Letter number 39 of February 2009


News : NEWS: How much dividend to pay in 2009?

Before answering this question, which may be in many firms’ directors’ minds, let’s recall a few basic ideas in this area:

1/ Paying a dividend is not compulsory. By definition, and contrary to interests which have to be paid unless going bankrupt, the dividend is optional and no legal or contractual background can enable the shareholder to demand its payment. Some very healthy firms (like Google or Berkhire Hathaway) have never paid a dividend and others (like France Telecom in 2002 for example) re-established it after cancelling it at one moment in their past.

2/ Contrary to the wages, the payment of which enriches the employees, the payment of a dividend does not make the shareholders richer since the value of the share drops by the amount of the dividend. If this were any different, all firms would have started paying dividends long ago and poverty would have been eradicated from this world. When a firm pays a dividend to a shareholder, the latter merely gets a part of his wealth back in cash. Pretending that shareholders have to tighten theirbelts just because the employees do the same may be politically fair but economically untrue. When the first earns a living, the other turns a part of his wealth into cash. Let’s also not forget that the development of employee shareholding enables many employees of a group to be, at the same time, shareholders of that group

3/ Although paid from 2008 results, the dividend is fixed keeping in mind a forecast of 2009 results, which is very difficult to establish today. This is its signal aspect (1).

4/ The huge psychological dimension of the dividend explains why its amount is usually given much thought. Thus, Dow Chemical took the trouble to announce on January 27th that they were thinking of reducing their dividend for the first time since 1912, after 389 undeclining quarterly dividends!

5/ Lastly, from a financial point of view, it makes sense for a firm not to pay dividends so as to be able to finance investments with a return rate higher than the cost of the capital (considering the investments could only be financed by self-financing). When, in 1998, Telefonica announced that they would not pay dividends so as to be able to grasp the many investment opportunities created in Latin America by the economic crisis, its market price rose by 9% in a day. Who said shareholders were short-sighted?

This clarified, what to do?

First, stop buying-back shares since that destroys shareholder equity and increases the firms’ indebtedness. Most listed groups have already done so, either to be able to face the deadlines of their loans in those credit crunch times, or to be in a favorable position to make acquisitions made cheap by the share prices’ levels. The only groups that can go on with buying-back shares are healthy groups which are not significantly indebted and which have no available opportunities for an external growth. They will stand as exceptions and will contribute to put money back into the economy instead of hoarding it and investing it in Treasury bills with a 1% interest, which is certainly not what shareholders expect from managers.

Then, the answer differs according to the situations.

To us, it does not make sense for a firm in a sector which is relatively moderately hit by the economic slow-down (agribusiness, energy, consumer goods…), little indebted, with stable or growing profits, to cancel or drastically cut its dividend. This would only add confusion to a climate of anxiety.

As for firms in different situations, we think it is wise to reduce or plainly cancel the 2008 dividend to keep cash in order to be able to face loans deadlines, non-renewed credit lines, uncontrolled working capital, restructuring costs. This cash may also enable the firm to grasp opportunities of internal growth by seizing some market shares from weakened competitors. Some financially interesting opportunities for external growth may also soon show up if they have not yet (2).

As a matter of fact, it is in those times of economic crisis that the best investments are made by those who dare and can afford to. To illustrate that fact, we could name The Equitable acquisition by Axa in 1991, that of Citroen by Peugeot in 1976, … The same could be said, in the field of internal growth, of the fact, announced last month that Steven Spielberg was joining Disney after spending 30 years with Universal, the producer of his first movie.

For more on dividends and share buy-backs, see chapter 38 of Vernimmen
(1) For more details, see chapter 38 of Vernimmen
(2) See The Vernimmen.com Newsletter #38 dated January 2009

Statistics : Corporate default rates

Research : Do managers listen to the market?

Many researchers have sought to establish why, following the announcement of a merger or acquisition, the market frequently reacts negatively and the potential acquirer’s share price falls. There would seem to be no logical explanation for this as most operations announced are usually satisfactorily completed. 

Three researchers have looked at how managers take the market’s reaction into account at the time of a merger or an acquisition(1) and they ask whether managers actually “listen” to the market. There results do not produce any surprises and confirm most of the theoretical predictions on the subject.

The study looks at the biggest transactions announced by US listed companies between 1990 and 2003 (a total of around 4,000 operations). The authors focus on transactions that are announced and then cancelled (12% of the sample). They show that the share prices of firms that end up cancelling an acquisition under perform their benchmark index at the time of the announcement by 2%. For acquisitions that go ahead, the share price rises by 1.3%. This result confirms that managers take the market’s reaction into account when deciding whether or not to complete an announced transaction.  An analysis of statistics comes up with other data which is also rather interesting. The transactions the least frequently cancelled are transactions that are not hostile, that are initiated by the largest corporations and that are not paid in shares.  

The authors then looked at factors that encouraged managers to listen to the markets. According to agency theory, managers may be tempted to pursue their own interests rather than the interests of shareholders. M&A transactions in particular could result in an individual manager becoming head of a larger corporation, thus enhancing his or her prestige and possibly increasing the size of  management’s compensation packages. The study shows that if there is a majority shareholder, management will be encouraged to pay greater attention to market reaction. This is also the case with there is a strong link between management’s income and the performance of the stock market. The probability that management will listen to the market rises by 5% per standard deviation in management income / stock performance sensitivity. These two mechanisms do offer some protection against any opportunistic behaviour on the part of managers.

Nevertheless, the results obtained, although statistically meaningful, are of relatively limited scope. Certain predictions of agency models are not confirmed by the figures that come out of the study (for example, the fact that a close-knit board of directors exercises better control over the CEO).  Additionally, better corporate governance only leads to a slight increase in the amount of attention paid by management to the market. 

The question as to why managers pay so little attention to the market remains unanswered. Is it a result of opportunistic behaviour, management’s access to private information which is better than information to which the market has access, or is there some other reason? The authors suggest that is has more to do with management’s short-sightedness when coping with market reactions.  They suggest that management should announce M&A operations during quiet periods when there is nothing else happening, so that they are in a better position to read and take into account market reactions.  This will bring a smile to the face of anyone who's ever been involved in an M&A deal.

(1) J.B. Kau, J.S. Linck and P.H. Rubin (2008), Do managers listen to the market ?, Journal of Corporate Finance, n°14, p.347-362.

Q&A : How to account for negative goodwill?

Goodwill arises when one company buys another company at a price that is different from its share of the target’s book equity. Most of the time, this difference is positive and after being reduced by revaluations of the target’s assets and liabilities at market value if any, it is booked under non current assets on the buyer’s balance sheet. Each year its value is tested and if necessary depreciated(1) producing an impairment loss recorded on the income statement.

Due to the current market turmoil, a larger number of companies are being bought at prices below the book value of equity, resulting in negative goodwill.
Under IFRS, or US GAAP, negative goodwill is simply recognised as a profit on the income statement in the year of the acquisition.

From a financial point of view this is obviously not a recurring item and consequently should not be included in the EPS computation(2). 
For example, Barclays Plc, the British bank, announced that its net income for 2008 was grossed up by £ 2,406m of gains on acquisition (negative goodwill) of which £ 2,262m were gains on the acquisition of Lehman Brothers North American business and consequently also reported an economic profit (of £ 1,760m) without this one-off pure accounting item.
(1) For more on goodwill, see chapter 6 of the Vernimmen.
(2) For more on EPS computation, see chapter 28 of the Vernimmen.