Dividend Policy at Fpl Group, Inc.

Problem Kate Stark, the electric utilities analyst at First Equity Securities Corporation was faced with a decision involving FPL Group on May 5, 1994. Three weeks earlier, she had valued FPL with a “hold” recommendation due to the belief that FPL would either keep its dividend payout at $2. 48 or increase it slightly. Today however, she saw a report from Merrill Lynch stating that they were downgrading FPL stock due to management’s concern that the dividend payout was too high given the increasing risks facing the industry.

This report caused Stark to reconsider his previous “hold” rating and she questioned if she would need to issue an updated report. Our problem was to determine if FPL is likely to change their current dividend policy and how such a dividend policy change would affect shareholders. From that analysis, we are to decide how Kate Stark should advise investors with regard to FPL stock. The Electric Utility Industry Evaluation The electric utilities industry consists of three stages: the generation, transmission, and distribution of electricity.

In the past, states had government agencies that regulated the prices and returns of utility companies. Due to several government Acts, the electric utilities industry became one with a large number of undiversified, intrastate companies operating under high federal and state government regulations. During the 1970’s and 1980’s, there began a rise of deregulation in many monopoly service industries, including the electric utility industry. By 1978, regulatory changes had started to break down electric utilities franchises as competition was introduced to the generation and transmission states.

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Deregulation of distribution, the final segment of the industry, was also starting at the onset of 1994. The state of California had proposed the addition of competition to the distribution of electricity when the California Public Utilities commission released a proposal to phase in retail wheeling beginning in 1996. The addition of retail wheeling allows customers to purchase electricity from other utilities than the local monopolies. Over time, all users would be given the option to pick their electricity supplier from a range of competitive bids.

The week after this proposal, the three largest utilities in California lost a combined $1. 8 billion of market value, an average 8% loss each. The recent deregulation and reshaping of the entire industry has forced FPL to consider the impact. Although Florida is not considering retail wheeling as of this point, utility commissions in 23 states are considering such proposals and the effect is expected to domino to the rest of the country, including Florida, in the near future. When retail wheeling becomes authorized in Florida, FPL will gain many potential competitors that previously didn’t supply to the South/East Florida area.

Florida has 4 major investor-owned utilities, 20 municipal and rural cooperative generating systems, 19 independent power producers, and several large investor-owned utilities of neighboring states that would all be competing for customers in Florida. FPL needs to be concerned of similar implications as those that occurred in California. It is expected that deregulation will decrease market share and therefore reduce profits since FPL will no longer gain the benefit of being a monopoly. FPL needs to make certain that they will be able to handle competition from both in state as well as out of state utilities.

As a result, it is possible that FPL may need to retain a larger amount of earnings than past years in order to prepare for the entry of competition into the industry. Cutting dividends would provide FPL with a significantly larger amount of retained earnings with which to adjust to the future industry challenges. Maintaining the high payout ratio may not be in FPL’s best interest if the challenges of reshaping the industry by retail wheeling are enacted in Florida. FPL Company Background FPL Group is the largest electric utility company in Florida and the fourth largest in the country.

As the population of Florida grew, FPL began to experience growth as a company as well. FPL continued to experience growth through 1970 when the rising cost of fuel, operating problems, and construction cost overruns began to reduce profitability. In an attempt to increase profitability and growth, FPL diversified itself by four major acquisitions. In an attempt to better improve operating issues, FPL started a quality control program employing 1,700 teams to examine every area of the company for ways to improve operations. Management was successful in mproving the operations of FPL as scheduled downtime decreased by 12% and customer complaints fell by 60%. By 1989, FPL was named as “one of the best-managed U. S. corporations” and given the Deming Prize for quality. Despite this improvement, FPL still experienced problems with safety concerns, growing demand which could soon exceed capacity, and low employee morale all as a result of focusing too highly on the quality improvement program. James Broadhead, who succeeded Marshall McDonald after his retirement in 1989, started restructuring the business and operations of FPL.

Broadhead’s long-term strategic plan was open to deregulation and full competition. He conducted an environmental scan that concluded FPL would need to have a commitment to quality and customer service, increase its focus on the utilities industry, expand capacity, and improve cost position. Broadhead scaled back the quality program and sold several of their non-utility businesses, as these areas were taking up too much time and effort of management, so that they could now focus on the core utility business. As a response to the expected increase in demand, FPL budgeted $6. billion dollars over the next 5 years for expansion. This included projects such as building new transmission lines, fixing up the oldest generating plant, improving the efficiency of all plants, and buying out a coal burning plant. By 1994, efficiency of operations and availability of resources had improved drastically. Broadhead also flattened the organization, reduced employees, and updated the budget in order improve profitability by cutting costs from 1. 82? to 1. 61? per kWh. By the beginning of 1994, Broadhead’s restructuring was looking like a success. 993 had been a record year for FPL and 1994 was expected to be even better as a result of decreasing costs (33% over the next five years) and increasing sales of 3. 4% each year, which exceeded the industry average of 2%. Financial Health of FPL When Broadhead took McDonald’s place as CEO of FPL in 1989 he made a lot of changes in FPL’s long-term plan. He sold many of FPL’s unprofitable subsidiaries and increased FPL’s capacity to fulfill the expected growth in demand. The effects of these changes in FPL are obvious in the ratio analysis.

We will be comparing FPL’s ratios to the financial ratios of Oklahoma G&E (OGE), another electric company. Liquidity Ratios The current ratio was used to observe the changes in FPL’s liquidity from 1989 to 1993 (page A-1). The current ratio started off strong in 1989 and 1990, however it decreased greatly in 1991, the year Broadhead sold some of FPL’s unprofitable subsidiaries. This is due to the fact that while its current assets decreased, FPL’s current liabilities increased by a greater margin due to a 697% increase in current maturities of long-term debt.

FPL’s current ratio barely surpassed 1 in 1992 and it faced a major decrease in 1993. FPL’s current ratio is greater than OGE’s current ratio in 1991 and 1992, however OGE’s current ratio increased in 1993 surpassing FPL’s current ratio. Debt Ratios. FPL is financed by a large amount of debt. Its debt-to-equity ratio decreased from 2. 1 in 1989 to 1. 81 in 1993 (page A-1). The debt-to-total-assets ratio is also slowly decreasing from . 67 in 1989 to . 64 in 1993. (page A-2). FPL’s debt ratios are very similar to OGE’s.

The largest difference occurs in 1991 with a difference of . 033, and this difference could be due to the extra amount of debt FPL generated that year. A quick analysis of these ratios proves that while FPL is financed by a large amount of debt, its debt is slowly decreasing. It may be, however, that FPL’s debt is decreasing at too slow of a rate to keep its dividends high. Coverage Ratios. A major problem facing FPL is its high interest expense. The interest coverage ratio shows how well FPL is able to pay its interest payments and FPL’s capacity to take on new debt.

FPL’s interest coverage ratio from 1989 to 1993 fluctuates from year to year, and the ratio is the highest in 1992 at 1. 77 and the lowest in 1990 at -. 068 (page A-2). This shows that it is very difficult for FPL to make interest payments and that FPL would not be able to take on new debt in the near future. OGE’s interest coverage ratio is greater than FPL’s interest ratio for all three years. This could signify that FPL’s debt, while similar in comparison to OGE, could have higher interest rates.

FPL’s financial ratios demonstrate that FPL has some problems that it needs to solve, the major problem being interest expense. Furthermore, while Broadhead’s plans are for the long-term, they are hurting FPL’s financial standing in the short-term. Cash Flow Analysis. FPL provides a statement of cash flows for the years 1989 to 1993 that shows the company’s cash inflows and outflows for each of the past five years (page A-3). The statement of cash flows is divided into three sections: operating, investing and financing activities.

FPL has experienced a net decrease in cash flow three of the past five years. This is due largely in part to FPL’s large amount of cash used in investing activities. Regardless of FPL’s net cash flow, its cash balance is always positive at year-end. FPL’s average cash balance at year-end for the past five years has been $127,330,000. This is a large cash balance and could be a sign that FPL is receiving too much of its cash from debt and can therefore decrease its borrowing. This can also be a sign that FPL can use more cash in its investing activities to improve their return on investment.

Future Outlook for FPL As the electric utility industry is experiencing reform, FPL’s competitive position and expected growth prospects in the future are important considerations. On the one hand, the industry would face an intense competitive environment as a result of the introduction of retail wheeling in Florida, which would require companies to invest more money into generating renewable and nontraditional energy, building new transmission systems, and building more plants to service customers. The addition of many competitors could be a threat to FPL’s current market share.

On the other hand, companies would also face great opportunities to expand their businesses. FPL is the largest electric utility in Florida and the fourth largest in the country. FPL’s service covers 27,650 square miles and contains a population of 6. 5 million people. The population in the area is expected to increase substantially in the following years, which will continue to improve FPL’s growth outlook. With the introduction of retail wheeling, FPL could gain the opportunity to provide power to a larger region of Florida and even into other states.

These reforms could give successful companies like FPL the opportunity to gain an even larger market share. When James Broadhead became the CEO of FPL, he developed a long-range strategic plan to focus on improving the utilities business. By 1994, operating efficiency had improved dramatically as nuclear plant availability had risen to 83%, compared to the industry average 70%, and fossil fuel plant availability had risen to 89%, compared to industry average 70%. At the same time, Broadhead also reversed FPL’s diversification program and reduced costs. Broadhead sold several of FPL’s non-utility businesses and lso focused on reducing administration costs by flatting the organization and reducing headcount by 30%. FPL had a good year in 1993 with a net income of $514, or $2. 75 per share. FPL was expected to have and even better year 1994 due to decreasing capital expenditures and increasing sales. FPL expenditures had totaled $5. 8 billion during the past five years, $800 million under budget. FPL was also expected to decline its expenditures by another 33% to $3. 9 billion over the next five years. FPL’s sales growth had exceeded the national average over the past five years (3. 4% annual growth versus 2. % industry average) and was expected to exceed the national average over the next five years as well (2. 7% versus 1. 8%). FPL was expected to grow 50% faster than the national average. This high level of expected growth compared to decreasing expenditures will give FPL a great competitive position in an industry about to experience the challenge of increased competition. As a result of the recent changes facing the industry in October of 1993, Standard and Poor’s Rating Group decided to change the way they rate investor-owned electric utilities by including an evaluation of competitive position.

They would consider factors such as prospects for customer and sales growth, revenue vulnerabilities and dependencies, rates by consumer class relative to competing utilities, adequacy of baseload and peaking capacity, fuel diversity, regulatory environment, and management’s financial goals. Based on an evaluation by S&P of these criteria, it was determined that FPL’s current position was rated well above the industry and was in the top 10% of all investor-owned utilities. This supports our conclusion that FPL has a strong competitive and business position.

Current Payout to FPL Shareholders As of late, the dividend payout ratio of FPL Group has been a primary focus of both investors and analysts. Historically, FPL had increased its dividend payout for the past 47 years, making it the longest running utility company and the third longest running publicly traded company to do so. Failure to increase the dividend payout ratio would end this streak. FPL has been increasing their dividends so greatly that they are growing even faster than earnings. The FPL Group’s current payout ratio is 91%, which was high or the industry with the average around 83. 65%. The fact that this payout ratio is at the high end of the industry, an industry already known for having high dividend payout ratios, is perceived as a sign of a healthy company. From a shareholder perspective, a dividend cut will most likely harm the value of FPL initially. It is possible that a number of FPL investors hold the stock because of the expectation of high dividend payouts. A cut would likely be viewed as a sign of poor financial health and would therefore drop the market price of FPL stock.

However, from an FPL perspective, this payout ratio is too high compared to the industry. FPL will need additional funds in order to be prepared for the changes facing the industry. The need to expand business operations and prepare for competition as a result of retail wheeling will make it very difficult to maintain the 91% payout ratio. By paying out a lower percentage, FPL could increase their potential growth opportunities and place the company ahead of the competition, which would ultimately improve the value of FPL for shareholders.

Dividend Policy The purpose of dividend payouts is to return wealth back to the company shareholders instead of using it for operations. Dividends provide investors with regular income from their investments and act as an incentive to continue or start investing in the company. The company’s share price will drop in relation to the dividend payout, because a company’s value has not risen, they are just allocating money differently. All dividends must be declared by the board of directors and are taxable as income to the recipients.

According to the Fundamentals of Financial Management textbook, a major aspect of a firm’s dividend policy is to determine the appropriate allocation of profits between dividend payments and additions to the firm’s retained earnings. There are arguments for and against paying dividends at all. Paying dividends leaves the company with less money to invest toward future growth and can therefore slow down expansion. Those in favor of not paying dividends say that the policy is irreverent because it does not technically matter how earnings are split between dividends and retained earnings.

There is no ultimate affect on the wealth of the shareholders. Another argument against dividends is that investors are able to create “homemade” dividends by selling some shares of stock to keep a regular income or by buying additional shares using the money received. Arguments for dividend payouts are that certain investors may prefer them to capital gains. Receiving money on a regular basis psychologically lowers the risk of investing to some people. Although capital gains are taxed at a lower percent then dividends, there are exceptions such as retirement and pension funds where no taxes are paid on either.

There is also a use for dividends as financial health signals. For example, if FPL Group, Inc has a steady dividend payout that suddenly increases, investors may think that there is a positive change in the expected profitability and will purchase additional shares, leading to an increase in its stock price. The opposite would be true if they cut a steadily paying dividend, resulting in a possible share price tumble due to nervous investors, even if FPL’s financial health remains strong. This information can be used to estimate the effect a cut to dividends would have on FPL shareholders.

Considering FLP has had traditionally high payouts for the electric utility industry and have been increasing dividends for forty-seven consecutive years, a dividend cut would be a large change in direction. Cuts were not historically common for utility companies except when financial trouble was stirring. Two examples have been given in the case: Consolidated Edison Company of New York, and Sierra Pacific Resources whose stock dropped by 23% and its shareholders sued. Investors at FPL could quite possibly see a cut as an indication of an increased financial risk, even if that is not the case.

If more investors leave or if they leave quicker than the new investors enter, this could lead to a temporarily depressed share price. In conclusion, from a shareholder point of view, continuing to increase dividends would be the best option, followed by holding them steady as next best. Alternatives The alternatives currently facing Kate Stark include: 1. Changing her recommendation to “sell”. 2. Changing her recommendation to “buy”. 3. Keeping her current recommendation of “hold”. Kate Stark may choose to lower her recommendation to sell because the stock price may continue to fall as talk of a dividend cut increases.

Investors holding the stock primarily because of the high dividend payouts may want to sell now. Once the decision to cut dividends is announced, the market price per share will drop. Selling now while the price has only started to drop could be the most profitable for investors not wishing to hold the stock if high dividends are not paid out. However, by selling now, shareholders are giving up their share of probable future gains. Investors could also decide to sell their shares now and then buy them again when the stock price is even lower to increase their gains.

This option would be very risky for shareholders however as it is unknown when or even if the stock price will fall to its lowest value. Stark may choose to change her recommendation to “buy”. The stock price has fallen by 6% during the past day already and it is not even a certainty that FPL will cut their dividends. As a result of positive future growth outlooks and a sound competitive position as discussed previously, we believe the stock price will increase again in the future so FPL stock offers many benefits to stockholders in the long run.

Buying now will give investors the opportunity to take advantage of probable increases in long-term wealth for a lower price. Stark could also decide to keep her previous recommendation of “hold”. Although the stock price may drop with news of a dividend cut, it would be unprofitable in the long term to sell because of the good growth prospects. Investors would miss out on possible gains by deciding to sell now. If FPL is able to raise their earnings, they could even maintain the high payout ratio by keeping the current $2. 48 dividend payout.

The financial strength and expected growth make this a possible situation despite the industry challenges that may occur. Holding the stock would allow investors to take advantage of these long-term gains. Conclusion and Recommendation Broadhead has greatly improved the efficiency of FPL’s operations, doing his best to cut costs and ensure growth prospects for the future. With competition at the core of his strategy, which is proving itself successful, Broadhead is developing FPL’s strong competitive position so they will be able to make the introduction of retail wheeling an opportunity instead of a threat.

Despite the challenges facing the changing industry, we expect FPL will continue to experience economic success and remain a healthy company. If FPL does decide to cut their dividends, we believe it would be to create additional retained earning so that FPL can reduce their debt position, better prepare for competition, and bring their payout ratio more in line with the industry average so it can continue to grow in the future- all of which will positively impact the value of FPL for shareholders. A dividend cut would therefore be in the best interest of the future growth of FPL, not because of financial problems.

However, dividend cuts are not common for utilities in sound financial health and shareholders usually respond negatively to a cut in dividends, so we do not think a dividend cut is at all a certainty. As a result of this analysis, we believe FPL could to be a good long-term investment. The problem is that we are unable to tell how much stock value would drop if dividends are cut, no matter what the reason for the cut. We would advise Kate Stark to keep her “hold” recommendation on FPL stock for these mentioned reasons.

FPL shows strong promise that they will continue to be profitable in the future, so investors would miss out on those long-term gains by selling now. Investors owning stock for long-term profitability reasons should hold because FPL will continue to experience growth in the future, especially since they have started preparing for competition now before it is even introduced. If investors are holding the stock because of the high payout ratio however, we would advise a sell recommendation for them because they may no longer receive the high dividends and we expect the stock price to drop even lower on an announcement of a dividend cut.

We would also recommend investors not yet owning shares of FPL to wait until FPL announces a dividend cut and then buy. This announcement would decrease FPL stock to its lowest price, which would be the best time to buy and therefore experience the greatest amount of gain.

Bibliography Van Horne, James C. , and John M. Wachowicz Jr. Fundamentals of Financial Management. 10th edition. NJ: Prentice-Hall, 1998. “OGE Annual Report 1993. ” OGE . N. p. , 03/29/1994. Web. 27 Nov 2010. .