Dividend Policy at IPL

Group
$ynopsis
A WaII Street anaIyst has just Iearned that FPL
Group (the hoIding company for FIorida Power and
Light, the country's fourth Iargest eIectric utiIity)
may decide to freeze its dividend at $2.48 per share
or possibIy cut the dividend at the company's
upcoming annuaI meeting.
The decision not to increase the dividend wiII end a
47-year streak of annuaI dividend increases-the
Iongest streak among utiIities and the third Iongest
streak among pubIicIy traded U.S. companies.
In response to the news, FPL's stock price is down
6%. The protagonist, Kate Stark, must decide
whether to revise her investment recommendation
on FPL in Iight of this new information.
ackground behind IPL's decision in dividend?
In 1992, federaI reguIators introduced whoIesaIe
wheeIing and, by mid-1994, state reguIators in 23
states are considering retaiI wheeIing proposaIs.
When the CaIifornia reguIators reIeased their retaiI
wheeIing proposaI, the three Iargest utiIities in the
state Iost a combined $1.8 biIIion in market vaIue.
S&P EIectric UtiIities Index has decIined more than
20% since September 1993. WhiIe much of this can
be attributed to the increase in interest rates, some
portion of the decIine is due to the effects of
dereguIation.
1 you are IPL CLO, what will you do?
Take a vote!
Increase dividend
Remain the same! ($2.48)
Cut dividend
What are your reasons behind your votes?
hy IPL want to increase dividend?
eet market expectation.
SignaI good earnings perspective.
Free cash fIow hypothesis.
hy IPL want to decrease dividend?
To signaI worsening industry prospect. (not
much so for FPL)
Increased competition Ieads to increased
voIatiIity in earnings, makes a high payout
ratio unIikeIy to maintain.
Other concerns than signaIing. Taxes,
transaction cost, or agency confIicts.
IPL's competitive advantages
FPL's service territory, eastern and southern FIorida,
country's fastest growing markets: FPL expects
annuaI growth of 2.7% (the U.S. average of 1.8%).
FPL's customer mix is aIso a competitive advantage
since industriaI saIes represent onIy 4% of totaI
saIes compared to an average of 21% for the others.
According to the retaiI wheeIing proposaIs, having a
Iow percentage of industriaI customers Iimits FPL's
risk to the threat of competition.
S&P ranked FPL's competitive position among the
top 10% of investor-owned utiIities.
IPL's 1inancial strength
FPL's cash fIow is improving due to increasing net
income and decIining capitaI expenditures.
FPL wiII have $601 miIIion in cash before common
dividends in 1998 compared to negative $832 miIIion
in cash fIow after dividends in 1992. By sIowing
dividend growth to 1% per year, FPL can fund its
dividend internaIIy by 1996 and reduce its payout
ratio to beIow 80% by 1998.
This strong future cash fIow makes it unIikeIy that
FPL wiII cut its dividend. Indeed, according to the
anaIyst, FPL views earnings growth as a possibIe
soIution to the high payout ratio probIem.
IPL's competitive disadvantages?
FPL is a high cost utiIity in a commodity
business. FPL's generating and transmission
costs are significantIy higher than most of its
competitors.
Because the competitors currentIy have excess
generating capacity (see the Ioad factor and
capacity margins) and sufficient transmission
capacity for the next severaI years, they pose a
serious threat to FPL's future profitabiIity.
Does signaling play a role in IPL's
dividend policy?
What FPL tries to signaI? Better? Or worse?
Improved competitive edge and financiaI
strength increase dividend.
Worsening industry profitabiIity cut
dividend.
The major probIem with cutting the dividend
is the IikeIihood of severe market reaction.
Both ConsoIidated Edison and Sierra Pacific
experienced significant share price decIines
in the wake of dividend cuts.
%axes and dividends 1or IPL
on-tax paying institutions (30%) generaIIy don't care
whichever capitaI gains or dividends.
For individuaIs (52%), between 1986 and 1993, they were
taxed at same rates. ore recentIy, tax codes favor
capitaI gains: the tax rate on Iong-term capitaI gains
peaks at 28% whiIe the rate on dividend income can go
as high as 39% for high income individuaIs.
Corporations, which own approximateIy 5% of shares,
can excIude a substantiaI portion of dividend income
from taxes. If they own Iess than 20% of a company's
stock, they can excIude 70% of dividend income; if they
own from 20% to 80% of the stock, they can excIude 80%;
and if they own more than 80%, they can excIude 100%.
The fact that FPL has a reIativeIy high dividend yieId
wouId seem to indicate that the tax disadvantage of
dividends does not concern its investors.
%ransactions Costs
One can see that operating cash fIows were
approximateIy equaI to investing cash fIows; Iong
term debt issuance was approximateIy equaI to
debt retirement; and stock issuance was
approximateIy equaI to the payment of common
dividends.
To pay the dividends, FPL issued 55 miIIion shares
of common stock worth $1.9 biIIion.
The investment banking fees for the issuances,
estimated at 3% of the totaI amount issued, wouId
equaI $60 miIIion.
As a generaI ruIe, a firm shouId not issue equity to
pay dividends because it resuIts in a deadweight
Ioss for investors.
gency costs
anagers own onIy 0.1% of stock.
Firm is to ratify a new executive compensation pIan,
which wiII emphasize net income and reduce the
extent to which bonuses are paid in stock.
agency confIict
If Broadhead were to pursue new ways to increase
net income, he might weII reduce the dividend. FPL
couId simpIy invest the $150 miIIion of savings
from cutting the dividend at 5% to yieId $7.5 miIIion
per year. This extra income wouId increase net
income by 1%-significant in an industry that is
growing at onIy 2% per year.
hat ill roadhead Do?
ay 9: FPL announces new financiaI strategy
32% reduction in quarterIy dividend
Dividend payout targeted at 60-65%
Repurchase 10 miIIion shares over 3 years
Reduce debt IeveIs
ove annuaI dividend announcement to February
Broadhead's expIanation for the cut that the firm
needs more financiaI fIexibiIity to deaI with future
competition. For eIectric utiIities industry which
generate Iarge amounts of free cash fIow,
financiaI sIack may not be such a good thing.
Stock price faIIs $4.375 to $27.50 [down 13.7%],
Stock price is down 22.3% since ApriI 29
Does a cut in dividend meet with
capital market's expectation?
FPL's competitive position and future cash fIow
seems to indicate that FPL may increase its
dividend or, at a minimum, hoId the dividend
where it is.
FPL's sharehoIders cIienteIe seems to be
satisfied with current payout doIIar and ratio.
Investors view the dividend cut as a bad signaI
regarding future profitabiIity because profitabIe
firms rareIy cut their dividends.
hat should $tark recommend to
her clients regarding IPL's stock-
buy, sell, or hold
%he a1termath
FPL cut dividend, and it's stock price dropped 14%
in one day
The recovery of the stock price begins immediateIy
after the initiaI decIine as anaIysts began to issue
"buy" recommendations.
FPL buy back shares after the cut in dividend. The
buyback in turns reduce shares, and increase EPS,
which is good for sharehoIders.
Investors had Iost $0.80 per share in dividends.
The FPL's buyback program has posted EPS
growth of 5.6% over the year ($2.91 in 1994 versus
$2.75 in 1993).