There They Go Again: Shareholder Distributions and Short Term-ism Rant

Blackrock’s Larry Fink is cautioning CEOs about giving in to activists. He suggests that CEOs are influenced by short term activists to increase shareholder distribution-dividends and repurchases. He prefers, and I agree, CEOs should first focus on investing their capital in new growth investments. This assumes of course that firms have positive NPV projects in which they can invest. This becomes more challenging the further we are into an economic recovery.  All too often CEOs feel the pressure to grow and the lure of size when the opportunities just are not there. This results in value destructive growth-both organic and over priced M&A. Not all CEOs are as skillful as Warren Buffett in making investment allocation decisions. Hence, not all CEOs can have Buffett’s zero payout policy.

Some firms simply have more cash than they can profitably reinvest given where they are in their life cycle. Firms should view distributions as a residual capital allocation decision involving the following:

1)     List all projects offering positive NPV

2)     Match opportunities with available internal resources -operating cash flow plus liquid resources

3)     If opportunities exceed internal resources, then raise external capital

4)     If opportunities are less than internal resources, then return the excess to shareholders

Shareholders can search market opportunities to redeploy their capital to higher valued use better than managers trying force the issue.

Next, Fink proposes a protective tax based mechanism to shield CEOs from dividend seeking activists by raising taxes on investments not held for at least 3 years. This would supposedly discourage short term actions. Again, he confuses an investor’s holding period with the market’s investment horizon. Capital markets are like time machines allowing investors to realize cash flows now by liquidating investments. Conversely, they can postpone consumption by increasing investments. The market price for each action is based on the same identical formula independent of the investor’s time horizon; namely the stock price is based on some estimate of future long term cash flow discounted for its risk. Efforts to penalize so called short term investors, however defined, will only reduce market liquidity and entrench management.

Value is created on the asset, left hand, side of the balance sheet by managers skillfully exploiting market opportunities. You cannot, however push on a string when the opportunities just are not there. Returning excess capital under those circumstances is not a sign of weak management, but of good stewardship. It is difficult to create value on the liability, right hand, side of the balance sheet. Nonetheless, you can destroy value by getting the right hand side wrong by being too stingy with dividends.

J

Rhyming or Repeating?

M&A volume is up substantially in 1H14. Some are worried the market may be overheating just as it did prior to financial crisis in 2006 and 2007. My view is this market is in a different stage than the 2006-2007 period. M&A has been depressed following the crisis. Current activity appears more like a return to normal than overheating. Keep in mind, the stock market increased over 30% last year while M&A was flat. The two are usually correlated.

Especially interesting is the increased activity of activist and hostile bids. In fact we are seeing a potentially new development of a combined activist-hostile bid with the Pershing Square-Valeant-Allergan Drama. Shareholders are putting increased pressure on management to do something. You survived the crisis-now do something beyond share repurchases with our excess cash. Thus,they are positively reacting to many announced deals. This factor plus an improving economy, cheap debt and a rising stock market are contributing factors.

Additional observations include:

1)   Deal Quality: deal quality is high. It is primarily larger consolidating and synergistic industrial transactions like 1990s versus the 2006-2007 private equity going private transactions. The deals are concentrated in the telecom and healthcare industries which are undergoing structural changes.

2)   Financial Structure: although debt remains plentiful and cheap strategic acquirers are primarily funding transactions with equity. The percentage of debt financed cash deals has fallen from over 65% in 2006-2007 to around 45%. This helps lower deal risk as sellers are participating in the future prospects of the new entity, and leverage levels remain modest. Sellers are willing to accept buyer stock given increased confidence in markets. They see the potential for a double dip price increase for an appreciating buyer stock post close.

3)   Private Equity (PE): LBO activity remains far below its 25% pre crisis percentage of total M&A. This reflects current high M&A prices and stiff competition from strategic buyers who have better synergy prospects than PE. PE has responded by using increased leverage to help offset higher purchase prices.

Of course, things can change quickly. The impact of the unwinding of the Fed’s quantitative easing program remains an issue. PE, with its large level of dry powder, could become more aggressive and drive up prices and debt levels. Thus, caution is warranted and disciplined bidding is needed by both strategic and PE acquirers. Nevertheless, the current market feels like it is in the early growth phase-not the later overheated stage. History appears to be rhyming - not repeating the overheated 2006-2007 period at this time.

j

Warren Buffett: Dividends and Acquisitions

Warren Buffett’s Berkshire Hathaway BRK is facing a dividend challenge from a small investor. The investor is seeking a resolution to be voted upon at BRK’s annual May meeting. The resolution calls for a regular dividend. BRK argues against the resolution on technical grounds stating the board already decides each year on shareholder distributions. To date BRK has not paid a dividend, although it has engaged in share repurchases when it considers its shares undervalued (defined as share price< 120% of intrinsic value).  Initially, it appears the investor may be right. Essentially, he argues as follows:

1.  BRK’s share price has lagged the S&P 500 index for 5 years
2.  Buffett admits having difficulty investing BRK’s huge cash flow and cash balances
3.  BRK is “elephant hunting”-looking for big deals
4.  The elephant hunting may result in forced errors
5.  Investors could better use the funds if they were return to them via dividends as repurchases would be ill advised at BRK’s current share price

Sounds like an approach used by activists like Carl Icahn against similar large firms with excess cash (e.g. Apple).

Buffett correctly points out dividends do not directly affect shareholder value. Dividends merely distribute value-they do not create value. What matters is who can invest the funds better-the firm or the shareholder. If the firm can do so thru organic or acquisition investments then it should retain the funds and make the appropriate capital allocations. Otherwise, the funds should be returned to shareholders. The decision rule is to retain and invest provided the expected returns exceed the cost of capital. The Dividend Discount Model shows Share Price=Dividend/ (Cost of Equity-Growth) where Growth= (1-Dividend Payout Ratio) x Return on New Investment. If investors need cash, then a better alternative, which may be more tax efficient, is for them to create homemade dividends by selling some of their shares.

Buffett’s record demonstrates good long term capital allocation decisions-albeit the last 5 years have been more problematic. Buffett, unlike the firms Icahn targets, eats his own cooking. Thus, the risks of value destructive capital misallocations from Agency Costs are reduced. BRK is more like long only hedge fund than a traditional maturing firm continuing to invest in declining projects. BRK can chose from a number of undervalued opportunities. I remember the last time Buffett was attacked as losing his touch in the 1990s with the tech boom. He was subsequently proven right.

I would trust Buffett for now to continue make good investment decisions. The dividend decision can be reconsidered should that trust turn out to be misplaced. For now, advantage Buffett.

J

Share Repurchases 2014

Share Repurchases reached post crisis record levels in 2013. This occurred while the S&P 500 rose over 30% for the year. Thus, it is becoming less likely shares are undervalued. Repurchases are justified, versus alternative distributions like dividends, only when the current share price is below the firm’s intrinsic value, which is based on the capitalized value of management’s forward plan. Consequently, 2014 repurchase volume should decline. My concern is some managers will maintain unjustified over priced repurchases to maintain their bonuses or enhance their stock option values. The focus of this post is on the return of excess cash as dividend substitutes and not debt financed capital structure repurchase alternatives.

Corporate liquidity reflected in excess cash balances continues to rise based on two factors. First, cash earnings improvements based on enhanced productivity continued their post crisis trend. Next, managers have been reluctant to reinvest in growth through either increased CAPEX or M&A. Excess cash should be returned to shareholders to reduce possible agency cost problems. This concern underlies shareholder activists like Carl Icahn’s request to Apple. The question is how that cash should be returned.

The basic choices for the return of excess liquidity include dividends, either special or regular, and share repurchases. As previously discussed Debate Part I and Part II, I have concerns that managers may misuse repurchases. Essentially, rather than invest in risky CAPEX and M&A with a delayed payback, some managers  such as those at IBM may opt for “safer” repurchases to manufacture incentive compensation relation EPS gains.

Cash rich firms with limited reinvestment opportunities should favor dividends over repurchases absent strong evidence that their shares are undervalued. The dividends can either be special or regular depending on management’s future earnings views. If EPS must be raised for some reason it can always be achieved via a reverse split. Tax issues should be second order consideration given institutional ownership at the majority of firms and other means to structure around the issue.

Either use it, return it but do not abuse excess cash by engaging in over priced share repurchases. Directors need to carefully monitor management repurchase recommendation.

J

Repurchases Part 4: Some Concluding Remarks

In three previous posts Repurchases: Part 1 Shareholders Beware and Repurchases Part 2: The Positive Side,  and Repurchases, Part 3: Joe Responds, Joe and I have debated the merits of repurchases.  Today's blog contains Part 4 where we continue the debate and try to summarize.  

Thanks to all for your comments.  You are also welcome to post them here.

Joe and Ralph

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Ralph:

Joe, your Repurchases Part 3 contains some great comments.  Maybe I'm being picky but I still kinda disagree with two points.  

First,  and this is technical, share repurchases can alter the capital structure and as they increase leverage, the tax shield increases.  This can create value if it doesn't increase risk excessively.   For many repurchases, this can be a minor effect.  However, a company can increase its leverage quickly by borrowing and using the proceeds to repurchase stock.

Also, while I agree you can replicate repurchases with special dividends, your shareholders will suffer much higher taxes.

Joe:

Yes, but you can get same leverage impact thru debt financed special dividend.

Regarding taxes - it depends on the shareholder base-clientele.

Ralph:

OK, I agree you can get the same leverage impact, good point, but still think either approach can create value.  It might be that we disagree whether leverage can 'create' value.

On taxes, yes, but capital gains  are taxed at a substantially lower rate than ordinary income (dividends).

Joe:

Taxes are not an issue for investors like untaxed pension funds

Microsoft’s 2004 32B special dividend is counterfactual.  If the tax

disadvantage is key,  then why didn't they use a repurchase?

Ralph:

I agree with your comments about untaxed pension funds - and institutional ownership is quite high in corporate America.  To other investors it would matter.

Regarding Microsoft, I don't know the answer.  I do note that in addition to the special dividend, they also repurchased shares.  So they actually did both.  As far as I know, Steve Ballmer and Bill Gates do pay taxes, so the mystery remains.  (Bill Gates was reported to donate the proceeds he received to his charity but I still think repurchases would have saved taxes.)

I do think we can agree that:

Share repurchases can be controversial!  And, while they offer tax advantages over dividends, they can be abused.  Two possibilities for this abuse are a) the apparent, but misleading, increase of earnings through repurchases and b) companies that overpay in repurchases harm existing shareholders. 

Dividends don’t produce the overpayment problem, but force shareholders to accept the distribution, while repurchases give them the option to defer.

Also, since it is difficult to precisely estimate the value of one’s shares, companies should proceed cautiously with repurchases. 

Finally, companies that cannot put cash to use at rates higher than those demanded by shareholders should return it in some form.  If you increase regular dividends make sure they can be sustained.  Otherwise, consider share repurchases and special dividends.