ISBN: 0-03-028931-9

Chapter 15 Distributions to Shareholders: Dividends and Share Repurchases

FPL Stuns the Market by Changing Its Dividend Policy

Profitable companies regularly face three important questions. (1) How much of its free cash flow should it pass on to shareholders? (2) Should it provide this cash to stockholders by raising the dividend or by repurchasing stock? (3) Should it maintain a stable, consistent payment policy, or should it let the payments vary as conditions change?
In this chapter we will discuss many of the issues that affect a firm's cash distribution policy. As we will see, most firms establish a policy that considers their forecasted cash flows and forecasted capital expenditures, and then try to stick to it. The policy can be changed, but this can cause problems because such changes inconvenience the firm's stockholders, send unintended signals, and convey the impression of dividend instability, all of which have negative implications for stock prices. Still, economic circumstances do change, and occasionally such changes require firms to change their dividend policies.
One of the most striking examples of a dividend policy change occurred in May 1994, when FPL Group, a utility holding company whose primary subsidiary is Florida Power & Light, announced a cut in its quarterly dividend from $0.62 per share to $0.42. At the same time, FPL stated that it would buy back 10 million of its common shares over the next three years to bolster its stock price. Here is the text of the letter to its stockholders in which FPL announced these changes:

Dear Shareholder,

Over the past several years, we have been working hard to enhance shareholder value by algning our strategy with a rapidly changing business environment…. The Energy Policy Act of 1992 has brought permanent changes to the electric industry. Although we have taken effective and sometimes painful steps to prepare for these changes, one critical problem remains. Our dividend payout ratio of 90 percent – the percentage of our earnings paid to shareholders as dividends – is far too high for a growth company. It is well above the industry average, and it has limited the growth in the price of our stock.
To meet the challenges of this competitive marketplace and to ensure the financial strength and flexibility necessary for success, the Board of Directors has announced a change in our financial strategy that includes the following milestones:

• A new dividend policy that provides for paying out 60 to 65 percent of prior years' earnings. This means a reduction in the quarterly dividend from 62 to 42 cents per share beginning with the next payment.
• The authorization to repurchase 10 million shares of common stock over the next three years, including at least four million shares next year.
• An earlier dividend evaluation beginning in February 1995 to more closely link dividend rates to annual earnings.

We believe this financial strategy will enhance long–term share value and will facilitate both earnings per share and dividend growth to about 5 percent per year over the next several years.
Adding to shareholder wealth in this manner should be increasingly significant given recent changes in the tax law, which have made capital gains more attractive than dividend income.
…We take this action from a position of strength. We are not being forced into a defensive position by expectations of poor financial performance. Rather, it is a strategic decision to align our dividend policy and your total return as a shareholder with the growth characteristics of our company.
We appreciate your understanding and support, and we will continue to provide updates on our progress in forthcoming shareholder reports.

Several analysts called the FPL decision a watershed event for the electric utility industry. FPL saw that its circumstances were changing – its core electric business was moving from a regulated monopoly environment to one of increasing competition, and the new environment required a stronger balance sheet and more financial flexibility than was consistent with a 90 percent payout policy. What did the market think about FPL's dividend policy change? The company's stock price fell by 14 percent the day the announcement was made. In the past, hundreds of dividend cuts followed by sharply lower earnings had conditioned investors to expect the worst when a company reduces its dividend – this is the signaling effect, which is discussed later in the chapter. However, over the next few months, as they understood FPL's actions better, analysts began to praise the decision and to recommend the stock. As a result, FPL's stock outperformed the average utility and soon exceeded the pre-announcement price.

DISCUSSION QUESTIONS

1. Looking at the example of FPL, which factor do you think is more important, positioning the firm for the future or satisfying stockholder demands for dividends?
2. Do you think FPL acted responsibly and correctly? Is there anything that FPL could have done better to avoid the substantial stock price drop it suffered?

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