The Exchange

Special Dividends Can’t Mask Ordinary Corporate Inefficiencies

The Exchange

The logic driving a spate of companies to declare special cash dividends ahead of a possible jump in dividend tax rates in 2013 is pretty clear, and the trend has been roundly welcomed by investors. The boards of these companies are being lauded for their attention to investors' tax exposure, and the chase is on for the next candidates for an extraordinary payout.

Yet less discussed is the fact that many of the companies kicking accumulated cash back to shareholders are, in effect, admitting they've been operating with inefficient balance sheets and paying unaccountably skimpy regular dividends up to this point.

Costco Wholesale Corp. (COST) Wednesday joined at least 68 other companies in the broad Russell 3000 index that have declared a special payout since September. The discount-warehouse chain set a $7 per share dividend to be paid in December, funded in part by a new bond issue. Other large companies set to distribute special dividends include Las Vegas Sands Corp. (LVS), Dillards Inc. (DDS) and Brown-Forman Corp. (BF-A, BF-B).

The Tax-Deadline Game

Many of the companies taking part in this tax-deadline cash-sharing game are controlled by families or other insider owners, whose interest in minimizing the tax bite on cash dividends is quite personal, aside from any consideration of the tax implications for other shareholders. The plausible threat of higher taxes certainly offers political cover for insider owners to harvest a pile of company cash without prompting the complaints of self-interest that might otherwise arise.

The very fact that these companies had stashes of cash sitting on the books that were apparently not needed to run the business, and not earmarked for future growth efforts, raises the question of why the boards weren't paying regular dividends at a higher rate all along, or at least buying back more stock. This underscores one way that family-steered public companies are often too conservative with capital structure and miserly with cash that rightly belongs to all investors.

More conceptually, these companies are implicitly telling individual shareholders that their cash can probably get a better return in, say, tax-shielded municipal bonds than by remaining invested in their business. A recipient of the special dividend cash of course has to solve the puzzle of how to redeploy it. Recycling it into other dividend-paying stocks exposes it again to tax hikes, corporate-bond interest usually triggers taxes at the income rate, cash yields nothing. So perhaps tax-shielded munis, yielding around 3%, stand in as the implied hurdle rate?

Costco, while not family controlled, has its co-founders on its board and is run — quite well, by the way — with a long-term, private-company mindset. Yet by most measures, its regular dividend rate of $1.10 a share is stingy, amounting to a 1.1% yield and around 25% of this year's expected earnings. Coscto, too, has arguably been under-leveraged. It has three times as much cash on its books as debt, ahead of the forthcoming debt offering.

Cash-Heavy Balance Sheets

Such cash-heavy balance sheets, while loved by bondholders, can indicate an inefficient capital structure that fails to deliver maximum benefit to equity owners. In this respect, Costco's decision to sell $2 billion worth of debt to partially fund its $3 billion special dividend could be a lasting positive for its shareholders, to the extent that the company maintains the new debt-to-capital mix.

To one degree or another, many of the other members of the special-dividend class of 2012 also run with lots of cash, have lower-than-average regular dividend payout ratios and perhaps carry too little debt. Academic research shows that the positive fundamental signals that are given off by generous regular dividends — carrying a message of financial health and confidence in future growth prospects — do not seem to apply to special dividends. A look at last year's class of special-dividend payers, which included The Limited Cos. (LTD), Verisign Inc. (VRSN) and Werner Enterprises Inc. (WERN), does not reveal any ongoing positive bias in their stock performance afterward.

Of course, this doesn't mean that extraordinary payouts in themselves foretell weak corporate results or poor future stock performance. But investors should consider whether the same traits that make a company a strong candidate for a special dividend — management's habit of allowing idle cash to pile up and inattention to maximizing shareholder returns through thoughtful capital allocation — make these stocks a less attractive buy-and-hold proposition once those dividend checks are cashed.

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