{"id":2227,"date":"2010-12-13T13:16:22","date_gmt":"2010-12-13T18:16:22","guid":{"rendered":"http:\/\/www.credittrends.com\/blog\/?p=2227"},"modified":"2010-12-13T15:32:24","modified_gmt":"2010-12-13T20:32:24","slug":"how-dividends-can-destroy-value","status":"publish","type":"post","link":"https:\/\/www.credittrends.com\/blog\/2010\/12\/13\/how-dividends-can-destroy-value\/","title":{"rendered":"How Dividends Can Destroy Value"},"content":{"rendered":"

News from the Federal Reserve last week that balance sheet cash represents 7.4% ($1.9 trillion) of non-financial corporation\u2019s assets presents as much reason for fear as celebration. In fact, the CT Capital<\/a> credit model may actually penalize firms having excess cash due to: (1) fear it will be unwisely spent; and, (2) balance sheet cash lowering the return on invested capital (ROIC). I much prefer firms invest excess cash into additional opportunities which offer even greater prospective free cash flows (adjusted for its cost of capital)\u2014that is the very essence of a value-producing entity which brings superior returns to shareholders.<\/p>\n

Dividend Recapitalizations Programs\u2014An Action We Should All Fear<\/strong><\/p>\n

Dividend recapitalizations (also referred to as a \u201crecap\u201d) are financial events whereby existing shareholders receive dividends in excess of annual free cash flows, thereby altering the firm\u2019s financial structure. Both the entity\u2019s cash may be removed and substantial debt assumed in the process.\u00a0 Although such programs are typically associated with a private equity (PE) firm, publicly held companies may also engage in a dividend recapitalization. Since the dividend is not covered by the free cash flows, thus leveraging the financial structure, the firm\u2019s fixed charge coverage and financial flexibility are negatively impacted.<\/p>\n

With the current after-tax cost of debt capital low, aren\u2019t these transactions just plain good financial engineering? No! Because by altering the financial structure the firm is robbed of financial flexibility\u2014and that has a real cost. A firm creates value by being able to produce free cash flows\u2014how can depleting the equity cushion aid the firm\u2019s purchase of productive capital or resources from which additional free cash flows are produced?<\/p>\n

How will these newly depleted firms gain access to capital for expansion and other business opportunities, given their balance sheets are swelled from self-aggrandizements? And will the Boards of Directors of these firms recognize these acts for what they are, or will they be swayed by the upfront cash with further promise of riches, and for which banks are now all too eager to lend?\u00a0 How will these firms be able to compete and grow without the required access to capital at a price that allows important projects to proceed?<\/p>\n

From Goldman Sachs (GS<\/a>) to GE Capital (GE<\/a>), financial intermediaries are cashing in on the not so new dividend recap business.\u00a0 Banks, which are tripping over each other to provide the financing for the recaps, are rationalizing their lending by pointing to the recap universe having a lower default rate than LBO debt. But is this the way for investors to evaluate the success of these deals?<\/strong> <\/em>Is getting an initial investment back with a huge return, then seeing a firm soaked in debt the new definition of success in the post credit-crisis world?<\/p>\n

On its website, BankAmerica (BAC<\/a>), one of the large intermediaries who have benefited from such fee income, points to the acceptable 6% default rate.\u00a0 Is that the ultimate objective of companies: not to default?\u00a0 Firms which have been through recaps, like Hertz (HTZ)<\/a>, may not have defaulted, but have been placed in a precarious position from which they may never recover. The list includes Hexion Specialty Chemical (HXN<\/a>), Burger King (BKC<\/a>), KB Toys, Warner Music (WMG<\/a>), Burlington Coat and countless others who have enriched their PE firms, yet in so doing have dismantled once solid, position-leading organizations.<\/p>\n

Take a look at Hertz, which sold stock at $15 per share in its 2006 IPO. Ambitious investment bankers and brokers, with their road shows and analyst research reports helped send the stock past $27; it now stands at $13.75 with\u00a0 over $12 billion in debt versus $11.75 billion at the time of the IPO. Losses have contributed to its $1billion in accumulated deficit.\u00a0 Shareholders equity, at the time of the IPO stood at $2.48 billion versus $2.1 billion as of its last 10-Q. It is plain to see that only the selling shareholders, who received a $1 billion dividend or almost half their investment back less than a year after its purchase, were the ones who truly benefitted.<\/p>\n

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The only way to create sustainable growth for the shareholder is for the firm to earn increasing amounts of free cash flows. This takes place through a growing capital base which can earn a consistently and normalized higher cash based ROIC than its cost of capital. Dividend recaps, by definition, are the antithesis of value creation. <\/strong>These transactions steal capital resources instead of allowing the firm to maximize the value-creating capital.<\/p>\n

Financial intermediaries and large corporations are so awash in cash they are beginning to lose sight of the most important investment axiom of risk versus reward, and thus are beginning to take on increasing amounts of hazard for the opportunity of grabbing an extra point or two of return.\u00a0 This is seen in the bidding up of leveraged loans (Illustration 1) and other debt which, under normal circumstances, would be laughed at. Today, conservative buyers, including those that were badly burnt just a few years ago are back in the arena, are willing participants in the recap game. As is evident in Illustration 2, high yield bonds are passed their pre-crisis level.<\/p>\n

Illustration 1- Leveraged Loan Index<\/strong><\/p>\n

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\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 Source: Bloomberg<\/p>\n

Illustration 2- High Yield Index<\/strong><\/p>\n

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Source: Bloomberg<\/p>\n

Perhaps my greatest fear, however, relates to the hundreds of billions of dollars in capital chasing the public universe of companies. How will Boards of Directors chose to fight off the PE firms? My bet is the same tactic: paying out the cash while leveraging the balance sheet with a \u201cspecial\u201d greenmail-type dividend.<\/p>\n

Surely there must be benefits from recap transactions?\u00a0 Where the PE firm may have done a good job eliminating excess fat, and enhanced expected free cash flows, it has not, due to the new financial structure, resulted in a firm having a lower cost of capital. A potentially \u201cmean and lean\u201d entity was replaced with a potential credit risk incapable of taking on the wide range of opportunities that previously existed.\u00a0 By virtue of leveraging of the balance sheet while getting nothing in return, both investors and employees are much worse-off.\u00a0 No jobs in research, no machinery, technology, or productive plant were put in place as multi-billion dollar checks were mailed out.\u00a0 And now, to the extent institutional investors smell the trillions of dollars available on the public side, it scares me.<\/strong><\/p>\n

On the Other Hand\u2026<\/strong><\/p>\n

You may ask: Aren\u2019t dividends a necessary component of investor\u2019s compensation? Not necessarily, as the price of a stock will be based on the present value of the free cash flows, regardless of whether it is paid out. In fact, because the tax system is biased in favor of capital gains, there should be a natural reluctance to pay dividends when value-adding opportunities exist.<\/p>\n

U.S. equity investors\u2019 are truly enriched (ask Warren Buffet) by placing capital into firms that produce goods and services which competitors, foreign and domestic, have difficulty challenging.\u00a0 The healthy enterprise requires creativity alongside of the capital\u2014if the bright minds and high achievers feel insecure, they will leave and go to the stronger outfit.<\/p>\n

Taking an undervalued company private and, by cost cutting, creating efficiencies up and down the supply chain, adding new markets and products, value-adding acquisitions, and then re-taking the firm public, is the superior alternative to both create value for the firm while rewarding shareholders.<\/p>\n

With the U.S. slowly losing the competitive international battle, it is difficult to make a case self dealing is the way out. Investors who applaud tax incentives aimed at enhancing productive capital and R&D should be at the forefront assailing these programs. Otherwise, what Congress gives, will easily be taken away. And long term, that isn\u2019t good for anyone.<\/p>\n

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