The So-Called Problem with Dividends

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We own a lot of European-headquartered companies (mainly British and Swiss) and a lot of companies that pay dividends. In U.S. business schools, students learn that a portfolio like this is frowned upon for a few explicitly stated reasons and some that are more subtly implied.

The So-Called Problem with Dividends
Dividends are the most explicitly hated thing in business school. Since dividends are taxed twice, once as corporate profits and again at the level of the shareholder who receives them, students learn that paying dividends should be the last resort of any company. Students are taught that it is better for the company to find (profitable) projects to invest in, to buy other companies (mergers and acquisitions), and to buy back its own stock. All fine ideas in the academic world, but let’s look at what happens in the real world.

The most popular thing for a company to do with excess cash is to buy back its own stock. This is frequently touted as “just as good as a dividend” or better because you don’t have to pay tax on it. What could go wrong?

Apparently, a lot. A June 2012 study by Credit Suisse analyzed the $2.7T in stock buybacks by S&P 500 companies from 2004 to 2011. They found that only 61 percent actually made money; that is, the company bought back stock and the share price rose above the buyback price. Not too bad. But only 36 percent of companies actually managed annual returns of 7 percent or more to their shareholders with their buyback programs.

The problem is nicely illustrated by the graph below. The blue line is the value of the S&P 500 (INDEXSP:.INX), and the black bars are the value of the stock buybacks companies are doing each month.
(Source: Credit Suisse [red highlights mine])

As you can see, companies bought back the most shares when their share price was high. When the market collapsed in 2008/2009 and share prices were low, stock buybacks almost ceased. Companies did the exact opposite of what they should have done!

If companies aren’t buying back their own stock, they are usually buying other companies. Studies have shown this doesn’t work out any better. (In fact, it’s worse.)

A 1999 KPMG study found that “83 percent of mergers were unsuccessful in producing any business benefits regarding shareholder value.” A McKinsey & Company study (no date given) found that 61 percent of all acquisition programs were failures because the acquisition strategies did not earn a sufficient return on funds invested. Here are some other quotes about the dismal rate of success when it comes to mergers and acquisitions: “70 percent of mergers fail to achieve their anticipated value…” from Weekly Corporate Growth Report. “Most [mergers] fail to add shareholder value…“ from Harvard Management Update.

In the real world, letting company management spend shareholders’ hard-earned money on stock buybacks or acquiring other companies is wasteful.

Several clients have asked me why we are continuing to invest in stocks that pay dividends since taxes on dividends may go up. What I would change if I had a client in the highest income tax bracket (assume tax rates go up to the pre-Bush tax cut rate of 39.6 percent) and dividends were taxed as income? For every $1 in dividends being paid, such clients will receive only 60.4 cents.

That seems bad until you compare it to the alternatives. If the company spent its excess cash on share buybacks, then clients could expect to see only 36 to 61 cents, depending on how you interpret the share buyback study. It’s either a tie or a big win for dividends.

If we compare the higher potential tax bite to the company buying another company, then there is an even wider gulf between getting dividends and paying the taxes and the alternative. If the KPMG study holds true, shareholders would see only 17 cents in value! Even using the most optimistic studies that show merger and acquisition success rates of around 50 percent, dividends still carry the day.

So what would I change? Nothing. If top tax rates for dividends start approaching 70 to 80 percent, then it’s time to rethink our dividend strategy for high income clients. At 70 to 80 percent, taxes on dividends would be about equal to the failure rates for the alternatives (stock buybacks and acquisitions).

The So-Called Problem with European Companies
We own BAE Systems PLC (PINK:BAESY), British American Tobacco PLC (NYSEAMEX:BTI) (LON:BATS), BP plc (NYSE:BP) (LON:BP), GlaxoSmithKline plc (NYSE:GSK), Imperial Tobacco Group PLC (PINK:ITYBY) (LON:IMT), Nestle SA (ETR:NESR), Novartis AG (NYSE:NVS), Pearson PLC (NYSE:PSO), Philip Morris International Inc. (NYSE:PM), Roche, Royal Dutch Shell plc (NYSE:RDS.A) (NYSE:RDS.B), Unilever plc (NYSE:UL), and Vodafone Group Plc (NASDAQ:VOD). More than half the holdings in our dividend portfolio are European-headquartered companies.

In my experience, schools subtly imply that U.S. based or American run firms are the archetype of capitalism. Europe is usually implied to be a suboptimal place to invest. It’s communicated (again subtly) as being a continent full of lazy employees unfit for investment. In addition, there are too many rules regarding the hiring and firing of workers and too much vacation time, unions are too strong, and the continent’s workers are coddled by socialist governments. (After all, we all know things like education, healthcare, and robust public infrastructure make for a sickly, untrained workforce and a poor environment for commerce.) Again, some of this is explicitly stated and some is not.

American companies represent the epitome of capitalism, and their CEOs are hardworking, entrepreneurial geniuses, which we are lucky to have running our companies because few people can do as good a job as this elite cadre.

In fact, one of my most vivid memories from business school was a class discussion regarding ever-rising CEO pay. I had been devouring books on Warren Buffett at the time and knew that he paid his managers and executives below market wages, but his companies were still well run and very profitable. I suggested in the class discussion that paying CEOs less money wouldn’t be a problem, because there would be a lot of capable, competent people willing to do the job for $1M instead of $10M and doing so might even be better because you might getting people who care about the company rather than just looking for a huge payday. The professor just laughed at my suggestion. The rest of the class wasn’t too impressed by my line of thinking either. The class continued on its merry way discussing why CEOs deserved their outrageous pay. (No doubt many in the class thought of themselves as future executives.)

Luckily for me I have never been particularly concerned about what everyone else thinks. I went on my merry way believing that the rest of the class and the professor just didn’t get it. I still think they don’t get it, and here’s why.

Here is a graphic from the Washington Post showing the rise in CEO compensation versus the rise in the S&P 500 (INDEXSP:.INX).

(Source: graphic from the Washington Post)

CEO pay has skyrocketed by 726.7 percent from 1978 to 2011 while the S&P 500 (INDEXSP:.INX) gained only 349.1 percent. What did shareholders get for management taking an increasingly larger amount of their profits? Nothing but a big lump of coal. As an aside, it was a nicer and purer quality lump of coal than the average worker got; they saw only a 5.7 percent increase in pay. This is part of the reason the economy is doing so poorly; companies literally are not paying workers enough to be able to purchase all of the goods and services they are capable of producing. Most of the profit is accruing to shareholders and management rather than being recycled into worker pay. In the long run, this trend is unsustainable.

But I digress. The following chart from The Economist shows executive pay at European companies compared to American ones. Executives in Europe are looting companies to a far lesser degree than in America.

European companies also tend to do a better job linking pay to actual business performance. The Economist article states, “European companies appear to be more determined than American ones to link pay to performance. ‘Firms in Europe have tended to put more stringent conditions on long-term incentive awards than in America,’ says Richard Bednarek, global director of executive remuneration for Hay Group. In America grants of shares are often not tied to performance, whereas European firms generally attach performance criteria to any grant of shares, typically depending on a comparison with a peer group. Such schemes often do not pay out at all, says Mr Bednarek.”

The article also gives an example of the CEO of Novartis AG (NYSE:NVS) getting paid 33 percent less in 2007 than in 2006 for missing performance targets.

Many European countries are also pursuing, or at least considering pursuing, regulations that are much more shareholder friendly. For instance, this article ( talks about a recent push in the UK for shareholders to have a binding vote on executive pay at least every three years. Imagine that! Laws that allow the owners of the companies to dictate how they are run!

While the company paying out $10M or $20M less to the CEO might not amount to a significant amount when the savings is divided up among shareholders, I strongly believe that the attitude set at the top of a company filters down through everything. If everyone sees that management treats the company as if it was a piggybank and can be looted for their own personal benefit, then what else is happening in the lower ranks that we don’t know about?

The thing I like most about European companies is that management and shareholders tend to focus on long-term, not short-term, value. Most European companies report results twice per year (final and interim or half year results) not each quarter as they do here in America. Reporting results quarterly has created an obsession between analysts trying to correctly forecast quarterly earnings and management trying to meet those unrealistic and frankly stupid expectations (businesses are managed over multi year periods, not quarter to quarter).

Short term-ism is rampant. The average holding period for a stock has tumbled from eight years in 1960 to four months in 2010. Four months. Imagine owning a company for four months. The NFL season is shorter (barely, I’ll admit it) than four months! The time it takes to earn the degree (an MBA) that supposedly qualifies you to run these companies takes longer than four months!

All of the short-term-ism can’t help but affect even the most well-meaning management. For example, one study (referenced in this Economist article) showed that publicly listed companies invest only 4 percent of their total assets for future projects compared to 10 percent for comparable privately held companies. Another study showed that 80 percent of managers are willing to reduce spending on R&D (here’s looking at you Mark Hurd, ex-CEO of HP) and advertising to hit quarterly numbers. Indeed, the iconic Jack Welch was notorious for doing everything and anything (and not all of it aboveboard) to insure GE made its quarterly numbers.

Instead, we like management such as Paul Polman, CEO of Unilever plc (NYSE:UL). Polman had Unilever stop publishing full financial results each quarter, he does not offer earnings guidance to analysts, and he has tried to attract long-term investors to the company. Plus, he has spoken out against the short-term greed culture of Wall Street.

In addition to creating perverse incentives of short-term thinking and neglecting long-term investment, the Wall Street culture of “everything now” also sucks up management’s time. A recent Wall Street Journal article mentioned several executives of public companies that spend 20 to 30 percent of their time meeting with Wall Street analysts.

It’s not that we like companies because they are European and we dislike American companies. It’s just that there tend to be more companies with the characteristics that we like in Europe than there are in America.

This is also not to say we will always buy these types of companies. After all, we own Viacom, which set a record for executive largesse last year when it came to pay packages. What can you do if the stock is so cheap and the company so attractive that you just have to buy it? Join an Occupy Wall Street protest for a few days, so you feel good about yourself and then buy the stock, I guess? (I don’t have any particular interest in being pepper sprayed or tased, so we just bought the stock and skipped the demonstration.)

Of course, not all companies butcher their acquisitions either, so we will discuss one that has done a good job in the next segment.

All the best,

Mystery Technology Company

I’m going to describe a company, show you the financials, and go through a valuation and you can tell me if you agree with the assessment about how much the company is worth. And if it deserves a place in our portfolio.

This company sells end-to-end computing solutions including servers, networking appliances, storage solutions, services, and software. This company does not sell desktop PCs, notebooks, or tablets. It does not compete with Apple Inc. (NASDAQ:AAPL), Samsung Electronics Co., Ltd. (LON:BC94), or Lenovo Group Limited (PINK:LNVGY). The target markets for the company’s products are small and medium size business but it also sells to large enterprises and public government customers. It can be thought of as the International Business Machines Corp. (NYSE:IBM), albeit with less cutting edge technology and innovation, for small and medium businesses. So far I think the company sounds interesting. If it was trading cheaply it might make a good buy.

Here is the trailing twelve month income statement for the company (all numbers are in millions)
Revenue:                                                                            $19,032.36
Cost of goods sold:                                                             $12,471.91
Gross profit:                                                                         $6,560.45
Gross margin:                                                                           34%
Operating expenses (SG&A and R&D):                               $3,045.18
Operating margin:                                                                    16%
Operating income:                                                              $3,515.28
Provision for income taxes:                                                  $562.44
Income tax rate:                                                                       16%
Net income:                                                                       $2,952.83

Now here is the tricky part. This company, like many tech companies, likes to buy other companies. It generally does this in lieu of lots of R&D spending. Unlike most companies this one is actually very successful at acquiring other companies and integrating their products and services. Management also has shown discipline and has walked away from deals when they got too expensive.
It would make sense to figure that some of the net income the company earned will need to be spent on future acquisitions or R&D to keep the company functioning. I choose $1B per year as the figure. That is roughly what the company spends in house on R&D now. So we are basically doubling R&D spending (except without the tax benefits).

So now we adjust net income as follows:
Net income:                                                                       $2,952.83
Adjustment for acquisitions in lieu of R&D:                        $1,000.00
Adjusted net income:                                                        $1,952.8

So here is how the company stacks up to International Business Machines Corp. (NYSE:IBM) so far. IBM has gross margins of 46.7% over the last twelve months versus our company’s 34%. IBM had a net profit margin of 15.5% versus 10.3% for our company (with the adjusted cost structure). Like I said it’s basically the poor man’s IBM. Maybe as the company grows the margins could improve? But let’s not count on it. So how much would you pay for this company?

Well IBM trades at about 14 times earnings. Warren Buffet recently bought a large stake in IBM making it one of his top holdings. IBM has fallen in price since then. I think it’s safe to say IBM is probably undervalued.

So, IBM probably trades for cheaper than it should at 14 times earnings but our company isn’t as good as IBM so 14 times earnings sounds about right. Our company is growing but faces a challenging macro environment and probably doesn’t have an economic moat as big as IBM.

At 14 times earnings our company would be worth $27.34B. Our company also has net cash of $5.15B on the balance sheet. This is cash, short term investments, and long term investments less any short and long term debt. Add the two together and our company is worth $32.49B.

Right now (the price has gone up slightly since I wrote this article) you can buy this company for $15.52B, more than 50% off! Mr. Market is having a Black Friday sale on this company.

Did you guess the name of company yet?

Well I kind of lied in the first part of the article. You can’t buy just this company. It comes attached to another company. A really crappy company. This other company makes desktop PCs, notebooks, tablets, printers, monitors, etc. It competes against every other PC company out there. The competition is brutal and PC sales are falling. It is lucky to squeeze out a few percentage points of profit from the $39.6B in sales it did over the last twelve months. Now do you know the name of the company?

It’s Dell Inc.

The first company I told you about is the result of a half decades long (and continuing) process to move Dell Inc. (NASDAQ:DELL) away from a commodity PC manufacturer. The first company includes Dell’s Servers, Networking, Dell Inc. (NASDAQ:DELL) owned IP Storage, and Services businesses. It is the revenue and profit those business units are generating right now, this year. Just valuing Dell on those business units gets you the $32.49B figure. The PC business may be worthless, or it may not be. Who knows, and at this stock price who cares. In our valuation we assigned it a value of zero. We are interested in only buying the IBM-like portion of Dell. Why is the stock cheap and getting cheaper? I don’t know for sure but I have a few guesses.

First, Wall Street prizes top line revenue growth above all else. I guess on the assumption that someday somehow a company will figure out how to turn all that revenue in to profits. Green Mountain Coffee Roasters Inc. (NASDAQ:GMCR),, inc. (NYSE:CRM), 3D Systems Corporation (NYSE:DDD), they all are or were Wall Street darlings with huge revenue growth that generated almost zero cash for shareholders. The stocks of course eventually or will eventually collapse.

Also, imagine telling your clients or investors you own Dell. They’d laugh in your face. Mine didn’t, because, thankfully, they are polite. But whenever I publish articles or tweet about Dell Inc. (NASDAQ:DELL) other anonymous denizens of the internet do. Don’t I know the PC is dead. Tablets are the future. Sales at Dell are falling. Apple will eat Dell’s lunch. The message was always clear Dell is a PC company and it is dying and I am a moron for buying it.

They are right, Dell the PC company is and has been dying for the past few years. But that’s not Dell. Dell is an end to end solutions provider focusing on small and medium businesses. Save for the current macro headwinds that business is doing fine.

So, would you buy the mini me version of IBM at these prices? Even though it comes with a tumor (the PC business)? It looks like a good deal to me.

For those that are curious below is the explanation for how I composed the income statement for the “good” part of Dell.
Dell discloses revenue for each line of business so the revenue computation was straightforward. Dell has also stated on numerous occasions that the good business account for “over 50% of gross margin”. So I took 51% of Dell’s total gross profit and computed the gross margins for the good businesses. I then grafted on the existing operating cost structure. Since Dell mixes lines of business in each reporting segment I believe the operating cost structure for the good business should be roughly the same as the non consumer PC business. I used the current tax rate to compute income taxes. The rest of the calculations are straight forward and/or explained in the article.

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