Tech-Stock Dividend Hoopla Deserves Closer Examination
By KEN BROWN and JESSE EISINGER
Staff Reporters of THE WALL STREET JOURNAL
When Oracle Corp. Chief Financial Officer Jeffrey O. Henley hinted that his company might start paying a dividend if President Bush's tax-cut plan took effect, investors sent the tech company's shares up 6.1% that day. It was almost as if investors were back in the giddy 1990s.
Mr. Henley's statement fulfilled the wildest dreams of tech investors -- that their beloved non-dividend-paying companies would somehow benefit from a dividend tax cut because these companies could, someday, start sharing some of their vaunted profitability with shareholders. Given that these same investors always seem to see a future paved with gold, it made sense to them to bid Oracle's shares higher right now, even before the tax plan was approved, much less before any dividends were raised.
There are several problems with the hoopla surrounding many companies that investors believe could pay real dividends. Many of them can't, because they throw off so little extra cash. Others won't want to because they are hooked on giving employees options instead, and paying dividends would make that more expensive. And if the ones that could afford it actually did pay out dividends, the dividend yield would be so paltry that it would reveal many of the stocks as still overvalued.
The average technology company hardly resembles the big free-cash-flow generating machines named Oracle, Microsoft Corp. and Cisco Systems Inc. They generate far less cash and are more cyclical, meaning when times get tough, their cash flows shrink considerably. That is one reason tech companies have a dividend yield of 0.28%, the lowest of any sector in the Standard & Poor's 500-stock index, which overall has a yield of 1.75%.
Of the 91 tech companies in the S&P 500, only 23 pay a dividend. The next lowest-yielding sector is consumer discretionary-goods makers, another cyclical sector, including auto manufacturers, which yields 0.91%. Health-care companies, which have high research-and-development costs just like tech companies, yield 1.48%.
If tech companies suddenly gave up their bedrock belief that they need to reinvest all their cash into their business to keep up with the frantic pace of innovation that characterizes the industry, and decided to pay out their cash, the yield wouldn't get anyone too excited. Take the 66 tech companies in the S&P 500 that generated free cash flow in the past 12 months and assume they pay out half of that as dividends. What happens to the yield for tech companies in the index? It rises to just 0.58%. Free cash flow is generally defined as cash from operations less capital expenditures and dividends, if any.
Over the past three years, tech stocks have been steadily losing value as myths about technology companies' ability to grow and their invulnerability to downturns have been debunked. But since many large tech companies, such as Microsoft, Cisco, Oracle, Dell Computer Corp. and Intel Corp. are sitting on huge cash hoards, investors have persisted in believing that somehow technology businesses have superprofitable characteristics. The dividend debate could deal a blow to this belief.
"What is the right value for these companies? If these companies are forced to pay dividends, you might see the market focus on the true economic power of these businesses," says Tom Doyle, of Victoria Partners, a Ramsey, N.J., private investment partnership.
The situation for tech companies is made more precarious by their addiction to stock options. Many tech companies use their available cash to buy back shares to offset the dilution caused when their employees exercise their options. If companies instead pay out their cash in the form of dividends, then their shares outstanding will continually rise, which means their earnings per share will suffer -- even as a dividend soaks up ever more cash.
To make matters worse, paying a dividend will lead employees to demand more options. Why? Because under the esoteric rules of options-pricing theory, the value of an option goes down as the dividend of a stock goes up. That is because a dividend makes a stock less volatile. (When stocks bounce around a lot, option holders get the chance to exercise their options when the underlying stock is high, making the transaction more profitable.)
"It's a potentially nasty circular spiral down," says Mr. Doyle. "They have to grant more options and have less cash to buy stock back."
Take Oracle, arguably one of the most profitable tech companies and one that generates lots of cash. It is sitting on a healthy $5.5 billion in cash and generated nearly $3 billion in free cash flow -- 55 cents a share -- in the most recent four quarters, according to market-data firm Multex Inc. Yet if Oracle decided to become the widows' and orphans' tech stock, its yield would be uninspiring. Assume, for instance, it devotes about half of its free cash flow to a dividend. The stock would yield 2.1%, only slightly more than the market average.
If Oracle decided to share its $5.5 billion cash hoard with investors, the payout would be about $1 a share. Now look at Oracle based on estimates of its ongoing profitability. In the fiscal year ending in May 2004, analysts expect the company to earn 46 cents a share. After the hypothetical, one-time distribution of its cash, that would fall to 44 cents a share because the company wouldn't be earning interest on the money.
If, in that year, it paid out 40% of its earnings as a dividend -- a healthy payout ratio -- that would mean about 18 cents a share. But for investors, that is a dividend yield of only about 1.4% on today's stock price of about $13 a share, though the share price likely would fall if Oracle pays out its cash hoard. For Oracle stock to approach a dividend yield of 2.5% to 3%, the stock would have to fall to about $6 or $7 a share.
That's low, but it gets worse. Mr. Doyle estimates that if Oracle bowed to the demands of its employees and issued more stock options because it is paying out a dividend, it would need to increase its grants by about 18%. Meanwhile, Oracle would be spending an estimated $900 million or so a year to fund its dividend. So Oracle would have to give more options to employees and have almost a billion dollars less to buy back shares to offset the dilution to outside shareholders.
To be sure, if another piece of President Bush's tax proposal -- that corporate profits would only be taxed once whether they are paid out in dividends or reinvested in the business -- gets approved, some tech companies could avoid the pressure to pay dividends. Under this proposal, such reinvested profits could be applied to a stockholder's cost basis, reducing any future capital-gains tax owed from a sale of the shares.
But since successful tech companies are generally so expensive relative to their earnings -- the price-to-earnings ratio for the Nasdaq 100 index is 39, roughly twice the level of the overall market -- share-price rises are disproportionate to a tech firm's earnings. In other words, if a company's earnings go up 10 cents a share, the price of a Nasdaq 100 stock will go up $3.90. So while the investor could get a tax break on 10 cents worth of a capital gain upon a sale, the overwhelming majority of the gain remains fully taxed. (And losses, of course, aren't taxed.)
This points to another reason why tech companies won't likely pay dividends. Their stocks are so volatile that a few pennies a share in dividends will be a speck of the total return of any moderately successful tech company. Oracle's share price, for example, rose 290% in 1999 and fell 50% in 2001, followed by a 22% drop in 2002. What's a 2% dividend yield next to those swings? |
