an electric utilities analyst at First Equity Securities Corporation, faced the decision whether or not to revise her own current Hold recommendation on FPLs stock. Following chairman Marshall McDonalds retirement in 1989, FPL experienced a streamlining of its businesses and operations under his successor, James Broadhead. At FPL, Broadhead implemented a commitment to quality and customer service, increased its focus on the utilities industry, expanded capacity, and improved its cost position. In the 1990s, Broadhead sold off several of FPLs non-utilities businesses.1 In May, 1994, one of the most important issues confronting the FPL Group was the decision whether or not to decrease their dividend payout ratio as a result of an evolving competitive market place. B. Competitive Position: Chairman James Broadheads vision for the electric utilities business was one of free and open competition, and he intended to better position FPL for such a marketplace.2 Initially, under chairman Marshall McDonald, FPL underwent a period of diversification and expansion in the 1970 and 80s, acquiring major companies in various industries, such as real estate, insurance, and information services.3 Later, under Broadhead, FPL reversed that trend of diversification and instead focused on streamlining their business and operation in order to improve efficiency and lower costs.

1 2

Harvard Business School, Dividend Policy at FPL Group, page 4. Harvard Business School, Dividend Policy at FPL Group, page 4. 3 Harvard Business School, Dividend Policy at FPL Group, page 3.

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Low capacity margin (8.6%) suggests FPL has less room for growth compared to their peer companies.4 FPLs Transmission and Power costs far exceed those of their competitors.5 o FPLs 1993 Transmission Costs are at the higher range compared to that of their peer companies. (FPL = $.0019 compared to an industry average of $.0010.) High transmission costs place FPL at a competitive disadvantage in a deregulated industry (Exhibit A below). o Power generation costs are high because FPL purchases 30% of power used in the generation process from outside sources, thereby making FPL sensitive to fluctuations in power purchase prices (Exhibit A below).
Exhibit A Competitive Position
FPL Group Transmission Cost/ KWH* Percent Of Power Purchased* $0.0019 30% Carolina Power $0.0009 11% Duke Power $0.0010 1% Florida Progress $0.0010 15% SCANA Corp $0.0007 26% Southern Co. $0.0008 7% TECO Energy $0.0006 3%

* Case Exhibit 7: Investor Owned Utilities in the Southeastern United States in 1993.

Regulatory Changes o 1992, Wholesale Wheeling enabled one utility to sell power to another utility company using third-party transmission. o 1994, Retail Wheeling allowed customers to buy power from utilities other than the local monopoly supplier through third-party transmission. Credit Risk o Concerns by rating agencies of FPLs interest expense given the 140 basis point increase in long-term interest rates since 1993.6

4 5

Case Exhibit 7, Investor-Owned utilities in the Southeast United States in 1993. Case Exhibit 7. 6 Harvard Business School, Dividend Policy at FPL Group, page 6

Corporate Finance

Columbia University

C. Recommendation: Dividend Policy It is our recommendation that FPL reduce its payout ratio to 60% because such a ratio would place them at the lower end of the range of that of their peer companies, better positioning FPL for future performance and growth in a recently deregulated industry.7 Additionally, reducing the payout ratio reduces taxes for their shareholders. Buy back shares subsequent to dividend cut. o In order to counteract negative market reaction to dividend cut. o Make firm less of a target for acquisition. II. Key Assumptions Our analysis is based on the following key assumptions: The Efficient market hypothesis applies. Analysts investment rating recommendations are limited to three options: o Buy o Sell o Hold Analysts use public information to formulate their recommendations, and make every effort to use reliable, comprehensive information. Signaling exists in the marketplace. III. Analysis: Dividend Policy Dividends are a share of a companys profits distributed to its shareholders. Companies, such as FPL, pay dividends to attract shareholders. Traditionally, utilities, with their large dividend payments, attract an income investor base, one less focused on growth and more focused on receiving steady cash.8 Conversely, growth investors generally seek to invest in companies with long-term capital appreciation prospects. Typically, such firms retain more of their earnings instead of distributing them in the form of dividends.

7 8

Dividend Payout ratio range was 60.8 106.2%, Case Exhibit 9. Individual investors hold approximately 51.9% of FPLs shares.

Corporate Finance

Columbia University

Advantages of Reducing Current Dividend Policy: Reduced payout ratio helps reduce exposure to increased industry risks, such as market volatility and deregulation. This suggests that FPLs current dividend policy is too high (<90% in 1993). Dividends are taxed more than capital gains (almost double); therefore by reducing or not issuing dividends a firm can save investors money in terms of the amount of taxes they will pay. Results in excess cash, which can then be used for future growth through acquisitions. (Current capacity is close to being maximized.) Disadvantages of Reducing Current Dividend Policy: Reducing its dividend would be seen as signaling in the marketplace, resulting in lowered stock price. Negative market reaction. Lesser share of the profits to shareholders by means of dividends. Dividends inject cash into the market, improving the macro-economic conditions. Despite a history of volatile earnings, FPL has maintained an inappropriately high payout ratio, thereby creating additional risk for the shareholders. Dividend cuts are not uncommon for utilities except in situations of financial trouble, and even then, are not well accepted by the market.9 According to the Miller-Modigliani theory, dividend policy should not matter since the returns that investors would earn would be the same as the return that the firm would receive if the cash were reinvested. III. Conclusion The recently deregulated electric utility industry introduced new market competitiveness. FPLs current dividend policy is inappropriately high for such a market environment. FPL must reduce its payout ratio to 60% because such a ratio would place FPL at the lower end of the range of that of their peer companies, better positioning FPL for Broadheads vision of future performance and growth. Kate Stark should revise her investment recommendation from hold to buy, upgrading her rating because the value reflected after the decrease in payout ratio is lower than the intrinsic value of the stock ($42.16, see Exhibit B). The lower value reflected by the decreased payout ratio is the result of the effect of signaling in the market.

Harvard Business School, Dividend Policy at FPL Group, page 6

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Columbia University

Exhibit B Key Ratios

Payout Ratio Dividend Change in Dividend (!d) Return on Equity Dividend Yield Effective Price per share 6% $41.33 Current 90% $2.48 Target 60% $1.65 -$0.83 12.50% 4% $42.16 a b c d e f

a: Current: Exhibit 7, Target: Case assumption; such a ratio would place FPL at the lower end of the range of that of their peer companies b: Current: Exhibit 7, Target: Dividends = (Change in Payout Ration) * Current Dividends c: Change In Dividends = Current Dividends - Target Dividends d: Exhibit 7 e: Current: Exhibit 7, Target: Dividend Yield = Annual Dividend / Price Per Share f: Current: Price Per Share = Annual Dividend / Dividend Yield