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How to Increase Dividends When Sales, Earnings Are Stagnating

November 16, 2012 | About:
Chandan Dubey

Chandan Dubey

99 followers
Here is a poser. How does a company with stagnant sales and earnings increase its dividend?

The solution in short is: share repurchase.

I am not as bullish as the next guy about share repurchases (see The Case against Share Buybacks). The reason is that the management, on average, is very bad at timing share repurchases. They end up buying at quite lofty prices and sometimes they need to dilute shareholders near the bottom. The banking stocks during 2002 to 2009 were a very good example of this apparently stupid way of rewarding shareholders (also GE). Other times, there are ulterior motives behind repurchases like a) supporting the share price b) making the ratios look prettier c) hiding dilution due to share/option rewards to the management d) and infrequently, it is the fashionable thing to do.

Another gripe I have is that no company mentions the price at which they are willing to buy their shares. When Buffett announced his repurchase plans he clearly stated that he is going to buy Berkshire stock up to 110% of the book value. This lack of an upper bound is sorely missing from many of the share repurchase announcements. There needs to be a significant shift in the mentality of the management. They need to buy shares opportunistically, even when they have cash in their buyback program. I mean, if they don’t want to buy it for their own account, why are they buying it for the company account on behalf of the shareholders?

On the positive side, share repurchases do make sense. Especially for a company which sees itself as a dividend growth investment. I want to talk about such a situation here by taking an idealized example.

Let us imagine a company which has stagnant sales and stagnant income. Preferably, it has a few well-known brands and it does not need to spend too much money to maintain its current business. The company has no growth opportunities and it is smart enough not to get into un-related business to increase sales.

How is the company going to reward its shareholders with increasing dividends in such a scenario?

Let us make the situation a bit more concrete. The company trades at a price-to-earning ratio of 10 and the dividend yield is 5%. Furthermore, the company has low capex and it represents 25% of the earnings. For simplicity, assume that the company has 100 shares and each one of its shares trade at $100. Also, assume that there is no inflation affecting sales, earning or capex.

YearShare price#SharesEarningCap-ExBuybackDividend/Share
One$100100$1,000$250$250$5
Two$10097.5$1,000$250$250$5.12
Three$10095$1,000$250$250$5.26
Four$10092.5$1,000$250$250$5.4
Five$10090$1,000$250$250$5.55


In a previous article (Oblivious Dividend Growth Investing), I discussed that dividend growth investors need to realize that their company has to increase sales and earnings by a significant amount to keep increasing their dividends. The only other way is to buy back shares.

About the author:

Chandan Dubey
I invest because I want to be free by the time I reach 40 years of age i.e., 2025. My investment style is to find a small number of bets with large margins of safety. I pay a lot of attention to management and their incentive. Ideally, I like to buy owner operator businesses. I am fortunate to have a strong inclination towards studying. I aid my financial understanding by extensive reading in psychology, economic, social sciences etc.

Rating: 3.9/5 (17 votes)

Comments

traderatwork
Traderatwork - 2 years ago
IMHO, most of the time, share repurchase are not so good for shareholder because the CEO or the board of directors do not know their company intrinsic value. Allocate capital is not easy and we do not have enough of Buffett or Munger so it end up dividend even though it's not really efficient became the better choice for the shareholder.
cdubey
Cdubey - 2 years ago
@Traderatwork: In some cases, buybacks even if done blindly are helpful. Some of these companies are Coco-Cola, McDonalds, National Grid etc. Maybe buying back shares when yield is higher than 5-6% and you have cash is a good rule of thumb for a dividend paying stock.

Sadly, managements around the world dupe themselves into believing that they have a great company at their hands. If we are looking at the overall health of the shareholder finances, banning buybacks would be a great idea.
cdubey
Cdubey - 2 years ago
By the way, the last claim about "banning buybacks" I only have empirical evidence. To "prove" it one will need to do an overall analysis on buybacks. I do not have sufficient data to pull that off.
batbeer2
Batbeer2 premium member - 2 years ago
>> The reason is that the management, on average, is very bad at timing share repurchases. They end up buying at quite lofty prices and sometimes they need to dilute shareholders near the bottom.

I can agree with half of that. Overdosing on debt and diluting shareholders at the bottom is not good but trying to buy shares from shareholders as cheap as possible is certainly NOT the job of the CEO.

Criticizing management for failing to do something they shouldn't be doing in the first place makes no sense. In fact, there's something to be said for allowing shareholders to cash out at the top isn't there?

Think about it, three guys own a business and the guy managing the business (not an owner) is trying to cheat one of them out of his stake... what would you think of that?

In short, buying back shares is good unless:

A) The company overdoses on debt to do it or

B) Management does it just to offset a mountain of options they are being granted.

Just random thoughts.

cdubey
Cdubey - 2 years ago
@Batbeer2: I see your point. In an ideal world the management will end up paying the correct price and no-one will feel cheated.

But if the guy managing the business overpays for the stake of the third guy then the second guy loses. If the management rewards the people who are cashing out by paying lofty prices then the people who are sticking with the company are losing money.

In most cases, management does not own a lot of company stock. If they keep overpaying to the people who are cashing out, the people who stay are the losers.

The question is: do you award a premium to the people who are cashing out or the people who are loyal to the company ?

Furthermore, there is no coercion here. The management is not cheating the people who are selling the shares. If you are willing to sell the shares to me at a much smaller price then they are worth, why is that cheating ? You are being punished for your stupidity.

Putting out a press release will in my opinion save us from the pang of moral quandary you feel. Every buyback release should say that the management will buy shares if they sell within a specified range. I point out the example given by Warren Buffett in case of Berkshire buybacks.

zepolinvestmentslp
Zepolinvestmentslp - 2 years ago
Share buybacks at discounted prices are clearly preferable to dividends. The qualifying factor here is the price. If the company buys back undervalued stock, selling shareholders suffer while long-term shareholders benefit. If the company buys its stock at inflated prices, sellers benefit and long-term holders lose out. Value investors, having a long-term orientation, generally look for companies that consistently repurchase their stocks during periods of undervaluation.

Management must decide when to return cash to shareholders and when to invest it. Earnings intelligently invested will generate higher future levels of free cash flow. On the other hand, poorly invested earnings destroy value. Warren Buffett has been an undisputed genius of capital allocation for over 50 years, and no one minds that his Berkshire Hathaway does not pay a dividend. On the other hand, some managements, especially those in struggling industries, would benefit their investors by returning capital to them rather than reinvesting in the business at low rates of return.

Identifying a company with a big cash stash and the ability to generate more is a great start. But the cash doesn’t do the shareholder any good unless management makes smart investments with it, or returns it to its owners via dividends or share buybacks. Management talent and intentions are crucial.

batbeer2
Batbeer2 premium member - 2 years ago
>> The question is: do you award a premium to the people who are cashing out or the people who are loyal to the company ?

Ehm.... no. That shouldn't be the question. Management can and should treat both equitably. If memory serves, Buffett once wrote management has a responsibility to promote a fair market for shareholders wishing to sell.

How are you going to distinguish between those that need the cash in retirement and those that are dumping their shares because Cramer says its a short?

In fact, do you really want to own shares of a company with management who feel you are somehow less worthy of their efforts if and when you want/need to sell? Would such an attitude make your shares worth more or less?

BTW, thanks for another article worth reading.
cdubey
Cdubey - 2 years ago
>> [color=#333333; font-size: 11.818181991577148px; line-height: 17.999998092651367px]If memory serves, Buffett once wrote management has a responsibility to promote a fair market for shareholders wishing to sell. [/color]

I completely agree with that sentiment. But I was contesting the following assertion in your previous comment. [color=#333333; font-size: 11.818181991577148px; line-height: 17.999998092651367px]

>>>>[/color] [color=#0080ff; font-size: 11.818181991577148px] [/color] [color=#333333; font-size: 11.818181991577148px; line-height: 17.999998092651367px]trying to buy shares from shareholders as cheap as possible is certainly NOT the job of the CEO.[/color]

[color=#333333; font-size: 11.818181991577148px; line-height: 17.999998092651367px]

I agree with this too. But the management needs to draw a line. In every buyback announcement the management should say something of this effect:

We are going to buy up to $1 billion worth of shares if they trade below 10xFCF.

OR

We are going to buy $1 billion worth of shares if they trade above a dividend yield of 5%.

Or something of that sort.

Buying without caring for the price is ridiculous. You would agree that the market is fickle and your shares may trade without any connection to the value of the stock. I find it very painful that the management of such companies still buy shares at these inflated prices.[/color] >> How are you going to distinguish between those that need the cash in retirement and those that are dumping their shares because Cramer says its a short?

You can not. But you do not need to. The management only buys the stock when they think it is undervalued to mildly overvalued.

>> In fact, do you really want to own shares of a company with management who feel you are somehow less worthy of their efforts if and when you want/need to sell? Would such an attitude make your shares worth more or less?


Again, no. The management is buying back shares on the open market. There is no question of being worthy or unworthy. The shareholder has to decide if they want to sell at the price they are quoted. If no-one sells then the price will go up. If it goes up above the mildly overvalued region then the management should not buy shares.

The amount of money managements pay for buying back shares is simply ridiculous. Look at HP, CSCO, GE, ISRG ... and endless others. There is no reason for Amazon to buyback its shares at such prices, is there ?

batbeer2
Batbeer2 premium member - 2 years ago
>> In every buyback announcement the management should say something of this effect:

We are going to buy up to $1 billion worth of shares if they trade below 10xFCF.

OR

We are going to buy $1 billion worth of shares if they trade above a dividend yield of 5%


Yes

>> There is no reason for Amazon to buyback its shares at such prices, is there ?

Why not? If they have cash to spare and the CEO is not Buffett, Watsa or Ian Cumming, they MUST return it to shareholders. A dividend is fine but IMHO, buybacks are better (tax).

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