Dividend Policy at Florida Power and Light (FPL) Group, Inc. Presented by: Dominic A. Labitzky Electric Utility Industry • The concept of a public utility developed in the late 19th century to refer to a monopoly supplier of a vital public service. The public service in this case is the generation, transmission and distribution of electricity. • In exchange for the monopoly right to supply electricity, power companies agreed to let government agencies regulate their prices and returns. • In 1935 the Federal Power Act gave the Federal Power Commission the authority to oversee wholesale transactions (sales) of electricity to utilities rather than to consumers. • Congress also passed the Public Utilities Holding Company Act (PUHCA) which gave the Securities and Exchange Commission the authority to regulate the utilities with inter-state systems or substantial investments in assets not related to electricity. •Consequently, the industry evolved into a large number of intra-state, and relatively un-diversified, utility companies operating under extensive Federal and State regulation. Rise of Deregulation • In 1978 Congress passed The Utilities Regulatory Policies Act. The act required local utilities to buy all their electrical output. • Fourteen years later, Congress introduced competition into the second segment of the industry (transmission) with the passage of the National Energy Policy Act of 1992. This act made it possible for utilities to demand access to another utility’s transmission system. • Deregulation of the final segment of the industry (distribution) had begun in early 1994. This brought a proposal by the State of California to the table introducing the notion of retail wheeling. • Under retail wheeling, customers would be allowed to purchase power from utilities other than their local utility company. The local utility would be required to open it’s transmission and distribution network to outside utilities wishing to sell power to consumers in that market. • Over time, the other major customer segments, commercial users and eventually residential users would get the right to pick their electricity suppliers. Effects of Deregulation • As a result of retail wheeling initiative, California’s three largest utilities lost total of $1.8 billion in market value in one week. • 23 other states began to consider variations of the California retail wheeling proposal. • These proposal had a profound effect on the competitive landscape of the utilities industry. • As a result of the now competitive landscape, Standard and Poor’s rating group announced a revision of its guidelines for evaluating investor owned electric utilities. • Factors in the new guidelines included customer and sales growth prospects, revenue vulnerability and dependencies as well rates by consumer class relative to competing utilities among others. What does all this mean? • The rise of deregulation in an industry that historically has been highly regulated causes new competition in the industry. • As of a result of this new competition, companies must reevaluate their business strategies to accommodate this new competitive environment and remain successful. • A previously mature industry is now transforming into an industry with prospects for growth. • Analyst will begin to follow the S&P guidelines to evaluate firms in this industry. In order to maintain or increase their stock’s attractiveness electricity utilities will have to developed competitive advantages over their peers. Dividend Policy at FPL Group, Inc. • “On May 5th , Merrill Lynch downgraded FPL’s stock because of their expectations that the directors of FPL will choose not to raise the annual dividend from $2.48.” • “Management has suggested that if feels that the dividend payout ratio is inappropriately high (in excess of 90% in 1993) given the increasing risk in the industry.” Dividends and Growth • Traditionally, the environment experienced by public electricity utilities allowed them to pay their investors extraordinarily high dividends. Exhibit 9 lists the dividend payout ratios by industry for the first quarter of 1994. The average payout ratio for electricity utility companies at 79.85% is clearly significantly higher than any other industry. • As of 1993 FPL Group, Inc.’s dividend payout ratio was 91%. A level significantly higher than the average of its peers. • With deregulation giving rise to competition FPL Group, Inc. needs to focus its operations and begin to grow its business in order to survive. By retaining only 9% of its earnings, the firm would find it very difficult to grow quickly without the expensive acquisition of capital. The current dividend payout ratio is too high considering the challenges the company will face in a deregulated and competitive environment. Why do firms pay dividends? Advantages/ Disadvantages of Cash Dividends • A dividend is a payment made out of a firm’s earnings to its owners or stockholders. Firms pay dividends to satisfy their investors’ desire for current income. • A common type of dividend is a cash dividend, a cash payment made directly to investors from the firm’s earnings. • Cash dividends are more tangible to investors. $1 in dividends is only subject to tax. An investor incurs no transaction cost in receiving the dividend. • However, cash dividends are subject to personal income tax rates which in some cases can be higher than capital gains taxes. So, some investors will stand to benefit more from cash dividends than others. Also, cash dividends decrease the share price while dividends in the form of a stock repurchase preserves share value. A lower payout ratio is advantageous for FPL • It is clear that the current payout ratio of 91% is too high. For FPL Group, Inc. lowering the pay out ratio to a lower value would be more appropriate. The lower payout ratio would provide the firm with much needed capital in the form of retained earnings. Stay Tuned… • The firm could use this capital to expand and grow the company as well as improve the firm’s capital structure. As stated in the case, the debt rating of FPL has been upgraded. This should make their cost of debt decrease. FPL can now pay off their high cost debt and use the savings created by the lower dividend to obtain debt at a lower cost if they so choose. A lower payout ratio is advantageous for Investors • First we must consider who the FPL investor is! (as shown in table 10) Individuals 51.9% Institutions 36.9% ESOP 11.1% • Because individuals make up the majority of FPL’s investors, we will address their needs at the highest level. • It would be advantageous for individual investors to have FPL’s Dividend payout ratio at a lower level for the following reasons: – Tax advantages: 28% capital gains tax Vs. Up to 39.6% personal income tax – Possibility of stock repurchase plan in the future – Allows dividend payout ratio to grow in the future – Possibility for increase in stock price caused by higher growth rates Some calculations • IGR under current dividend payout (1993 data) Plowback Ratio = b = 1- Dividend Payout = 1 - .91 = .09 ROA = Net Income / Total Assets = $514 million / $13,078 million = .0393 or 3.93% => IGR = (ROA * b) / (1 – ROA * b) = (.0393 * .09) / (1 - .0393 * .09) = .0035 or .35% Obviously, the firm depends on outside sources of financing! • IGR under a lower dividend payout (1993 data) Our analysis and facts from case point to a reduced dividend payout ratio of around 65%. Plowback Ratio = b = 1- Dividend Payout = 1 - .65 = .35 ROA = Net Income / Total Assets = $514 million / $13,078 million = .0393 or 3.93% => IGR = (ROA * b) / (1 – ROA * b) = (.0393 * .35) / (1 - .0393 * .35) = .014 or 1.4% The firm depends on outside sources of financing but its ability to grow from with in is increased by 400%! How much cash does this actually translate into? A few more calculations • With net income of $514 million (1993) the current plowback ratio translates into $46.26 million of retained earnings. With a reduced dividend payout ratio leading to a higher plowback ratio the resulting increase to the firm’s retained earnings is roughly $134 million. NI = $514 million At a 9% plowback ratio: $514 million * 9% = $46.26 million At a 35% plowback ratio: $514 million * 35% = $179.90 million $179.90 million -$ 46.26 million _____________ $133.64 million => roughly $134 million Analyst perspective and recommendations • As analyst we would like to see a reduction in FPL’s dividend payout ratio. In this new competitive environment we feel that FPL would be better served with a lower dividend payout ratio because it makes no sense to have a high payout ratio in a growth industry. • Traditionally a cut in a companies dividends would indicate a problem with the financial position, causing a decline in stock price. However, in the case of FPL we feel that the company is coming from a position of strength which makes this perception irrelevant. • We do realize that initially the company could see a short term decline in stock price from a dividend cut however, we would expect the long term outlook of the company to be in a better competitive position giving way to growth and eventually a rise in the stock price. • Under the scenario where FPL cuts its dividends we would recommend a Buy rating. Since the Price of FPL has fallen by more than 6% we feel the stock is a good value at this time. The End That’s all Folks
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