Thursday, 12 March 2015

Shareholder Return: Dividends and Repurchases

This post relates to academic research that studies the multitude of factors affecting management decisions regarding how returns are distributed to stakeholders.

Investor returns not only constitute dividends, but also capital gain. The latter is used mainly as it presents financial benefits for the corporation, as it is considered a financial expense, reducing the firm’s income tax. On the other hand, shareholders face increased tax. This suggests management interests influences dividends and therefore highlights an agency problem between shareholders and executives (Decort and Procianoy 2012).

Nonetheless investor expectations are taken into consideration in dividend policy. For instance, stable dividends are preferred and expected by investors due to the minimal risk in returns (Lintner 1956). A deviation from shareholder expectations stimulates an immediate market reaction that can reduce the market capitalisation of the company. Despite this, the Miller and Modigliani theory asserts dividends and profit have no significant relationship in perfect markets; rather, the risk of its assets is key to determining the value of a firm. However, market imperfections such as agency conflicts, transaction costs and asymmetrical information are factors that influence dividend decisions as then it affects the value of the firm (Miller and Modigliani 1961). Baker and Powell (1999) argue dividend policy has an influence on firm value, and such dividend relevance is due to bird in the hand, tax preference, signalling and agency explanations.
Bird in the Hand Explanation - This argument states dividends act as a certain investor return relative to capital gains, hence provides a tangible incentive to ensure investors do not abandon the stock. Due to lower risk of dividends, companies should maximise dividend payout ratio and set high dividend yield to increase share price, since companies with a track record of dividend payments are traded at a premium (Fama and French 2001). However, Bhattacharya (1979) argues otherwise, stating that maximising the present dividend payout ratio will reduce the stock’s ex-dividend price. Therefore such a strategy will fail to maximise company value by lowering risk of future cash flows.
Signalling Explanation - Dividend policy communicates information to investors regarding the company’s earnings and future prospects. Dividend announcements reveal management’s perspective of the company’s future profitability (Miller and Rock 1985). Asymmetry of information implies internal management hold greater information than external investors, hence dividend changes reduce such asymmetry by allowing investors to analyse the stock price. Battacharya (1979) considers the shareholders’ horizon as a finite period, hence a high dividend payout signals it has invested in projects with high net present value therefore providing sufficient cash flow to honour the shareholder’s expectations. Dividends therefore provide information regarding both past and present earnings (Benartzi et al. 1997), suggesting market responses to changes in dividends are delayed responses to previous changes in earnings (Koch and Sun 2004).
Firms that use signalling tend to experience lower growth and higher variability in earnings but higher increases in asset turnover, are smaller and are less dependent on debt financing in the long term (McCann and Olson 1994), suggesting these are also internal factors influencing the allocation of dividends.  However such dividend changes are ambiguous until the market is able to recognise between firms in the growth stage and firms with minimal investment opportunities (Easterbrook 1994). Soter, Brigham and Evanson (1996) report that when FPL Group announced a 32% cutback in its quarterly dividend, the market reacted negatively through a 20% stock price decline. However, analysts realised such a dividend policy was strategic to enhance long-term growth opportunities and financial flexibility as opposed to signalling distress.
Li and Zhao (2008) also repudiate signalling theory and find ceteris paribus, information asymmetry causes firms to distribute smaller and less dividend payments and are less likely to increase such returns, casting doubt on the practicality of signalling theory.
Tax-Preference Explanation - Tax preference theory argues investors favour fund retention over dividend payout as otherwise only specific investors, that is, those subject to minimal tax rates, would be attracted to invest. The tax clientele effect applies to stocks with low payouts, as they should only attract higher taxed investors. Such investors favour capital gains, hence minimising dividend payout will maximise stock prices.
Agency Explanation - Jensen and Meckling (1976) advance the agency theory, which posits dividend policy acts as an incentive for management to reduce agency costs derived from the conflict of interests between internal management and shareholders. Agency costs increase if management exploit the perquisites out of retaining funds, and investing them in a sub-optimal manner. As maximising dividend payout reduces internal cash reserves controlled by management and increases external financing into the company’s capital structure, external capital suppliers therefore subject the company to increased scrutiny, diminishing the likelihood of suboptimal investments (Rozeff 1982). Thus dividend payments provide a mechanism to monitor management performance and align them to shareholder interests.
Premiums - Share repurchase is another form of investor return as the firm exchanges cash for shares owned by investors. Under the signalling theory, providing such a return occurs if the firm believes share prices are under-priced on a fundamental basis, or if they desire to increase their earnings per share (Stephens and Weisbach 1998), particularly if there were tax savings in adding debt to capital structure, increasing leverage (Young 1969). However, Wanscly, Lane and Sarkar (1989) finds three factors more directly affecting share repurchase decisions are to eradicate shareholders’ structure to minimise administrative burden of having minority shareholders, defend against takeovers, or if they have excess cash with limited investment opportunities. Excess cash results in the agency problem as management may invest in sub-optimal investments, hence the firm must pay out the excess cash through either stock repurchase or dividend payout. Due to the reputational penalties involved in volatile dividend payouts, management have greater incentive to retire stock instead. This also allows them to provide shares for internal programs such as exercising stock options or employee bonus and retirement programs.
Case Studies
Share Repurchase
Lynas Corporation, currently experiencing a deteriorating economic condition and financial distress due to the firm’s inability to cover operating and capital costs (Forbes 2014), have not issued any share buyback offers.  Tabtieng (2013) states terminating this mechanism of return provision is influenced by stock price changes. If the company’s stock price increased from its current level of 8.3 cents (ASX 2014), Lynas Corporation could resell to gain, unless they value ownership structure over financial statement content. This is because in terms of financial statements, surges in inappropriate retained earnings whilst outstanding and nonoutstanding shares are reduced means shareholder equity is on par with previous periods.  However, the company gains through an ability to pay out dividends or maintain a buffer against economic downturns. Under the signalling theory, providing such a return would signal that Lynas shares are underpriced on a fundamental basis, or they desire to increase their earnings per share (Stephens and Weisbach 1998).  As a result, we believe Lynas Corporation should consider the positive impacts of share repurchase as an investor return instrument.  
Likewise, Lynch (2014) focuses on BHP’s minimisation of gearing levels to 30% and their goal to maintain annual capital expenditure at $15 billion, which can both trigger share repurchase and investments.  BHP Billiton, one of the world’s largest producers of major commodities, is a company in a relatively ‘strong’ financial position, posting an underlying attributable net profit of US$7.8 billion for the half year ended 31 December 2013 (BHP 2014).  While share repurchase enables debt reduction, we believe that due to the internal competition for available capital and growing share price, BHP should favour long term investor returns from growth investment rather than short term cash dividends or buybacks.
During the December 2013 half year BHP issued a four tranche Global Bond, providing investors with fixed levels of returns from 2.050% to 5%, and a floating rate option, depending upon investor risk preference (BHP 2014).  Its Senior Floating Rate Notes due in 2016, provided investors with a return only 25 basis points above US Dollar LIBOR due to the high credit rating of the company and its senior debt as A1, an upper medium grade investment quality, highlighted in Moody’s BHP Biliton Limited Credit Rating (2014).  It could be inferred that BHP’s chosen capital structure, with debt to equity ratio currently 0.4, is successful in achieving minimum debt financing costs, while providing sufficient cash flow to meet its commitments. However, Heath Jansen, Citi analyst, posits that the main limitation BHP faces in increasing their payout ratio (including repurchases) was their net debt, which once cut to $20 billion, should increase dividends by 7%.
Stock repurchase has a stronger practical application in BHP. According to BHP Billiton (2011), their repurchase of 4.4% of its issued equity capital was priced at a 14% discount at $40.85 per share. This, like Lynas, can improve earnings and cash flow per share and return on equity given the lesser amount of issued capital, benefiting all shareholders regardless of their participation. For instance, the investors’ capital proceeds accumulate to $9.31, $9.03 of it being the difference between the tax value and the buyback price. The significant factor affecting the buyback was external, being the oversubscription by investors which introduced the need to scale back tenders. Shareholders who sold back their stocks at 14% discount had a priority allocation of shares repurchased before such a scale back was applied.
BHP’s recent announcement of a buyback despite failure to execute suggests it acts as a marketing mechanism, to facilitate a shareholder friendly image (L├╝cke and Pindur 2002). Chambers (2014) suggests the buyback deferral provides predictability in future cash returns. Capital losses have also been prevented by investor anticipation of BHP’s buyback, as seen by its uncorrelated trajectory with iron ore prices (Chunn 2014). Such a decision not to deliver however has stimulated downgrades by Credit Suisse, a response that we agree with, as in the long run BHP cannot trade above its core valuation. BHP therefore valued a short term shareholder friendly reputation over the negative implications of uncertainty surrounding its capital management.
Dividends
BHP Billiton supports optimal dividend policy in terms of their progressive payout model, where they increase or at least preserve their base dividend for each payment (BHP 2014). Despite their recent profit collapse of 30%, BHP still managed to increase its dividend by 2 cents, up from $US0.57 to $US0.59 (Mason 2014).  In fact, ceteris parabus, lower dependence on the mining sector due to declining iron ore prices translates to a free cash flow pre-dividend payout of $10 billion; a margin sufficient to rebase dividends upwards by 5%-10% in the next financial year (Ker 2014). However, Lynas Corporation has not provided such returns, in fact they have refrained from paying any dividends due to their decline in financial performance (ASX 2014). Lynas Corporation’s actions still support the significance of the optimal cumulative dividend model, as cutting back on dividends has produced a greater negative reaction relative to a predictable dividend payout ratio (Jose and Stevens 1989).
Moreover, Neems (2014) reports that BHPs demerger resulted in returns in the form of shares in the new company and involved a transferral of only minimal debt so as to not override equity holder returns. We disagree with their current dividend policies, instead recommending management should look to increasing the dividends at a faster rate. BHP’s dividend yield is a mere 3% at current market prices, which combined with relatively costly stocks that have underperformed recently, leaves investors expecting higher returns (Mason 2014).
Their decision to retain their progressive dividend payout model means the dividend decision remains a residual decision dependent on cash reserves. However, BHP’s estimation that the company loses $135 million with each incremental dollar fall in iron ore prices questions the remaining reserves (Bell 2014), placing emphasis on the formulating of a long-term market share strategy to appease investor return demands.  Colonial First State approximates that in 2014, there was a $300 billion fall in capital expenditure in the resources sector (Ker 2014), resulting in long term supply shortages. However, continuously investing in BHP’s asset base will increase long term supply. The fact that this contradicts shareholder demand for dividends and buybacks highlights the need for BHP to deliver returns in another form such as discounted shares or a renounceable rights offer.
Contrastingly, Lynas Corporation has opted for such returns, partly due to their lack of dividends from financial distress. Lynas Corporation: shareholder entitlement offer (2014) reports on an offer in which 150 million new shares to institutional investors raised $83 million and existing shareholders were given a renounceable offer of 5 new shares priced at 9 cents a share, 2.5 cents lower their previous market price for every 14 shares already held. The subsequent market selling resulted in speculative capital gains before the share price dropped down to 9 cents.
Further, levering the firm through a strict and conditional senior loan facility of $225 million provides investors security in the event of further debt raising, as 50% of debt finance will first be used for partial investor repayment until the principal falls to $125m. (Lynas Corporation 2014). My recommendation for Lynas Corporation management involves a stronger focus on restructuring loans to amend Lynas’ debt amortization schedule to align it with planned future profitability (Roddan 2014), whilst reaping in the additional funds raised from the discounted share placement. Therefore this will improve liquidity, debottleneck operations and effectively transition the company from a start up stage to a growth stage through funding further investments (Morningstar 2014).

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