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 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 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.

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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, Spring 2000.
4. See Stanley Block, "A Study of Financial Analysts: Practice and Theory," Financial Analysts Journal, July/August 1999.
5. A negative correlation indicates that companies with lower payout ratios have a higher percent of institutional ownership and that companies with higher payout ratios have a lower percent of institutional ownership, other things being equal. The interpretation of this analysis is somewhat confounded by the fact that some institutions have tax-free investment accounts, while others do not.
6. John McKinnon, "Bush Endorses Tax-Law Changes Intended To Boost Jittery Investors," The Wall Street Journal, August 14, 2002, p. A4.

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