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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

provide an adverse signal that management would not want to give. Rather, utilities may be slowing or stopping growth in dividends-despite earnings growth-with the payout ratio consequently declining gradually. During the period of changing payout policy, these circumstances make growth in dividends a poor proxy of expected future growth for utilities. Instead, growth in earnings per share serves as a better indicator. A study of financial analysts showed that, for stocks in general, analysts consider dividends a far less important consideration than they do earnings and cash flow. 4 Even as far back as December 1999, Goldman Sachs in an electric utility publication stated that:

Most of the utilities, however, are viewed as neither income nor growth vehicles, and this eliminates a large part of the potential investor base. Managements' reorientation of the total return proposition toward growth and away from dividend yield has to some degree alienated traditional income investors, as they see risk to both dividends and dividend growth.

Interestingly, there is a significant negative correlation between the percent of institutional ownership, per , and the level of the payout ratio for both electric utilities and gas distribution utilities. 5/p>

What the Future Holds

The drop in utility stock prices is likely to herald the beginning of more and larger stock repurchase plans by utilities. However, potential changes that have been proposed of late may turn the above analysis on its head. Recently there has been public discussion about allowing: (1) dividends to be tax deductible for companies; or (2) dividends to be tax deductible for investors; or (3) both. 6 Should such a change occur, utilities along with other companies would reconsider their dividend policies, and the balance currently being struck between share repurchases and dividend payments could change radically.

  1. In 1998, for the first time ever, companies in general in the United States distributed more cash to investors through share repurchases than through cash dividends (see Gustavo Grullon and David Ikenberry, "What Do We Know About Stock Repurchases?", Journal of Applied Corporate Finance, Spring 2000, p. 31).
  2. Even apart from repurchases related to the current low utility stock price level, companies may repurchase stock nearly continuously in the future in order to have an adequate supply of company-owned, issued-but-not-outstanding shares (i.e., Treasury shares) needed to satisfy company stock plans (e.g., employee stock option plans [ESOPs], dividend reinvestment plans [DRIPs] and management stock option plans), without having to increase the number of shares outstanding.
  3. See, for example, David Ikenberry and Theo Vermaelen, "The Option to Repurchase Stock," Financial Management, Winter 1996; David Ikenberry, Josef Lakonishok and Theo Vermaelen, "Market Under Reaction to Open Market Share Repurchases," Journal of Financial Economics, Volume 39, 1995; William R. Nelson, "Evidence of Excess Returns on Firms That Issue or Repurchase Equity," Federal Reserve Board Staff Finance and Economics Discussion Series, January 1999; Dennis Soter and Eugene Brigham, "The Dividend Cut 'Heard 'Round the World': The Case of FPL," Journal of Applied Corporate Finance, Spring 1996; Gustavo Grullon and David Ikenberry, "What Do We Know About Stock Repurchases?", Journal of Applied Corporate Finance,