Consulting » COVER STORY – Dividends: “I have nothing to declare but my genius”.

COVER STORY - Dividends: "I have nothing to declare but my genius".

Shrewd managers may find that the best way to build shareholder value is to retain earnings, not distribute them. But they'd better make sure that they have some brilliant ideas about what to do with all their cash.

According to figures compiled by JP Morgan and Datastream, in the eleven years from 1987 to 1997, UK companies increased their dividend payout from 39% of earnings to a high of 58% in 1992. In 1997, ignoring share buy-backs, dividends still amounted to 47% of earnings. But does this make sense? Microsoft pays no dividend. Nor does Berkshire Hathaway, Warren Buffett’s giant US insurance and investment vehicle, which has increased its per share book value from $19 in the mid-1960s to $25,488 in 1997, an increase of 24.1% compounded annually. So why do UK companies appear keen to pay out dividends? The first reason could be that investors want a regular income. Small investors do not have the clout to drive dividend policy, but the UK’s highly developed institutional investor base does. “Pension funds have been focused on income,” says Paul Gibbs, head of analytical policy at JP Morgan. “They have been instrumental in getting dividends jacked up each year.” That may be changing, though. David Morgan, chief executive of the coal industry pension schemes, believes it makes little difference to a pension fund whether it gains its cash flow from dividends, share buy-backs or from realising part of its stake. “Our aim is to maximise the growth in our overall return,” he says. If FDs do feel under pressure to pay dividends, Morgan believes that is not necessarily the wish of pension fund trustees. “We are the second largest scheme in the UK and we are not taking that view,” he says. There is, after all, an alternative to income from dividends: if you want yield, buy gilts. Admittedly, gilts have not always been the best investments, especially in an inflationary environment. As a spokesman for Mercury Asset Management says: “Over a thirty year period there has been an enormous disparity between total returns on equities and gilts.” But a mix of gilts in a portfolio can provide income that might otherwise be offered by dividend-paying equity. Tim Gregory, UK income fund manager at Gartmore, says: “Our income funds combine investment in growth-oriented equity with fixed income bonds. As income fund managers it is very much about the total return we generate. If we said we couldn’t invest in (pharmaceuticals and telecoms) because of the lower yield, we would have been guaranteed to underperform.” The second cause of the UK’s partiality for dividends, and one that influenced the institutions, was the tax system. Although from April, Advance Corporation Tax will be a thing of the past, the erstwhile ability of pension funds to effectively boost their income through reclaiming tax credits made dividends a favourite source of income. Theoretically, in future, there should be neutrality between income and capital gain. A third traditional reason to justify dividend payments is that they provide a signalling mechanism to the City: dividend up equals management’s faith in the future; dividend down equals trouble ahead. But this is more a matter of folklore than fact, even though, as Guy Feld, head of research at broker Teather & Greenwood, says: “A dividend cut is still a highly market-sensitive event. You will see a share devaluation.” The key issue is that the drop is neither permanent nor significant. Chris Higson, associate professor of accounting at the London Business School, states categorically: “Research shows that dividends don’t affect company value.” Comprehensive disclosure requirements mean that dividend cuts due to poor performance rarely come as a total shock. Nevertheless, the habit of paying steady dividends is still hard to break. “In the UK we have the conservative attitude that dividends should be similar to last year and just that little bit more,” says Andrew Tivey, corporate finance partner with Ernst & Young. “We are concerned with smoothing. That has been the traditional UK model.” One last reason for the popularity of dividends may be that managers have not taken note of economic and corporate finance theory. “There has been a misunderstanding of what a company’s objectives are. Managers have understood it to be to grow income and dividends,” says Gibbs. “They should have concentrated on growing shareholder value, and then distributed what was left over.” Considerable research has been done in the field since Franco Modigliani and Merton Miller, working in the 1950s and 1960s, worked out that, ignoring taxes and other market imperfections, a firm’s dividend policy does not affect its market value. A dividend may increase a shareholder’s income, but this is neutralised by a corresponding reduction in share value. The theory says that flows from investments affect market value, which means that management is charged with achieving value growth through finding suitable investments. “The shareholder expects a return from his investment in the company,” says Sri Srikanthan, senior lecturer in finance and accounting at Cranfield School of Management. “He is happy to get the return in dividends or growth. People should pay dividends if they don’t have a better investment.” Evidence suggests this does happen. Mature companies have higher payout ratios than high growth ones. Generally, if companies are able to use profits to generate returns greater than shareholders can earn elsewhere, they should keep and invest those profits. But some academics argue that paying dividends can protect shareholders from management frittering funds away. “Traditional economic theory states that managers should be rational,” says Dr Ameziane Lasfer, reader in finance at the City University Business School. “But the agency theory states that, in reality, managers may not be rational. They may undertake projects that do not have positive net present values. So by means of dividends, shareholders restrain managers from investing in negative NPV projects.” Both Lasfer and LBS’s Higson suggest it is better for management to have to come back to investors and ask for cash for specific investments, for example through a rights issue, as they will then have to demonstrate the value to be gained by the investment. “I personally have a preference for companies paying out a dividend, and then, if they need to, asking for it back,” says Higson. “We tend to worry about companies sitting on piles of cash and wasting it.” These academics haven’t persuaded everyone, though. Back at JP Morgan, Gibbs describes this idea as “naive”, arguing that business does not work in the way Higson describes. It would be rare for a discrete investment project to suddenly come along and require £1bn. “There should be continuous reinvestment,” he says. “It’s our view that dividends should not be a priority.” Even assuming a company cannot find investments that add value for shareholders, passing cash back through a normal dividend may still not be the best distribution method. What about a scrip dividend, special dividend or share buy-back? The decision depends, for example, on whether a company wants to restructure its capital. Dividend Re-investment Plans (DRIPs) enable shareholders to use their cash dividends to purchase shares on the open market and so increase their investment – though that cash is gone as far as the company is concerned. Lloyds TSB Registrars offers this service, claiming it provides an alternative to scrip dividends and the capital dilution that goes with them. With DRIPs, dividends are paid to the registrar who then instructs a broker to buy shares on their behalf. Share buy-backs have recently emerged as a popular way of distributing surplus capital. In 1996 companies applying this technique included Boots, Barclays, Safeway and Reckitt & Colman. Warburg Dillon Read has advised on around half the share buy-backs in the UK in the last two years. “I think we will see a dramatic number in 1999,” says Max Ziff, managing director in charge of the Corporate Analysis and Structuring team. “There was an initial surge – in 1997 it was very popular – and then some holding off because companies said they were waiting until April 1999. After then I think we’ll see a lot more.” There were still many major share buy-backs in 1998, such as Bass (£850m), Dalgety (£675m), GEC (£358m) and BTR (£1.5bn). Share buy-backs can be innovatively structured. For example, Bass returned its £850m by issuing B shares, which shareholders could redeem any time between 10 February and 7 April 1998. This enabled investors to make their gains in either or both tax years, maximising tax reliefs. “Buy-backs are preferential because shareholders can decide whether they want to sell back their shares or not,” says Lucy Chennells, senior researcher at the Institute for Fiscal Studies. “A special dividend is a blanket payment and you cannot choose not to receive it.” Opting for a share buy-back has another benefit, too: it can have a positive impact on earnings per share. It also increases the proportion of low cost, tax deductible debt as compared to higher cost equity. It thus offers a company the chance to achieve a capital restructuring that provides the optimal leverage ratio and so reduces the weighted after-tax cost of capital. And buy-backs can be seen as one-off events that don’t build expectation of similar pay-outs. There are signs that companies are increasingly thinking in terms of a distribution policy, which includes buy-backs, as opposed to a dividend policy. Since 1997, Lucas Varity’s policy has been to buy back 3-4% of shares a year. “We limit the buy-back to 3-4% for tax and accounting reasons,” says Nicholas Jones, group director of corporate relations. The group combines the share buy-back with dividends, which it grows roughly in line with operating profits. “Each company must find its own way to pass value back to its shareholders, but we are committed to providing superior returns to shareholders, a principal means of which is through the application of buy-backs,” he says. Share buy-backs could become even more common in future, depending on the results of the DTI’s consultation on the subject, which, among other questions, is considering allowing companies to buy up to 10% of their share capital and hold it “in treasury” for later resale. US companies already have this advantage, but law change or no, UK culture is adjusting. “It will take time but there is a move in the UK towards a US-style system of dividends, where UK companies will not feel they have to hike them on a systematic basis,” says Ziff. “They will look at their capital needs and return the rest.” IT recruiter Select Appointments is ahead of the game. The £650m market cap group followed a normal UK dividend policy until last year when it effectively eradicated the dividend apart from a nominal amount. Since September 1996 the company has been listed in the UK and on Nasdaq. James Wellesley Wesley, MD of Granville Corporate Finance, believes the City accepted this dividend policy partly because of its US listing and partly because it is a “good company”. He says: “I think UK institutions are less preoccupied with dividends than they used to be. Certainly in the small company arena they are more concerned with things like liquidity or growth potential. But changing dividend policy remains a much more dangerous game in the UK than the US.” Dangerous game or not, managers need to be sure of the rationale for the distribution policy that they are following. High dividends may no longer be enough to persuade investors that management really is adding value. Indeed, paying out dividends may show that managers do not have enough good investment ideas of their own. IT GROWTH COMPANIES PLAY THE UK DIVIDEND GAME: TETRA AND ROYALBLUE Software developer Tetra plc’s total dividend for the year ended 30 November 1998, its first as a listed company, was 0.6p per share. The management took the advice of its brokers, both on whether to pay a dividend, and then on the amount, which was set in line with the market norm. “From my point of view I would rather keep all the cash I have,” says FD Lawrence Steingold. “I would rather not pay dividends. In the US it isn’t expected, but in the UK it is, and as a small company, where the volume of shares traded is small, we have to encourage investors. One way is to pay dividends. It should be enough so investors believe the company is doing well and will continue to do well.” Software supplier royalblue group, which listed in June 1997, also set its first dividend in line with the market norm, and subsequently it has kept the payout in line with profit and EPS, paying a total dividend for the year to 31 December 1998 of 2.25p. FD Andy Malpass also notes the difference between the US and the UK. “If you look at Nasdaq, shareholders would not expect any dividend,” he says. “The total concentration would be on capital growth. But there is an expectation of a dividend from UK investors. Pressure to pay comes comes from institutions, especially on small companies.” THE ZERO DIVIDEND PAYER: MONUMENT OIL & GAS Monument Oil & Gas doesn’t pay dividends. As a relatively small oil producer, Monument sees its cash flow swing dramatically, depending on whether it is in an investment phase or whether projects have come on stream. “We have felt to date that capital returns are not best achieved by dividends, given the business and the period we are in, and the size we are,” says FD Liz Airey. “In future it could become appropriate for us, but when thinking of dividends one has the old-fashioned idea of a dividend that goes up year on year. It’s hard to see that as appropriate for a company that either has a substantial cash investment or a cash inflow. You could declare dividends as a proportion of spare cash flow, but that may not fit into the investment boxes the City has. You could fall between income funds and capital funds. Primarily, the people who invest in us are investing for capital growth.” In 1996, with cash going spare, Monument combined returning £30m to investors with a capital restructuring, creating a new holding company, which issued redeemable shares. Shareholders could then cash in holdings by choosing redeemable shares, or maintain investment by opting for ordinary shares. “It was a one-off, rather than anything that would be deemed repeatable,” says Airey. “It worked well because it allowed shareholders to have a return or take a higher holding.” In future Airey might consider a buy-back or a special dividend, whichever is most appropriate at the time. DIVIDENDS, REVISITED This is at least the fifth time that this magazine has taken a look at company dividend policies since we launched in 1984 (back then, we were known as Financial Decisions). In March 1989, we looked at how high dividends were in fashion and how companies sometimes felt under pressure to increase their payout ratios. This was true even in cases where the companies concerned either couldn’t afford it, or were facing a hostile takeover bid and needed to sweeten their shareholders to keep them loyal. Consolidated Gold Fields, for example, doubled its dividend as it tried to fend off an unwelcome approach from Minorco. Tomkins jacked up its dividend by 49% because, said FD Ian Duncan, “Our yield was low compared with the people we were competing with for funds, and we decided to put that right in a way we could sustain.” By March 1991, however, recession was ripping holes in company earnings and balance sheets, leaving more and more dividends in danger of being uncovered by earnings. Problem: maintain the payout ratio to keep investors happy? Or cut the divi and conserve cash? GEC took a middle route, freezing its interim dividend. Its shares fell 4%. Trafalgar House bravely held its final dividend after increasing its interim, even though full-year profits had fallen more than 40%. “We have taken a long-term view of our business, which is obviously targeted at the next century,” said chief executive Sir Eric Parker as the full-year payout edged up to 18.4p per share. In 1992, Trafalgar House slashed the dividend by two-thirds, then halved it to 3.2p in 1993. It paid its last dividend in 1994 – one penny – before finally succumbing to a takeover approach by Kvaerner in 1996 (but not before clawing back more than £920m in rights issues over 1991-94). We wrote in 1991 that cutting the dividend and incurring the wrath of the institutional investor may be the lesser of two evils: “Companies that don’t cut dividends for fear of disappointing investors and sending a pessimistic message about the strength of the business could be storing up trouble.” Ironically, two years after that, a survey conducted in association with 3i showed how barely a quarter FDs believed that institutional investors had the greatest influence on dividend decisions. The chairman/chief executive and the FD – in that order – were far and away more influential, our survey found. But right back at the beginning, in our launch issue, dated October 1984, we asked the question “Who needs dividends?” – especially when companies simultaneously launch a rights issue. An article by Jeremy Edwards, a research associate with the Institute for Fiscal Studies, argued that the correct answer was “pension funds” because, given their tax-exempt status, they could claw back the ACT tax credit. Now that’s gone, does anybody at all need dividends? Andrew Sawers.

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