FPL group is a utility company that has been operating in Florida as a monopoly. As part of its deregulation programs, the United States government is considering a deregulation of the utility industry. Such deregulation has already started in other states like California, and the affected utility companies have realized significant losses because of increased competition. FPL is considering a decrease in its dividend payout ratio in order to conserve resources in the wake of a possible deregulation and changing industry landscape. It is determined that the company can either decrease its dividend payout over time by maintaining a constant dividend or effect a swift decrease in dividend payout by making an immediate dividend cut. Although MM model dictates that dividend policy in irrelevant, the dividend cut might accompany a decrease in share price because of the strong clientele and signaling effect in the utility industry. Moreover, it is believed that the current stock price assumes a strong dividend growth rate, which might not materialize in the adverse industry climate. Therefore, Kate Stark, the analyst following FPL Group, should issue a sell recommendation on the stock.
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FPL Group is Florida’s largest electric utility company. The company was formed in 1925 through the consolidation of numerous electric and gas companies. FP&L grew steadily over the next 50 years until rising fuel costs, operating issues, and construction costs began to decrease profitability. To address problems in operations, FPL implemented quality control program, which reduced the scheduled downtime from 18% to 4% and decreased customer complaints by 60%. The new chairman, Broadhead, emphasized a commitment to quality and customer service. He also increased focus on the utilities industry – expanding capacity, and improving cost positions. The company’s performance improved drastically in the recent years. Standard & Poor’s ranked FPL amongst the top 10% investor-owned utility companies. The company performance is expected to be good in the coming periods as it is expected to grow at a higher rate than the industry average. However, the changing landscape of the industry poses certain risks to the future performance of the company. This has given rise to fears that the company may cut its future dividends. This has prompted a review by Kate Stark – an equity analyst following the company.
Industry Environment and Dividend Preferences
Until the 1970s and 1980s, the government played a major role in determining the rates, returns, and capacity planning of the power industry. Congress passed several laws regulating the sale of wholesale energy and even formed committees to monitor utility companies’ dealings. During the 1970s and 1980s, deregulation weakened the monopolies in many industries. The focus of the deregulation was now shifting towards the electric utilities industry. In 1992, the National Energy Policy Act (NEPA) was passed that required utility companies to make their transmission lines available to third-party users. Further deregulation might even allow competition in the distribution of electricity to end users. This poses a high risk to the competitive position of FPL. Although FPL is quite efficient in large, investor owned utility companies, it faces a considerable risk from smaller operators under a possible deregulation. California and Michigan have already adopted a certain form of deregulation in the distribution segment: retail wheeling. Retail wheeling allows customers to buy power from any utility, not just their local monopoly supplier. Utility companies in California indicated an average loss of 8% of market value each year because of retail wheeling.
The industry is also characterized by high payout ratios. Data about the investor owned utilities in the Southeast United States reveal that the payout for most companies is higher than 70%. FPL has one of the highest payout ratios of 91%. FPL has also maintained an increasing dividend for the past 47 years - the third highest streak amongst all the publicly traded companies. Miller & Modigliani argues that the dividend payout policy should not matter for an individual. MM model would theorize that, ignoring the tax differences, a decrease in dividends would have no effect on the value of FPL. A decrease in dividends would be compensated by an added increase in the stock price of the company (capital gains) such that the total return remains the same. Thereby, an investor can create ‘home-made’ dividends by selling a portion of his shares.
MM model makes certain restrictive assumptions (such as no tax differences) and ignores many external factors. Many factors influence the dividend policy of a company. Two factors that are relevant to the case of FPL are clientele effect and signaling. There are certain investors who might prefer a high dividend payout ratio. Such investors might have invested in FPL since it has historically paid high dividends. This assertion is also supported by the case study where the shares of FPL are described as a substitute for treasury bonds. Therefore, a drop is dividend policy might not be welcomed by the clientele that prefer high payout stocks. Such investors might want to sell their shares because of low payout ratio, leading to a fall in stock prices. Similarly, dividend increases are meant to signal the competitive strength on the company. This is especially true for a company like FPL that has a 47-year streak of increasing dividend. If the company suddenly decides to make a dividend cut, investors might take it as a negative signal about the future performance of the company. The signaling argument hold some traction because it is reasonable for investors to believe that the company would not want to break its 47-year streak unless the dividend cut is a last resort measure that is absolutely necessary to maintain the profitability of the company.
There seems to be a strong presence of signaling and clientele effect in the utility industry. Historically, dividend cuts by companies have not been received well by investors. In two previous cases, stock prices fell by more than 20% following a cut in dividends. Interestingly, both the companies were financially healthy and the cut is dividends could not be fully attributed to worsening performance of the company. Therefore, it might not be desirable for a company to cut its dividend in the utility industry. FPL should not be looking to cut cut its dividend unless it is necessary.
Analysis of Dividend Policy
The company’s has already indicated that it considers its payout ratio to be too high. Therefore, it is clear that the management wants to decrease the payout ratio to the lower spectrum of the industry payout ratios. Dividends are a use of funds available to equity holders. It is important to estimate the funds available to equity holder before we can comment on the appropriateness of different dividend policies. Free cash flows to equity (FCFE) is a measure to the cash flows available to equity shareholders. The attached spreadsheet details the calculation of FCFE. It is calculated by adjusting the net income for non-cash charges (depreciation and amortization), capital expenditures, debt, and preferred dividends. The FCFE details the maximum cash that can be distributed to shareholders as dividend. Therefore, the FCFE can be compared to various possible dividend policies to investigate their prospects.
It is important to evaluate the financial position of the company under different dividend scenarios. Ideally, the company should choose a dividend policy that provides them a balance between operational stability and maintaining the confidence of their investors. There are three possible scenarios under consideration for the forecasted five years from 1994 to 1998: an increase in dividends at an annual growth rate of 2%, a constant dividend policy, and a 20% dividend cut followed by an annual growth rate of 5%. The attached spreadsheet calculates the effects of each of these alternative scenarios.
Scenario 1: Continued Dividend Growth
The 2% annual growth rate is commensurate with the growth in industry sales. Under this growth rate, the payout ratio is expected to decrease from 92% in 1994 to 85% in 1998. This position may not be preferred by the management, as it will maintain a high growth rate relative to the industry average. A more potent problem arises when the total dividend is compared to the FCFE. The projected dividend is twice the amount of cash flow available for shareholders (FCFE). The dividend payout remains considerably more than the FCFE until 1996. This implies that the company will either have to use its previous reserves or borrow additional money in order to pay the dividends. Even in 1997 and 1998, the dividend payout is only slightly less than FCFE, indicating that only a marginal amount of cash can be retained within the company. This is in sharp contrast to the management’s intention of conserving profits for future uncertainties.
Scenario 2: Stable Dividends
The second option is to maintain a constant dividend policy for the next five years. Under this policy, the dividend payout ratio is projected to drop to 80% by 1997. The 80% payout can be seen as an average payout ratio for the industry. Therefore, it might be reasonable target payout ratio for the industry. If the management is looking for an even lower payout ratio, the ratio is projected to drop further to 77% by 1998. Therefore, the stable dividend policy can be used to lower the payout ratio over a period of four to five years. However, the dividends paid are still much higher than FCFE. The FCFE is lower than net income, primarily because of the high capital expenditures projected to be incurred by the company. Nevertheless, the dividends are expected to decrease to 85% of FCFE in three years’ time.
Scenario 3: Dividend Cut
The third option is to cut the dividend by 20% and subsequently increase the annual dividends by 5%. The 20% cut in dividends will decrease the dividend payout ratio to almost 70%, while a 5% dividend growth rate will gradually increase the payout to 75%. This scenario has been constructed with the view that companies tend to cut their dividends by more than the required amount in order to alleviate the possibility of a second dividend cut in the future. Under such a scenario, the dividends exceed the FCFE only in the first two years. In the later years, the FCFE is considerably higher than dividends, allowing the company to allocate funds for other purposes.
Predicting the Price Changes
It is clear that an increase in dividends is not a viable option from management’s viewpoint. A constant dividend can decrease the payout ratio to desirable level in five years, whereas a dividend cut provides a swift solution to the problem. The problem is that the dividend cut might accompany a decrease in prices. Apart from the consideration of shareholders’ well being, a price decrease is not in the best interests of management. The senior management’s compensation was affected by the price of the company’s shares. A substantial part of the bonuses was paid in stock options, which were directly proportional to the changes is stock prices. Similarly, a decrease in the dividend policy could result in a lawsuit or at least additional scrutiny by the shareholders. Therefore, it is reasonable to assume that the management would not want to affect a decrease in stock price unless it is essential. We have already talked about how the industry might have strong clientele and signaling factors that might cause the stock prices to drop because of a cut in dividend. We can also model the changes in stock prices under different dividend policies.
The capital asset pricing model (CAPM) can be used to calculate the required return on equity. The risk-free rate is assumed to be equal to the long-term (30-year) treasury bond yield. The yield is around 7.3% in May 1994. The beta is mentioned as 0.6, while the equity risk premium is assumed to be 6%. This gives as the required return on equity of 10.9%. The projected dividends for the next five years are available under the two scenarios of constant dividend and a dividend cut. Therefore, the dividend discount model can be applied to calculate the growth rate of dividends that is expected to result in the current price of $32 for FPL. The attached spreadsheet details these calculations. If the dividends are cut by 20% in the next year, the dividends will need to grow at a rate of 5.2% forever in order to justify a price of $32. On the other hand, if the dividends are not decreased, the dividends will need to grow at 3.5% to justify a price of $32.
The company is facing an uncertain future, as the forecasts are likely to be much lower in the wake of a possible deregulation. The possibility and the extent of the deregulation are not certain, but there is a clear threat. The FCFE does not permit the dividends to continually increase at a rate higher than 2%. Therefore, the best bet is that the company will maintain the current dividends to lower the payout ratio over time. For Kate Stark, the decision is not that difficult. The analysis reveals that the company will need to maintain a growth rate of at least 3.5% in order to justify its current price of $32. It is highly unlikely that the company will be able to sustain a growth rate of 3.5% in the longer term. The sales of the company are currently growing at 2.7%, and the growth rate is likely to be much lower or even negative if the deregulation is undertaken. The company’s price is expected to decrease even further on the announcement of a constant dividend policy. Therefore, Kate Stark should issue a sell recommendation for the stock of FPL.
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