The Dividend
Yield Trap
Higher payouts aren't
enough over the
long term.
October 2004
By George W. Bilicic and Ian C. Connor
The past two years witnessed the ascendancy of dividend yield in the valuations of U.S. electric utilities. The recent primacy of yield in utility-industry valuations is the product of a unique confluence of factors. The collapse of most of the industry's non-regulated growth initiatives has resulted in a market that attributes little value to the industry's growth prospects beyond that which has been historically generated by the expansion of rate base-1 to 3 percent. To the degree that non-regulated growth is credited in the current market, such credit is principally limited to conservative, incremental strategies and even then such strategies are often discounted by the market.
The industry's low regulated growth profile, coupled with the absence of credible, broad-based non-regulated growth strategies, remains the most important strategic issue confronting the industry today.
Dividend Yield: Current and Long-Term
Valuation Considerations
The significant value implications to the industry of its persistent growth issue are masked by the market's current pursuit of yield, which has marginalized such considerations. Such an exaggerated bias toward yield, however, is episodic: a temporary displacement of fundamental considerations of value based on total return by current U.S. economic policies, principal among them being historically low interest rates and the 2003 dividend tax cut. The former phenomenon is a function of federal stimulus policies reflecting the broader economic uncertainties, which have proven unexpectedly trenchant. In an environment where the benchmark 10-year Treasury is yielding only 4.3 percent and the S&P 500 offers only equivocal returns, the bond-substitute properties of a regulated utility with a comparable or superior dividend yield present a compelling alternative to investors.
Such a low interest-rate environment, however, is not sustainable over the long term. As interest rates rise, the industry's yield proposition will diminish relative to government securities, compressing values (see Figure 1, p. 69). More importantly, with yield no longer being the principal investment proposition, investors will again begin to discriminate among utilities based upon fundamental considerations of long-term growth and, by extension, total return.
The 2003 Dividend Tax Cut: Dividend Policies Revisited
Of long-term significance to the U.S. electric utility industry are the value and financial policy implications of the 2003 dividend tax cut. At a minimum, the equalizing of the taxation of dividend yield and capital gain has enhanced the value proposition of the industry. On an absolute basis, the after-tax total return of an illustrative utility with an 8 percent total return comprised of 4 percent dividend yield and 4 percent long-term earnings growth improved from 5.8 percent to 6.8 percent, or 17 percent. On a relative basis, the impact is equally significant. For example, consider two utilities with the same nominal total returns of 8 percent: One utility's return is comprised of 3 percent dividend yield and 5 percent earnings growth; the other utility's return is comprised of 5 percent dividend yield and 3 percent earnings growth. Prior to the dividend tax cut, the higher growth utility's after-tax total return was 6.1 percent, while the higher yielding utility's was 5.6 percent, a 10 percent differential. After the dividend tax cut, each utility offers the same 6.8 percent after-tax total return.
Further, while on a nominal basis the returns of these two illustrative utilities are now the same on a pre- and after-tax basis, the higher dividend-yielding utility arguably offers the better investment proposition on a risk adjusted basis (assuming a sustainable dividend policy). In fact, adjusting for risk, utilities that offer total returns balanced heavily toward dividend yield theoretically may offer better returns than other investments with nominally higher returns but which are weighted significantly toward presumptively riskier non-regulated growth.
Thus, on a risk adjusted basis, a utility offering an 8 percent total return comprised of 5 percent yield and
3 percent growth may be a better return proposition than a utility or other investment opportunity offering a 10 percent total return comprised of 7 percent non-regulated growth and 3 percent yield. The 2003 tax cut accordingly represents a fundamental shift in traditional conceptions of utility total return and valuation that the industry must now consider in aligning their financial, investment, and capital policies.
Capital Structure Implications
The parameters of this realignment, while important, are not as significant as they might initially appear, however. Indeed, for most of the U.S. electric utility industry that already has a balanced, sustainable dividend policy with payout ratios and growth in line with their peers and the broader industry, there likely is little, if any, need for adjustment. Certainly utilities should avoid exaggerated, unsustainable payout policies to enhance yield to court higher valuations in response to short-term market valuation phenomena, such as the current historically low interest-rate environment.
Conversely, those utilities that have either regulated or non-regulated growth strategies that are viable and receive significant capital markets credit may not have any need for competitive dividend policies from a total return perspective. Nor, in most instances, do such utilities have the capital resources to fund the capital investment of such superior growth strategies as well as sustain dividend payout policies in line with those utilities with lower growth capital requirements.
Finally, in addition to the embedded 2008 sunset provision, current dividend tax policies are subject to political risk, either in the form of the 2004 political elections or fiscal pressure resulting from the United States' currently high deficits. Over-committing to dividend yield exposes a utility to potentially significant adverse consequences if current dividend taxation policies are reversed or amended; such political bets are not in the interests of utilities or their shareholders.
The utilities for which an adjustment of dividend policies is perhaps necessary are those that have traditionally, or recently, neglected yield. Such relative neglect of yield in favor of growth investment was to a significant degree an outgrowth of the unequal tax treatment of dividend versus capital gain income, which discouraged distributing cash directly to shareholders in the form of dividends. However, as noted above, available non-regulated investment opportunities have decreased, and along with them the claims such initiatives once made on utilities' cash flows. As a result, such utilities may still have attractive relative long-term growth rates of 4 to 5 percent based on some residual and viable non-regulated businesses, but their dividend yields are typically only in the range of 2 to 3 percent, resulting in deficient yield and total return propositions relative to their peers and the broader industry, particularly on a risk-adjusted basis. As a result, in the current market environment, such utilities may find themselves trading at a discount.
Catch-22
Such a valuation discount carries important implications for a utility's equity currency, cost-of-capital, and strategic leverage. In some respects, they are caught in a catch-22. Largely foreclosed from pursuing meaningful growth through non-regulated investment, their constrained dividend yield policies, initially conceived with the object of redirecting free cash flow toward such growth investment, now results in a trading discount, impairing the ability of such utilities to pursue the one viable, credible growth strategy that remains accessible to the broader industry: mergers and acquisitions.
Until recently, industry leaders Exelon and FPL were representative of this class of utilities described above. Each was characterized by above-average long-term growth rates, lower-than-average dividend payout, and significant free cash flow after dividends. And, most important, as a result of their low yield and lower total return, each correspondingly traded at a discount to its peers and the broader industry indexes.
Exelon provides a particularly instructive example in this regard. Exelon traded at a persistent discount to its peers and the broader industry since 2003 (and the enactment of the dividend tax cut). Conventional wisdom attributed this discount to its potential 2007 earnings cliff associated with the expiration of the CTC revenue collection. However, from a total return perspective, Exelon's 1.4x P/E-to-total-return ratio was in line with its peers and the broader industry. Notwithstanding its strong long-term earnings growth rate, its dividend yield based on a payout ratio of only 40 percent was 3.3 percent, approximately 15 percent below its peers. Exelon's resulting total return was 8.5 percent, a 9 percent discount to its peers' median of approximately 9.3 percent, or the same discount reflected in its forward P/E. Thus, irrespective of the market's current dividend yield bias in valuations, Exelon properly should have traded at a discount based on fundamental considerations of total return.
Perhaps recognizing this, Exelon, on July 28, 2004, rechanneled a portion of its significant free cash flow to announce that it was raising its dividend 11 percent, to $1.22 per share, and targeting a payout ratio in 2005 of 50 to 60 percent, in line with its peers and the industry. Since Exelon's announcement, its share price has increased approximately 12 percent, creating in excess of $2.7 billion in incremental equity value for its shareholders. Further, Exelon's trading discount to its peers and the broader industry has largely dissipated. Exelon currently trades at a 2005 P/E of 12.6x; a dividend yield of 4.4 percent (based on a 2005 payout ratio of 55 percent); and, based on a pro forma 2005 projected total return of 9.7 percent, a P/E-to-total return ratio of 1.3x.2 Each of these metrics is approximately in line with its peers. As importantly, Exelon's strategic leverage and flexibility to pursue growth also is improved.
A nearly identical set of circumstances and results occurred in respect to FPL and its recent dividend enhancement initiative. By bringing its dividend payout and yield in line with its peers and the broader industry, FPL also effectively addressed its equity discount in the market, and, thereby, improved its strategic leverage and flexibility.
The Long-Term Premium Determinant: Growth
Notwithstanding the current primacy of yield, once utilities properly calibrate their dividend policies to reflect the new return realities of the dividend tax cut and/or valuation drivers move away from yield as a result of changes in interest rates or otherwise, the long-term growth component of total return will re-emerge as a determinant factor in the industry's sustainable valuation levels and, most importantly, will dictate which utilities are able to command a premium valuation in the market. As noted above, unlike dividend yield deficiencies that (assuming sufficient cash flow generative capacities) can be addressed through the adjustment of financial policies, the avenues available to pursue long-term growth that surpass regulated return levels of 1 to 3 percent are limited. Further, it is almost certainly the case that the current average long-term growth rate for the U.S. electric industry of 4.6 percent is too optimistic.3 The industry's true long-term growth proposition is closer to 2 to 3 percent, and then only if the industry is able to successfully execute on cost-cutting initiatives. In this regard, it is worth noting that during the past 30 years the industry has achieved a compound average growth rate of only 1 percent.
With current trading multiples implying long-term growth rates for the industry of approximately 4.5 to 6 percent, this apparent growth expectations gap translates into significant potential value compression risk in the industry should the current market's dividend yield bias begin to abate and more balanced considerations of growth and total return re-emerge as appropriately weighted components of industry valuations. With the truncation of the industry's non-regulated growth strategies, there is only one strategy that credibly presents to the industry a broad-based, accessible means of generating meaningful growth to address this deficiency: mergers and acquisitions.
The Growth Proposition: Mergers & Acquisitions
The value proposition of merger and acquisition strategies is manifest. Cost savings and synergies, derived principally from non-fuel operations and management savings but also variously from the benefits of scale and the transfer of best practices, among others, form the core of the proposition. Such transactions also provide other, less quantifiable, but no less important, benefits, including diversification of market and regulatory risk as well as the financial scale and resources to address the likely future significant capital requirements of the industry and withstand material adverse operational and financial events.
Even those transactions that are retrospectively deemed unsuccessful were in fact generally able to realize significant synergy and cost saving benefits, often in excess of the targets set at each transaction's public announcement. Where such mergers and acquisitions generally foundered were either in the failure to achieve broader strategic objectives, such as convergence or other revenue-synergies-based strategies, or in simple regulatory or strategic miscalculation. And, while the broader strategic objectives may have proven illusory, the embedded value propositions of cost savings, synergies, and scale remain compelling.
However, the parameters of success in mergers and acquisitions, while manifest and meaningful, are exacting. As a result, such strategies require excellence of conception and execution. The strategic rationales of such transactions must be compelling and accessible to a skeptical investor base, particularly as compared with executing on other growth strategies or even the status quo. In this regard, the potential returns must be compelling enough to overcome ostensibly lower-risk means of enhancing shareholder returns, namely share repurchase initiatives.
Share Repurchase Initiatives: Comparative Return Proposition
The potential emergence of share repurchase initiatives signals and reinforces several important emerging trends in the U.S. utility industry. The first stems from the industry's successful and significant financial and operational retrenchment over the past several years. Industry credit quality has improved and continues to improve markedly (though it is still below pre-1990 levels) as cash flow and earnings increase and debt levels are reduced. The second relates to the limited non-regulated growth strategies available to the industry, which constrain capital investment outlets and create a free cash flow surplus for the industry. Current estimates forecast that the U.S. electric utility industry will generate more than $15 billion annually in free cash flow through 2010.5 European utilities face a similar projected cash situation, with E.ON alone projected to generate approximately $5 billion to $6 billion annually in free cash flow. As a result, merger and acquisitions strategies (as well as any other growth investment strategies) must compete with capital structure initiatives, such as share repurchase programs, as the most viable means to deliver superior returns and value to shareholders.
The financial proposition of share repurchase programs is relatively straightforward. Such strategies represent an alternative to dividends to distribute excess free cash flow to investors (though the historical tax efficiency component of share repurchase programs relative to dividends was effectively eliminated by the 2003 dividend tax cut). The share repurchase value proposition is effectively a financial mechanism to achieve earnings-per-share accretion by using a lower cost-of-capital (cash/debt) to buy-in a higher cost-of-capital (public market equity), effectively leveraging the capital structure (and inviting negative credit scrutiny) to increase equity returns.
However, while a share repurchase strategy is certainly advisable and beneficial in certain circumstances to enhance equity value, it is also limited and limiting in important respects. While accretive to earnings, such strategies do not alter the fundamental growth profile of a utility, nor do they create incremental enterprise value. Any EPS accretion is effectively "one time" in nature, limited to the duration of the program unless it is fixed and long-term in nature. And even these equity benefits are usually discounted in the market given the typically indicative, changeable parameters and soft commitments that characterize such initiatives, both in terms of timing and magnitude. It is not unusual for companies to announce their intentions to execute a share repurchase program only to later fail to follow through, or to do so at materially lower levels than initially indicated.
Nor are share repurchase programs immune from execution risk. As with any other investment, share repurchases can potentially destroy value to the degree that they are executed at inflated valuations. This is an important consideration for the utility industry in particular at present. As noted previously, the industry currently trades at premium valuation levels relative to historical parameters. Whereas the average one-year forward P/E for the industry during the past 20 years implies sustainable P/E levels of approximately 12.0x, the industry today is trading at a P/E of approximately 13.5-14.0x. (see Figure 2).6 An additional indicator that the industry may be fully valued at present is its relative P/E to that of the S&P 500. The industry historically has traded on a P/E basis at approximately 0.7x the S&P 500; currently, it is trading at approximately 0.9x, a 20 percent premium to historical levels.
As in the case of dividends, then, while share repurchase programs may be tactically or financially appropriate in certain circumstances to enhance total return and shareholder value, they are not typically viable or sustainable strategies to deliver long-term growth and shareholder value, particularly as compared with investment in growth initiatives or mergers and acquisitions. Certainly, with respect to merger and acquisition strategies, share repurchase programs do not capture the same incremental multi-dimensional benefits-most notably the compound strengths of enhanced scale, including cost-of-capital efficiencies, greater regulatory influence, and fuel,
geographic and operational diversity, among others.
The More Things Change...
Ultimately, though the collapse of non-regulated strategies as a solution to the industry's low growth characteristics and the 2003 dividend tax cut have altered the parameters of U.S. utilities in evaluating strategies to increase shareholder value, in many respects the fundamental issue confronting the industry remains unchanged: how to achieve superior long-term growth in an intrinsically low-growth industry. While utilities should continue to evaluate their financial policies and capital structures in respect of dividend yield and share repurchase policies, the answer to the industry's long-term growth issues continues to be the successful execution of merger and acquisition strategies.
George Bilicic heads the Global Power & Utilities Group of Lazard in New York, where he is a managing director. Ian Connor is a director in this group. Contact Bilicic at george.bilicic@
lazard.com and Connor at ian.connor@lazard.com.
Endnotes
- Recognizing that for certain institutional investors such relative tax considerations are immaterial.
- As of Sept. 3, 2004.
- Based on average long-term growth rate of component utilities in Lazard Core Utility Index.
- Source: Bernstein Research Report dated June 2004.
- Free cash flow defined as cash from operations less capital expenditures.
- Based on Lazard Core Utility Index.
- Neither of these historical benchmarks are adjusted for the potential impact of the dividend tax cut on industry values.
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