Dividend Policy at FPL Group PDF

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Case 7 - Dividend Policy at FPL Group, Inc. Memo From: Maxime Gauthier-Grace (260611276); Samuel Hodhod (260696304); Clement Lai (260665485); Francis Poirier-Cloutier (260690546); John Poole (260655638); Natali Yerokhina Mazer (260744560) Subject: Dividend Policy: FPL Group, Inc. Problem: Florida Power & Light Company (FPL) has historically been an industry leader in terms of dividend payouts for nearly half a century, with a 47 year streak of dividend increases. However, due to recent trouble resulting from rising interest rates and increased competition, FPL’s management has stated that the company’s payout ratio is too high given the uncertain business environment. Consequently, many analysts have downgraded FPL’s stock rating from a Buy to a Hold, resulting in a 6% stock price decrease. In re-evaluating their existing dividend policy, FPL’s management must not only consider the effects of a change on longterm earnings, but also the market reaction associated with a change. Options: 1) Status Quo - Keep current dividend payout ratio of 89.5% 2) Reduce Dividend Amount 3) Keep current dividend payout amount of $2.47 4) Increase dividend amount by growing out of high payout ratio Recommendation: Due to Florida Power & Light Company’s ownership mostly being low income individual who rely on dividend payments and the importance of signaling, we recommend option four: increase dividend amount by growing out of high payout ratio. Option four gives the best value to our shareholders and continue to signal our belief in strong future cash flows.

Analysis Company Background and Current Economic Conditions

Florida Power & Light Company (FPL) currently has the highest dividend payout ratio out of all investor-owned utilities in the Southeast, with a dividend payout amount that has increased for 47 consecutive years. This historical streak of dividend increases places FPL first among all utilities and third among all public traded companies. As a result, the company’s high dividend payout ratio, along with its diversified portfolio and strong operational quality, has made FPL a popular company for investors. However, there has been recent uncertainty regarding FPL’s next dividend payment due to rising interest rates and increased competition, which have contributed to a market downturn and a drop in FPL’s stock price. The industry that FPL operates in is facing drastic changes. For a long period of time, power companies were given monopoly supplier rights at the expense of allowing government agencies to regulate prices and returns. However, the recent rise of deregulation has substantially affected firms such as FPL. Rising competition accompanied with the adoption of the full retail wheeling system has caused an increase in competition in the distribution of electricity. Local utility companies were required to open their transmission and distribution network to outside utilities wishing to sell power in that market. FPL was sued for neglecting this and for charging excessive rates. Furthermore, certain acts were passed to promote the use of renewable and non-traditional fuels such as geothermal, solar, and wind power that require companies like FPL to purchase any electricity generated by these qualified facilities. Another aspect that FPL must consider is the rising cost of debt. With a large increase in long-term interest rates, borrowing through external financing could be expensive for the firm. As it is expected that the firm will invest heavily in capital expenditure to stay competitive in the industry, FPL might prefer using retained earnings to invest at a lower cost. However, as dividends are paid out of retained earnings, this would necessitate a change in dividend policy. Importance of Dividend Policy Dividend policy is concerned with the timing and amount of dividends that are paid out by a company to its shareholders. In the lack of market-frictions, Modigliani-Miller theory states that dividend policy is irrelevant, as dividends do not affect firm value. However, due to the varying tax rates that exist between dividend income and capital gains, as well as transaction costs for converting shares into cash, certain investors are willing to pay more for high-dividend stocks. On the contrary, because dividend income is often taxed at a higher rate than capital gains, certain high-income investors may prefer low-to-no dividend stocks. In addition, dividend increases also serve as a signal of good news about a company’s cash flows and earnings, while a decrease signals the opposite. Assumptions To accurately assess the impact of a dividend policy change, several key assumptions were made. First, to calculate the earnings per share (EPS) for future years, we took the projected net income values divided by the average shares outstanding. Then, dividend policy implications were calculated accordingly using this projected EPS value. Secondly, another assumption that was made was regarding the current dividend payout percentage. Although the exhibit showing FPL’s dividend payout relative to its industry peers showed a value of 91%, to ensure an accurate representation of our projections, we remained consistent with our

methodology, and divided historical dividends per share by EPS before extraordinary items to calculate the policy. Doing so yielded a payout ratio of 89.5% for 1993. Alternatives Option 1: Fix dividend payout ratio at its current amount of 89.5% FPL must first evaluate if they should continue with the status quo with currently the payout ratio stands at 89.5%, which is the highest in the market. 1993 has been a record year financially for FPL, with the benefits of restructuring and a new strategic direction creating efficiency gains that helped drive down operating and maintenance expenses. This positive trend is expected to continue into 1994 and beyond due to rising sales and lowered CAPEX. As such, FPL may decide to maintain its current dividend payout ratio and avoid any further negative market reaction on its stock price. However this position may not be possible. FPL’s management believe the payout ratio is too high given the uncertain and more competitive business environment. Attempting to maintain the dividend payout ratio by growing dividends at the same rate as growth in net earnings may lead to FPL being forced into a dividend cut if earnings drop in the future, which will harm the stock price. Furthermore, maintaining the current payout ratio means that the company will not be able to grow its dividends by a large amount in the coming years (unless earnings significantly surpass expectations which, given the current environment, is unlikely). A low dividend growth rate could make the company’s stock less attractive for investors who want to see significant increases in dividends. Finally, keeping the company’s payout ratio constant would put additional stress on FPL to cover its interest payments. Having taken out $3.7 billion in long- term debt to pay for its CAPEX, FPL will have significant debt obligations in the future which may increase if they cannot fund future investment through retained earnings. While the benefits of this strategy are attractive, the potential long-term downsides could be extremely harmful and thus maintaining the current dividend payout ratio is unsustainable. Option 2: Reduce the dividend amount that is paid out Reducing the dividend payout will reduce the financial risk associated with a potential default caused by the increase in interest rates. Furthermore, high-dividend-paying utility stocks fail to attract high tax bracket investors, who prefer low dividend payouts and high capital gains. However, FPL would have to reduce payout significantly to single digit rates or even completely eliminate it for its stock to attract such investors. FPL’s current list of shareholders consist predominantly of low tax bracket stakeholders, 51.9% of which are individuals, who prefer low to medium payout stocks, and 36.9% of which are tax free institutions, who do not receive taxes on dividends and would prefer medium dividend stocks. Therefore, any dividend decrease is a negative signal of future performance. Although reducing significantly is a way to ensure positive signalling in future times. Considering the historically bad reactions to dividend cuts, as well as FPL potentially breaking its 47 yearlong streak of consistent dividend increases, the signalling of poor future expectations would likely outweigh potential benefits of a substantial dividend cut. It is thus deemed too risky for FPL to go through with such action. Option 3: Fix dividend payout at its current amount of $2.48 Another possible option for FPL would be to maintain the current dividend amount of

$2.47. With the dividend amount paid to investors kept constant, retained earnings should grow at a faster rate than previously, leading to a lowered dividend payout ratio over time. Benefits of this scenario include higher retained earnings for the firm. As a result, FPL could potentially use this internal source of funding to invest heavily into capital expenditure without the need of taking more debt that would require higher costs of borrowing. This would allow the firm to adapt to current industry conditions, while still having a relatively high dividend payout ratio relative to the industry average of 77%. However, decreasing the payout ratio would still remain a bad signal to the markets. Consequently, should FPL choose this option, there could potentially further decrease in stock price. Furthermore, the firm’s shareholders who have mainly invested in FPL for the high dividend payout due to their tax conditions would be in a less favorable position and likely be unhappy. However, there may be rising concerns as to why dividend payments are not growing in the long run. In this option, the costs seem to outweigh the benefits and is therefore not an appropriate choice for FPL. Option 4: Increase dividend amount, but at a slower rate than earnings (reducing payout ratio) A fourth option is for FPL to grow out of its high payout ratio. From 1984 to 1993, dividends have been growing at an average rate of 3.80%, compared to an average earning per share growth of 0.89% during the same period. This has resulted in an unsustainable payout ratio increase of almost 25%, from 66.79% in 1984 to 89.5% in 1993. It is clear that FPL needs to revise the rate at which it grows its dividend, and ensure it reaches a dividend payout that is sustainable and more comparable to the industry average of 77%. With promising earnings forecasts, even given the potential increase in competition as a result of deregulation, if dividends increased at a slower rate of 1% a year compared to earnings’ average projected growth of 3.2%, the payout ratio would drop substantially from 90% to 81% over the 5 year period (Appendix 4). The information content effect of the dividend suggests that it is the expectations of good times, and not only the stockholders’ affinity for income that raises the stock price. Increasing the payout by 1% but reducing the payout ratio not only signals positive future performance but is also a protective measure to prevent the risk of needing to reduce dividend payout to its original amount. Although this strategy could deter high tax bracket individuals from investing in FPL, the majority of FPL’s current shareholders are low-bracket investors who prefer dividend payments and current income. A lower payout ratio allows FPL to assign a greater share of its net income to its capital expenditure program without taking on more debt, while also keeping investors content with a growing dividend and the second-highest payout ratio in the industry. Appendix 1) Status Quo - Keep current dividend payout ratio of 89.5% EPS

1992

1993

1994

1995

1996

1997

1998

2,65

2,76

2,75

2,90

3,00

3,10

3,20

2,43

2,47

2,46

2,60

2,68

2,78

2,87

91,7%

89,50%

89,50%

89,50%

89,50%

89,50%

89,50%

-0,33%

0,00%

0,00%

0,00%

0,00%

0,00%

0,00%

Dividend yield

6,00%

6,00%

6,00%

6,00%

6,00%

6,00%

6,00%

Share Price

$40,50

$41,17

$41,02

$43,25

$44,73

$46,28

$47,76

Dividend per share Dividend payout % Change in dividend payout

2) Reduce Dividend Amount Year

1993

1994

1995

1996

1997

1998

EPS

2,76

2,75

2,90

3,00

3,10

3,20

DIV/Share

2,47

1,68

1,85

2,04

2,25

2,48

Payout Ratio

89,49%

61,00%

63,80%

68,04%

72,52%

77,46%

3) Keep current dividend payout amount of $2.47 EPS Dividend per share

1992

1993

1994

1995

1996

1997

1998

2,65

2,76

2,75

2,90

3,00

3,10

3,20

2,47

2,47

2,47

2,47

2,47

2,47

2,47

93,21%

89,49%

89,82%

85,19%

82,38%

79,61%

77,15%

% Change in dividend payout

3,80%

-3,99%

0,36%

-5,16%

-3,30%

-3,36%

-3,09%

Dividend yield

6,00%

6,00%

6,00%

6,00%

6,00%

6,00%

6,00%

Share Price

$41,17

$41,17

$41,17

$41,17

$41,17

$41,17

$41,17

1992

1993

1994

1995

1996

1997

1998

Dividend payout

4) Increase dividend amount by growing out of high payout ratio EPS

2,65

2,76

2,75

2,90

3,00

3,10

3,20

Dividend per share

2,43

2,47

2,47

2,47

2,47

2,47

2,47

1,67%

1,65%

0,00%

0,00%

0,00%

0,00%

0,00%

91,70%

89,49%

89,82%

85,19%

82,38%

79,61%

77,15%

2,12%

-2,41%

0,36%

-5,16%

-3,30%

-3,36%

-3,09%

Div growth rate Dividend payout % Change in dividend payout Dividend yield

6,00%

6,00%

6,00%

6,00%

6,00%

6,00%

6,00%

Share Price

$40,50

$41,17

$41,17

$41,17

$41,17

$41,17

$41,17...