[BETA] Fortnightly

The pros and cons of dividend pay-out reductions and stock repurchase programs in uncertain economic times.

The Dow Jones Utility Average currently stands at its lowest level in five years. Electric and gas utilities, along with U.S. companies generally, have been consistently lowering their payout ratios over the past several years, and that downward trend is projected to continue. What do these facts portend for utility investors in the near future?

If the trend toward lower payout ratios continues, utilities will be regarded less and less as income stocks, and more as hybrid income/growth investments. We could see a significant increase in utility stock repurchases. Utility management may see this as a more flexible and tax efficient way to return funds to stockholders than through growing dividend payments. Given the projected decline in payout ratios, these stock repurchases may become a partial substitute for dividend payments. While capital gains may represent most of the return received by utility investors, they are merely an exchange of wealth among individual shareholders. In other words, capital gains are what investors provide to each other. The only ways that utility companies can provide cash to investors directly is through dividend payments and stock repurchases. In the current environment, the historic division of free cash flow between dividend payments and stock repurchases may be altered, with dividend growth slowing and stock buybacks increasing. ¹

Why Utility Companies Repurchase Stock

Given the depressed level of utility stocks currently, stock repurchases are likely to increase substantially for utility companies. ² This near-term phenomenon of a stock buyback for a utility creates a short-term demand for a stock that raises stock prices above what they would have been, absent the buyback plan. This is simply because, in a depressed market, large-scale buying of its own stock by a company certainly would provide investors with a cushion. Academic studies have shown that company repurchasing of stock does support a stock in a down market to some extent, thus lowering downside risk for investors. Furthermore, if the market turns around and starts rising, the fact that a company, itself, is buying back stock, merely adds to the buying pressure already in effect from a buoyant market. Often, the mere announcement of a stock repurchase plan boosts a company's stock price. Financial studies indicate that companies involved in stock repurchase plans experience market returns some three to 15 percent above what could be expected otherwise. ³

In financial theory, when a company's stock price is relatively low and management believes that a company is undervalued, a stock repurchase plan will be used in part for management to project its confidence in the future, and in part to capture the benefit of the undervaluation for shareholders who retain their stock. In addition to the current possible undervaluation, there are several other reasons why utility management may institute stock repurchase plans:

1. Management may use stock repurchases to gradually lower the common equity ratio, if it is deemed too high. Alternatively, stock repurchases can be a tool for maintaining the common equity ratio level, with repurchases