Dividends are BACK!

There was an interesting Blog post recently on the Economist's website discussing dividends, and how recent studies have shown that companies that pay dividends/have higher dividend payouts tend to generate higher future earnings growth.  This is somewhat counterintuitive considering we've heard for decades that "growth" companies must continuously retain earnings to fund future growth initiatives.  While this may be true for early stage companies, for more mature companies the retention of earnings may have the opposite effect.

For many companies, that large cash hoard may be burning a hole in their pockets, prompting some rather imprudent decisions, or worse, to decisions which actually destroy shareholder value.  Managing a large cash reserve may cause managers to engage in "empire building," wasting cash on expensive acquisitions that may not deliver the returns expected or add any economic value to investors.  There are countless examples of acquisitions gone wrong, resulting in divestitures, write downs and years of underperformance as managers seek to make their mistakes work out.  The cash hoard may also have an inflationary impact on salaries and benefits for senior managers as well, though this is probably just a coincidence.

So the question then becomes, is paying a dividend the right action for your company?  Well, it's a decision that ultimately only the Board of Directors can make, but here are some thoughts that may guide a well-warranted discussion.

First a point of clarification, we are really addressing only regular dividends, whether annual, semi-annual or quarterly, NOT special dividends.  Special dividends in my opinion are of questionable value to shareholders, it might provide a nice payday, but does nothing to ensure long-term performance, or enhance the value of the stock.

In an environment where T-bills yield zero return, or sometimes less, and the 10-year Treasury bond is yielding 2.2%, there is something to be said for paying dividends.  For most companies, not paying a dividend puts you at the same cash yield position as a T-bill, but without the downside protection.  If your company has a $10 stock and you were to implement a small dividend, say 5-cents per quarter, that’s $0.20 per year, and suddenly you have a 2.0% dividend yield which is comparable to 10-year T-bonds.  Some might say that such a small dividend is meaningless, but for yield investors, it doesn’t matter if it’s a 5-cent quarterly payout on a $10 stock or a 50-cent quarterly payout on a $100 stock, the yield is the same, and that is increasingly attractive to investors in the pitiful yield environment the Fed has created.

Beyond the yield argument, paying a dividend also opens up your company to a whole new segment of investors, income investors that look for growth or value companies, but require some sort of yield to meet their investment criteria.  There are a lot of growth and income funds or income value funds that simply can’t buy stocks that pay no dividends.

You are also providing a return for shareholders while not sacrificing share liquidity as you are in a buyback.  Many smaller companies today are jumping on the buyback bandwagon, hoping that will satisfy investors and boost their share price.  Buybacks have their place, but there are some drawbacks: 1) they drain trading liquidity, which is not good for low liquidity stocks; 2) they do not create discipline for management, you don’t have to buy back specific amounts each quarter, it’s merely a matter of convenience, unlike a dividend which has to be paid every quarter; and 3) the old argument about the buyback tide lifting the boat of share price, thus benefiting all shareholders is less compelling today – after all with capital gains tax rates and dividend tax rates being equal, there is little tax benefit to the buyback vs. dividend, and the increased valuation may occur anyway as investors start valuing the company on a yield basis as well.

Finally, dividends may also be used to promote increased share ownership.  Many companies offer dividend reinvestment plans which allow individual investors to reinvest dividends into additional shares (these used to be really popular back in the 1990s, but then dividends went out of favor).  Even without a company-sponsored plan, many brokers also have similar programs – I know in my personal account at TD Ameritrade, all dividends are automatically reinvested into shares every quarter, this increasing share ownership.  It's a small matter, but a potentially easy way to promote retail investor participation, an area often overlooked by management teams.  Perhaps it's time to take a new look at dividends at your company.

FD and Guidance, a Tricky Topic

We recently had client who was headed to a conference with presentation deck in hand, including the guidance they had issued several weeks earlier, when they were advised by outside counsel that “if you represent it, you are bringing it current,” meaning they were issuing "new" guidance and were thus required to file an 8-K.  While we recognize that this is the conservative approach frequently advocated by lawyers, we don’t think it’s correct and may make things worse.

By way of background, a NIRI survey of 269 public companies in the fall of 2010 found that 90 percent of responding companies provide forward-looking guidance in some form, 81 percent on at least one financial measure.  The most common forms of guidance are revenue (62%), capital expenditures (60%), tax rate (59%), and earnings (58%).  The report found that those who do guide most frequently communicate annual estimates, and the most common period for communicating those estimates is quarterly. 

The governing statute is Regulation Fair Disclosure (Reg. FD) and the following from the SEC website, updated August 14, 2009 provides some insight.  The question is: “Can an issuer ever confirm selectively a forecast it has previously made to the public without triggering the rule’s public reporting requirement?”  The answer is Yes, which is then qualified with regard to whether the confirmation can be considered material, weighing factors like the time since the initial guidance and events which may have intervened.  Our suggestion to management has always been that a confirmation is material and deserves an 8-K under any circumstances.

However, the question here is whether a company can refer to prior guidance without either explicitly or implicitly confirming it, thus triggering the disclosure requirement.  To this point, the SEC question responds as follows: “If an issuer wishes to refer back to the prior estimate without implicitly confirming it, the issuer should make clear that the prior estimate was as of the date it was given and is not being updated as of the time of the subsequent statement.”

Most English-speakers would observe that this makes possible the discussion of prior guidance without having to constantly bring it current.  The critical qualifier here is the assertion that the guidance speaks only as of the date it was given, which must, in our view, be attached to the guidance comment in writing, verbally, and in whatever other way is available.

The outside counsel position carries other complications as well. If a company is under the impression that even mentioning the prior guidance is confirming it, then the CFO and IRO can respond only “no comment” in phone conversations or meetings when asked about earnings guidance, unless they are willing to file an 8K to avoid potential selective disclosure. 

Under this interpretation, there is also the problem of signaling or creating a responsibility to update (supposedly taken care of by the safe harbor language).  For instance, a company could be willing to confirm guidance until it learns internally that the guidance is no longer correct.  At that point, simply going silent may not be sufficient disclosure of what the company actually knows.

To these points, we believe that an actively enforced and regular disclosure policy is vital.  It is particularly relevant in the SEC’s Flowserve enforcement action, which dealt with confirmation of earnings guidance.

Flowserve had a disclosure policy that mandated a specific response to earnings guidance questions, to wit: “Although business conditions are subject to change, in accordance with Flowserve’s policy, the current earnings guidance was effective at the date given and is not being updated until the company publicly announces updated guidance.”

The SEC’s action was not that the policy was improper, but that it was not followed by the CEO, CFO and IRO in certain conversations with analysts where management reaffirmed guidance between these public announcements.  The SEC action points out both that the reaffirmation was material because of changes in business conditions and the stock price.  They assert that management failed to follow its own policy by refraining from confirming or updating guidance in an appropriate public way (they denied having done so).

Our recommendations are as follows: Reg. FD is a critical metric guiding company disclosure in any form.  A robust communications practice requires thorough understanding of the regulation and its application in order to keep important investment information flowing within appropriate channels.  A review of the company’s disclosure policy is a good idea to determine how it approaches the question of affirming guidance.  If the policy does not touch on this, perhaps it should.

We also suggest that companies offer guidance only at fixed intervals and decline to update or confirm in the interim to avoid Reg. FD issues and signaling.

We believe that companies can refer to previously issued guidance without confirming or updating it, as long as the reference is thoroughly qualified as to the date the guidance was issued and the company’s policy of only offering guidance confirmation or updates at the reporting of quarterly earnings.