By Alex Gavrish, Etalon Investment Research; author of “Wall Street Back To Basics

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Near the end of the year some companies announce special dividends. The practice of paying special dividends was common once. Firms that once regularly paid specials include such “blue chip” corporations as General Motors, Exxon, Gillette, Johnson & Johnson, Pfizer, and Boeing. The practice was predictable, just like regular dividends. Currently, special dividends are rare, and few companies pay them, However, investors can still find them. In recent years large special dividends were paid by such companies as OptionsXpress (brokerage company), Shanda Games (internet gaming), Limited Brands (clothing retail), Progressive Corp (insurance), and others. What is the right way to think about these events, and how one can profit from special dividend payments?

How To Profit From Special Dividends

Two types of special dividends

[drizzle]Special dividends can be divided into two types. First type is essentially an extra “bonus” distribution of cash to shareholders. For example, in a given year, company’s profitability could be above estimates and management can decide to make a one-time distribution to shareholders. Such payments are often done by companies that already pay a regular quarterly dividend and usually amount to less than 10% of company’s market capitalization. Stock market’s reaction to a special dividend is usually positive. Overall, these payments are a good sign. They signal to shareholders that company has the ability to return cash and is also willing to do so. The latter is not trivial at all when you consider the inherent conflicts of interest between management and shareholders. Such payments therefore should signal to investors that it is worthwhile to research the company further.

Second type of a special dividend is really an exceptional event and is less common than a “standard” special dividend. It can be very large, sometimes an amount that is more than 20% of company’s market capitalization. The reasons for such large cash distribution can be different. Company might sell an asset, for example, or it can decide to “recapitalize” itself by disbursing of a large cash holding on its balance sheet and even taking on debt. This second type of special dividend can also give rise to a range of scenarios with regards to the share price, and is often characterized by certain inefficiencies that can be exploited profitably by more active and aggressive type of investors. Lets see two examples of both types of dividends.

Standard special dividend

A good example of a “standard” type of payment is a recently announced special dividend by The Buckle Inc. The Buckle, Inc. is a leading retailer of medium to better–priced casual apparel, footwear, and accessories for fashion–conscious young men and women. The company currently operates over 450 stores in 44 states, under the names Buckle and The Buckle. On December 9, 2014, company announced that its board authorized a $2.77 per share special cash dividend, as well as a $0.23 per share quarterly dividend. Based on a recent closing share price of $53.13, regular quarterly dividend provides investors with a 1.73% annual dividend yield, while a special dividend provides a yield of 5.21%. Together, both dividends add up to a total annual dividend yield of 6.95%. Looking at the past few years, one can easily notice that payment of a special dividend is a standard practice for the company. Over the past five years company returned $16.91 to shareholders through regular and special dividends, the sum that represents an average annual yield of 6.3% (based on a recent share price). In addition to attractive dividend yield, the company is also valued reasonably cheap and trades at an EV/EBITDA multiple of x8.2 (based on results for fiscal year that ended February 1, 2014).

Exceptional special dividend

An example of an “exceptional” type of payment would be a recently announced special dividend by KLA-Tencor. KLA-Tencor Corporation is a leading provider of process control and yield management solutions, partners with customers around the world to develop state-of-the-art inspection and metrology technologies. These technologies serve the semiconductor, LED and other related nano-electronics industries. On October 23, 2014, company announced a plan for a leveraged recapitalization. Company will pay a special cash dividend of $16.5 per share, or a total of $2.75 billion. Based on a closing share price the day before the announcement, such dividend represented approximately 23% of company’s market capitalization. KLA-Tencor also increased its share repurchase program to $1.25 billion, which it plans to complete over the next 12 to 18 months. Combined with a special dividend, total capital that would be directed to stockholders would be $4 billion, or approximately 34.3% of company’s market capitalization.

Conclusion

Payment of a special dividend is usually a positive sign to company’s shareholders. By paying careful attention to the valuation of a company, investors can identify attractive investment targets. In addition, in case of a very large special dividend, more active and aggressive traders might be able to exploit the stock price inefficiency that surrounds the dividend payment event.

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