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Cut the Pay-Out, Boost the Buy-Back?

The pros and cons of dividend pay-out reductions and stock repurchase programs in uncertain economic times.
Fortnightly Magazine - October 15 2002
  1. offsetting the retention of earnings.
  2. Some utilities currently have excess cash flow due to reduced construction expenditures, proceeds from plant sales or securitization, or some other source. Rather than having this excess cash flow possibly go toward inordinate management benefits, management can use funds to benefits shareholders by repurchasing common stock.
  3. Recently, utilities have seen a substantial increase in the variability of their operating cash flow needs, due to unexpected spikes in the cost of purchased gas and purchased power, among other factors. A common stock repurchase program provides a utility with much more flexibility in returning cash to stockholders compared to dividend payments, which have severe constraints against downward adjustments. A repurchase program is like an option a utility company can choose to exercise, or not-and it can also choose the amount and the timeframe of the exercise. For example, if a utility encounters financial distress, it can either slow or discontinue stock repurchases-something it can do both with less public notice and less adverse stock market reaction than would accompany a dividend reduction. A repurchase plan provides flexibility not only to utilities, but also to their shareholders. Shareholders can sell stock back to the utility, if that is their choice. Alternatively, shareholders can retain their stock and participate in the potential excess returns suggested by the academic studies referenced above.

Now let us examine some of the effects that share repurchase programs have on utility company cash flow and financial reporting. Because a common stock repurchase program reduces the number of shares outstanding, the dollar amount of cash common dividends that must be paid is reduced. Since common dividends are not tax deductible, this represents a reduction in after-tax funds that the company must disperse. Implementing a stock repurchase plan generally can be done without the risk of incurring negative financial reporting repercussions. If a utility repurchases its own stock and the price of the stock then declines, the (unrealized) capital loss does not have to be reflected in reported earnings. Furthermore, the funds used to implement a share repurchase program do not reduce reported earnings per share.

Changing Dividend Payout Policy

Currently, almost half of the companies in the Value Line universe do not pay dividends. Less than twenty percent of the companies traded on the American Stock Exchange or NASDAQ were paying dividends recently. While utilities formerly were known as income stocks, they are undergoing a restructuring of their dividend policies. Electric utilities and gas distribution utilities had a median payout ratio of about 77 percent in 1995, according to individual company data reported in The Value Line Investment Survey. In the near future, the payout ratios for those utilities are projected to fall to 50 percent or below. While in some instances this reduction in the dividend payout ratio is due to financial weakness, in the great majority of cases, it is due to a conscious choice to change the payout policy. Utilities are not taking the outright step of cutting their dividend payments in order to effect a change in payout policy, as that would likely