Debt-financed Dividends Part III

Well I guess the folks at the Wall Street Journal got wind of my recent blog postings, because on Tuesday there appeared a story on page C1 about exactly this issue. Incidentally, it pointed out that in addition to the companies I have mentioned, Domino’s Pizza (DPZ) also recently announced a “dividend recap.” I feel somewhat better about my confusion now, because even this article didn’t profess any really decent argument in favor of these transactions.

Let us review when levering a company makes sense and why. Debt is good because it allows firms to do more with the same amount of equity capital. However, the argument has also been made that debt can be better than equity since it provides a tax shield (through the deductibility of interest payments) that equity does not. But unlike equity financing, debt must be reliably serviced through regular interest payments, else the firm will find itself in bankruptcy. So to rely too heavily on debt generally puts the firm in a very precarious situation, which consequently hurts the firm’s credit rating and raises its cost of debt. Theory therefore suggests that, at some point, management should find an elusive “optimal” capital structure, since debt has both benefits and drawbacks.

Hopefully the paragraph above illustrates that the benefit of debt is in the capital that it raises. A dividend-recap raises no capital, it merely alters the debt-to-equity ratio (same assets, more debt -> less equity). The stock will be worth less because of the lower total equity, but the shareholder will also have the dividend in his pocket. So in a world of no taxes, this would have no effect on value (this follows from Modigliani and Miller 1958). As a value investor, value is my main criterion, not earnings, share price appreciation or any combination of the two.

But in a world of taxes, two things happen; a) the company gets a tax savings from the service of its debt over years to come and b) the individual must pay personal income taxes on the dividend now which could otherwise be deferred indefinitely. Unfortunately, so long as the corporate tax rate is the same as the personal tax rate, the cost of b) will always be larger than the cost of a) because of the time value of money.

So it seems the proponents of dividend recaps are relying on the higher returns to shareholders that the new capital structure will generate to sell the idea. By “returns to shareholders” I presume they mean return on equity, and to look at return on equity in isolation is meaningless, since it can easily be manipulated by simply boosting the level of debt. What an investor should be concerned about is return on invested capital, and as we have seen the amount of total capital does not change. However, as I mentioned in Part II, the cost of this capital may fall. In fact, it must fall if management is not making a value-destroying decision.

Thus, the primary indicator of whether the dividend-recap creates value is whether the time value of money consequence mentioned above outweighs a reduction to the firm’s annual cost of capital. I surmise that this difference is minimal anyway, suggesting that the whole thing is a really just a wash.

So why undertake it? Well Scotts Miracle-Gro (SMG) recently paid a fully debt-financed special dividend of $8. But guess who got cut the biggest check. CEO and Chairman Jim Hagedorn, who owns 21 million shares and 31% of the company, ended up receiving $168 million from this transaction. Or how about Health Management Associates (HMA) which paid a $10 special dividend on March 2, representing nearly half of the firm’s market cap. Chairman William Schoen owns 13.5 million shares and 6% of his company and got an easy $135 million paycheck. Don’t misunderstand, though. I have no objection to these people’s wealth and proportional sharing in corporate distributions. But given the financial meaninglessness of the transaction, I cannot help but be a little skeptical.

By conducting the dividend recap, these individuals were able to get a huge payday while not receiving any “compensation” from the company. Similarly, they were not forced to sacrifice any controlling interest they may have had as they would if they had simply sold shares. Finally, they were able to diversify their wealth some without triggering an insider sales filing, which may be seen as a negative signal by the market, lowering the value of their remaining shares. So there are plenty of positives for these insiders that are not applicable to the ordinary individual shareholder.

FD: I have no position in any company mentioned in this post.

Debt-financed Dividends Part II

After combing through a collection of press releases, conference calls and other materials, I concluded that the most worrisome aspect of the so-called "dividend re-cap" phenomenon is the tremendous managerial spin and occasionally deception that it demonstrates. Invariably, management ends up bragging about their company’s ability to pay these abnormally large dividends. Perhaps, since cash is king, the complacent investor ought to be impressed that the company has the resources necessary to carry out such a transaction. And the whole thing can be spun as a recapitalization, which, although accurate, really just glamorizes an otherwise unnecessary transaction.

The truth is that probably most any big company could obtain the debt financing needed pay a large special dividend if it so chose. The question, then, is why would it make this decision.

On March 2, Dean Foods (DF) announced a special dividend of $15 per share payable on April 2 and funded entirely by a senior, partially secured, credit facility. The stock currently trades at $48. The corresponding conference call and press release were titled “Dean Foods Announces Plan to Return Approximately $2.0 Billion to Shareholders.” I might argue that no cash is actually being “returned” to shareholders, since the capital the shareholders contributed is still tied up in the company’s assets. Rather, the company is merely transferring money from its lenders to its equity holders.

Management repeatedly refers to the set of transactions as a recapitalization. There is certainly nothing wrong with a recapitalization if the company believes that it needs to restructure its balance sheet. In fact, oftentimes a restructuring would benefit the firm. For instance, if its cost of equity capital is tremendously higher than its cost of debt, then adding more debt to reduce the cost of equity might be worthwhile. Typically a firm will achieve such an objective by issuing debt (or any type of borrowing) and repurchasing stock, and if stock is more costly than debt then it will have reduced its cost of capital. Interestingly, at the same time it announced its special dividend, Dean Foods also announced it was discontinuing its share repurchase program.

Could it be that the firm is reluctant to repurchase its shares because it believes they are overvalued?

Although Chairman Gregg Engles makes passing reference to a desire to reduce the cost of capital in the conference call, he does not elaborate. Maybe this is because the transaction does not actually achieve a lower cost of capital. It may reduce the firm’s average cost of capital by increasing the debt-to-equity ratio, but the overall dollar cost will not improve. This is because that special dividend is itself a cost of equity and is being paid for with debt, which has its own cost. Of course, the same could be said for borrowing to repurchase shares. But if the impact of the new debt on the firm's current credit rating is significant enough, it could easily negate the benefit from any savings from reducing the level of equity capital.

But the rest of the management’s comments aren’t consistent with those of a firm desiring more leverage. When pressed about the impact the new leverage will have on earnings, Engles tells a Bear Stearns analyst that the company should be “back at our current leverage level… by the end of ’09.” A transaction that alters the balance sheet for only two years doesn’t sound like something designed to generate a “more appropriate capital structure.” If it is a temporary exploitation of cheap debt, then why do the company representatives neglect to discuss the actual terms of the borrowing, which would evidence the relative benefits of the transaction? And why do company representatives fail to discuss what impact the transaction will have on the company’s existing cost of debt?

In the Q&A portion of the conference call, the sell-side analysts were certainly not reluctant to congratulate the company on the transaction. But although the deal is extraordinary, it doesn’t seem to really produce any particular benefit to the company or any of its stakeholders, at least none that the call participants ever discuss.

And there is one group of stakeholders, though, that should be the most upset about these transactions, even on a strictly financial level: the bondholders. Ordinarily when a company takes on new debt it uses that cash to boost its productivity. Hopefully, the cash gets used to expand operations or invest in a new line of business. So even subordinate claimants like bondholders ought not get too upset since that new money should be working to ultimately increase income, and debt coverage accordingly. But with these transactions, the money that comes in immediately goes out producing no operational benefit to the company.

Additionally, the new debt is secured and senior, presumably subordinating other claims to the financing of the one-time dividend. This ought to have damaging consequences to the ratings on its corporate debentures, and should outrage bondholders. For instance, CFO Jack Callahan agrees that the expected level of debt paydown will match free cash flow over that time. This is probably why, the day after the announcement, Standard & Poors downgraded the company’s debt citing a “weaker financial profile” and sending its 7% bonds down 3.875 cents. Why then, doesn't the company simply use its next two years' free cash cash flow to fund a new, higher quarterly dividend and avoid higher debt burden?

I guess my conclusion from this part of my musing is that, any way you interpret it, the debt-financed special dividend is not a good signal for a potential investment in the company’s stock or bonds.

FD: I have no position in any company mentioned in this post.

Debt-financed Dividends Part I

About two years ago I tuned in to CNBC to see Ameritrade CEO Joe Moglia boasting about the company’s recently announced acquisition with TD Waterhouse. He seemed especially proud of one-time special dividend of $6 per share to be paid to Ameritrade shareholders prior to the merger. What struck me as odd, however, was that he also explained that about two-thirds of this dividend would be financed not with cash currently on hand, but through new debt financing the company had obtained.

I thought about this, questioning my own understanding of capital structure, but couldn’t convince myself that such an event actually benefited Ameritrade shareholders. Isn’t the company essentially forcing shareholders to take on a loan they never asked for and, at the same time, forcing an income tax payment that could otherwise be deferred (and at a long-term capital gains tax rate) to be made this year? About a year after that, Joe Moglia visited our college and I had the opportunity to speak with him one-on-one.

I can say unhesitatingly that Mr. Moglia is an outstanding and motivational leader. The story of his life is rather famous in business now, and I was not dissuaded of the characterization and reputation that follows him. He really seems like a great guy. Nonetheless I couldn’t get past the seemingly irrational dividend payment the company had made. And so I asked him, “What was the rationale behind borrowing to pay a dividend?” His response, peppered with reminders of how beneficial the merger would be, was that the special dividend was a reward to the Ameritrade shareholders that had stuck with the company throughout the difficult times following the tech bubble.

I was unconvinced. Naturally the stock price immediately dropped by $6 upon the dividend payment, and the balance sheet was left much more levered. So although the shareholders were “rewarded” with a check for $6, their stock was also worth just as much less. Not my kind of reward. Surely there is a reasonable explanation for this. When I pressed further, Mr. Moglia explained that the company had an excellent credit rating and sufficient cash flow to pay off all the debt within a few years.

Still, though, the plan had several blatant drawbacks. Through interest expense it reduces the company's future net income and the repayment of the principal will dramatically reduce future free cash flow. This limits the amount of capital available to be reinvested and used to expand the business. Where would such capital thus need to come from? Well either from borrowing more, resulting in mitigated net reduction of the debt, or from issuing more equity, which would dilute the current shareholders’ proportional ownership.

Dividends have become more popular and investor demand for them has increased over the past few years as the simple result of their new tax status. Long-term capital gains were once taxed at a rate of 20%, which was usually always less than the marginal tax rate investors would pay on their dividends. So there was a clear disadvantage to dividends.

With both long-term capital gains tax rates and dividend tax rates now both at 15%, there is more parity and the new relative attractiveness of dividends has made them more common. But that doesn’t excuse their overuse. Dividends still face the disadvantage of forcing a tax payment sooner rather than later.

Of course all this is old news now, but I have been thinking about the issue lately because there have been three similar special dividends announced that have caught my eye. As with the case of Ameritrade, the justification for them seems to me to be dubious. The announcements come from Health Management Associates (HMA), Scotts Miracle-Gro (SMG) and Dean Foods (DF). I will look at each of those in Parts II and III.

FD: I have no position in any company mentioned in this post.

Thoughts On the Home Depot Situation

It was one year ago that Business Week suggestively declared, in its cover story no less, that Home Depot was “thriving under CEO Bob Nardelli’s military-style rule.” Under Nardelli, the story explains, HD began recruiting military veterans and focused on “conquering customers” just as the military works to conquer the enemy. Nevermind that such a strategy seemed somewhat dangerous even at the time (the story documents a “culture of fear” as described by anonymous former executives), with the benefit of hindsight we now know that it was simply the wrong choice.

We should have known better. We knew that Nardelli, who took over the firm as the first non-founder CEO in December 2000, oversaw a HD share price that went precisely nowhere, from $42/share in 2000 to $42/share 2006. But we also knew from the 2006 proxy statement that Nardelli earned a total of $12 million in cash compensation from the company – that is, excluding option and restricted stock grants, which were sizable. But $7 million of this compensation was in the form of a bonus. A bonus for what, you may ask. Well, admittedly, earnings and revenues did grow nicely over this time but come on, what is the CEO’s job really?

The proxy gets yet more suspect the further you read. The company even admits that Nardelli’s “annual bonus shall be not less than $3,000,000.” So is it a bonus or is it salary? You tell me. Regardless, it later came to light that Nardelli’s total compensation in 2005 was worth somewhere around $38 million, and nearly $250 million over his five-year tenure through December 2005. To me, notwithstanding that I am merely an outsider with no management experience of my own, this just looks categorically egregious.

If the pay of the CEO wasn’t enough to make one question the direction of the company, then surely the CEO’s outright contempt towards shareholders should have been. At the shareholders meeting last May, which lasted all of 30 minutes and which the entire board of directors (save for Nardelli, the Chairman) boycotted, Nardelli refused to take shareholder questions. I am not even a Home Depot shareholder, and this made me livid. But it also caused me to avoid HD stock like the plague.

I am glad I did avoid it, because $250 million in severance for someone who effectively failed at his job is just a slap in the face.

The Business Week story concluded by citing a survey that suggested the anti-touchy-feely, threatening demeanor that Nardelli uses to manage may surface in the interaction store employees have with customers. Today I read articles like the one on MSN from earlier this week that seem to echo my own personal feelings about the company – that by mistreating employees the customer experience has suffered, and Home Depot is no longer a pleasant place to visit. With an alternative like Lowes, I feel, there is really no reason to shop at or to invest in Home Depot.

Hopefully, after Nardelli’s January ouster, things may be able to change. But how quickly a new CEO can change the culture of a 350,000-person firm remains to be seen. I hope, for the sake of the corporate financial system, that the Bob Nardelli type of behavior continues to outrage investors.

FD: I have no position in any firm mentioned in this post.

Can Buffett-wisdom calm the market?

The Berkshire annual report will be released this afternoon at 3:00 central. This is unusual as in the past it has been released over the weekend. Since we are in the midst of a very turbulent market it seems the report's release couldn't have come at a better time. By the way, I don't intend for this blog to serve as a news source, but thought some folks might like some good news like this on a day like today.