Business & Money

Energy experts debate the pros and cons of the Bush administration's proposal to eliminate the double taxation of dividends.
Fortnightly Magazine - January 15 2003

Double Taxation Repeal: Fire or Ice?



Energy experts debate the pros and cons of the Bush administration's proposal to eliminate the double taxation of dividends.

The repeal of the double taxation of the dividend has been argued unsuccessfully for years in Washington. But with a Republican-controlled Congress and an economy in need of a stimulus, it's an idea whose time may have come. [Editor's note: At press time, the Bush administration had not issued its policy on repeal of the double taxation of the dividend.]

Certainly, one might think that this is cause for celebration for electric utilities, which pay the biggest dividends. But there are potential pitfalls. Experts say repeal is not a slam-dunk for the industry.

Paul Donahue describes a "fire and ice" debate that's brewing throughout the industry. Donahue, a managing director of Global Power & Utility Capital Markets at investment bank Morgan Stanley, says, "Utilities and real estate investment trusts [REITs] might find that they have more competition, instead of rising to the top." A bigger question, Donahue says, is what might happen if tax relief leads big industrials or cyclical tech companies like Microsoft to start paying out larger dividends. Some believe utilities could lose their staple as the go-to income investment for widows, orphans, and the upcoming wave of retiring baby boomers looking for safe stocks, he says.

But Donahue says others argue that a change to the dividend tax policy that favors investors would probably benefit those companies that already pay dividends, and that it would probably take years for companies that don't pay dividends to feel enough pressure from shareholders to alter their dividend policies.

"[Of course], it is hard to believe that tax relief on dividends will result in diminished valuations of utilities," Donahue said. "At worst it is a neutral event, but more than likely a positive."

If utilities retain their appeal as the kings of the dividend after repeal of the tax, most analysts agree that the sheer number of baby boomers retiring and purchasing dividend stocks could push up utility valuations materially.

"[Furthermore], even on below trend operating earnings the payout ratio for the S&P today is 15 percentage points below long-term averages. Putting an average payout ratio on current earnings would actually result in among the highest dividend yields versus government bonds in about 30 years," says Morgan Stanley's chief U.S. Strategist, Steve Galbraith, in a report.

According to Standard & Poor's, 71 percent of the stocks in the S&P 500 currently pay dividends. Across all exchanges, only 39 percent of all equities pay dividends. Granted, about 81 percent of the S&P 500's market capitalization pays dividends, but that is down from 98 percent in 1980.

For its part, Morgan Stanley generally believes repeal would be a positive for the industry, but like many on Wall Street, the bank is still waiting to see the fine print before fully endorsing the policy. According to investment bank Williams Capital, the administration is examining the "potential benefits of various tax cuts schemes."

"Potential outcomes discussed are a reduction or elimination of taxes on dividend income for individuals and corporations. White House officials have suggested that a dividend taxation only benefiting individuals is a more likely scenario," the company says, in an equity research report.

As to the issue of whether corporations or individuals, or both, should get the tax benefit, Merrill Lynch's Chief U.S. Strategist Richard Bernstein, in a report, says that the more corporations get to share the benefit, the less bullish the tax change could be for the equity market. "It's probably politically unfeasible for corporations to receive the full tax benefit, but we would not be surprised to see corporations lobby to share some of the benefit," he says.

In fact, the American Gas Association in late December called for repeal in three separate letters to the president, the vice president, and the Treasury, but the letter did not specify who should receive the benefit.

Were corporations able to share in the benefit, "firms would find it advantageous to shift the capital structure in favor of equities, away from debt, as the relative cost of equity financing would decline," says J.P. Morgan Equity Analyst Carlos Asilis, in a report.

But would repeal help some of the cash-strapped and debt-heavy energy merchants and diversified utilities teetering on the verge of bankruptcy? Could the repeal be the difference between a downgrade for some and not for others? The answer is a resounding no. Ellen Lapson, managing director at credit rating agency Fitch Ratings, says the utility industry is divided between the haves and the have-nots. "The have-nots are affected by their own bad investments in risky whole markets or those of their affiliates and are most likely to have cut their dividend. Then, there is another set of companies that have not been affected by wholesale events, such as vertically integrated utilities and distributors of gas and electricity," she says.

"The repeal is only going to help those who do not have problems, which are typically the utilities that continue to pay the biggest dividends. From a credit standpoint, [repeal] will be significant to the entire industry over the long run, but it is not likely to have any short-term impact on utility credit," Lapson says. Furthermore, if the repeal were passed today, she believes the dichotomy between the haves and the have-nots would only increase.

Business News Bytes

Ameren Projects Lower Earnings in 2003

Ameren announced that it expects to earn $2.80 to $3.05 per share, below the analyst consensus of $3.14 per share. In a press release, Chairman and CEO Charles W. Mueller says, "Our company and the energy sector as a whole are facing significant economic and market-related changes that we expect will put pressure on 2003 earnings. These challenges include weak energy markets, a soft economy, rising employee benefit costs, and escalating insurance and security costs."

El Paso Reports Strong Liquidity and More Asset Sales in 2003

El Paso Corp. has announced that liquidity stood at $3.4 billion as of Dec. 18. The company said in a release that collateral requirements from recent ratings actions "have been consistent with expectations, and the company's liquidity remains strong."

The liquidity consists of $1.3 billion in cash, $3 billion from a 364-day bank facility, and $1 billion from a multi-year facility, totaling $5.3 billion. The company has used $1.5 billion toward a 364-day facility and $400 million toward multi-year letters of credit. At press time, El Paso Corp. says that in 2002 it closed on more than $3.6 billion in asset sales. El Paso expects to complete another approximately $1.4 billion in non-core asset sales by the end of the first quarter and $1 billion during the rest of 2003.

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