We strongly discourage Ms Stark from changing her recommendation on FPL. Our evaluation suggests that it is better to keep a HOLD recommendation. We expect a decline in dividends from FPL, but this decision is tactical rather than based on financial considerations. The decrease in dividends is expected to improve future growth opportunities and will only have a minimal effect on the stock price. By implementing dividend cuts, FPL will be better prepared to face upcoming challenges.
Despite FPL cutting its dividend for the first time in 47 years, investors will eventually recognize that the sudden decrease in stock value can be offset by anticipated future growth. To justify our suggestion of retaining this stock, we must ascertain the extent to which the growth rate needs to rise to compensate for the reduction in dividends. Utilizing Treasury yields spanning a 30-year period until May 1994, and assuming a risk-free rate of 7.5% along with a market premium of 6%, our analysis forecasts that FPL’s projected return on equity is 11.1%.
Using a Dividend Discount Model, it has been determined that the growth rate is 3.14% based on the current stock price of $32. This information allows for calculating the required growth rate for each dividend cut to maintain a stock price of $32, assuming the current dividend is $2.47. Figure 1 showcases different scenarios of dividend cuts and their corresponding new dividend per share values resulting from this analysis. For example, if dividends were reduced by 25%, the new dividend per share would be $1.853. To sustain a share price of $32, FPL must demonstrate an annual dividend growth rate of approximately 5% to investors.
This analysis assumes that the company’s leverage ratio remains unchanged, resulting in a constant return on equity. We predict that the dividend will likely be reduced by approximately 20%. This reduction would indicate a payout ratio of 72%, which is lower than the industry average. However, the projected growth rate of 4.64% seems attainable. From 1984 to 1989, FPL maintained an average dividend growth rate of 5% while maintaining an average payout ratio of close to 70%. In May 1994, the primary challenges facing FPL are competition and margins.
Deregulation of power distribution is a significant subject in the industry, and FPL’s agenda includes plans to implement retail wheeling in neighboring states such as California. If similar changes occur in Florida, FPL would face more competition. With some of the highest prices in the industry (Exhibit 7), FPL will undoubtedly experience margin compression as deregulation progresses. Like what happened in California, if retailing wheeling is accepted in Florida, major energy industry players (including FPL) are likely to lose a portion of their market value.
However, it may be that FPL will be less affected by this issue than its competitors, as indicated by its low beta since September 1993. FPL has not effectively adjusted to the increasing deregulation in the industry. They are currently in negotiations with the Florida Municipal Power Agency to establish a fair price for the use of FPL’s transmission systems. This indicates a lack of readiness to handle further deregulation in the future. Despite their past difficulties with deregulation, FPL’s customer mix puts them in a better position than others to address the challenges presented by retail wheeling.
All proposals for retail wheeling discussed in the case involve multi-year, phased implementations. These implementations prioritize the plan rollout for large industrial companies first, followed by business users, and finally residential users. Despite 56% of FPL’s sales coming from residential users and only 4% from industrials, FPL’s main revenue source may not be at risk until several years after the introduction of retail wheeling. In fact, FPL’s management could view this as an opportunity to enhance their market share in the industrial and commercial sectors, resulting in a positive change in the short-term.
To access this opportunity, FPL must address its prices and costs. Exhibit 7 shows that FPL has the industry’s highest rates (per KWH) for every market segment. These high prices are unlikely to attract new customers with the introduction of retail wheeling. Additionally, FPL also has some of the industry’s highest costs (per KWH). This means that lowering prices will lead to margin compression and further decrease profitability.
Despite James Broadhead’s focus on cost reduction and quality maintenance, lowering costs will be a challenging task for FPL. Although FPL has achieved remarkable results under his leadership, it is possible that all possible cost reductions have already been implemented. As a result, FPL still maintains some of the highest costs per KWH in the industry. Additionally, while the case does not mention it, the rise of retail wheeling may offer an opportunity for FPL to expand its market beyond Florida.
Given the low projections for capital expenditure in the coming years and the consequent decrease in dividends, FPL has the opportunity to make significant investments in expanding its capacity. This would enable them to meet the growing demand from other markets as deregulation persists. As for Question 3 Payout policy, it seems to be influenced by Earnings before Exceptional (E-BE) items. For the past four years, FPL has maintained a relatively steady payout ratio of around 90% of E-BE items. Prior to 1990, the payout ratio consistently remained below 80%.
During the period from 1988 to 1993, FPL distributed about 91% of its Earnings Before Interest and Taxes (EBIT) in order to support sustainable growth and allocate more funds for reinvestment in the business. Although the Compound Annual Growth Rate (CAGR) of EBIT was lower than that of dividends during this time, with rates of 4.72% and 10.9%, respectively, when taking into account the increase in outstanding shares, the growth rates for Earnings Per Share (EPS) and Dividends Per Share (DPS) decreased to -2.42% and 2.53%. The average payout ratio during this period was approximately 87%.
By analyzing the financial data from the past five years, we can determine the average return on equity (ROE) for that specific time frame. To calculate the sustainable growth rate for future earnings and dividends, we multiply this average by the retention ratio (1-payout). We view this average as indicative of long-term growth rates because any improvements in operations may be counteracted by competitive pressures. The combination of an average ROE of 12.31% and an average payout of 87% results in a sustainable growth rate in earnings of 1.59%. The main cause for the increase in ROE over the last five years can be primarily attributed to enhancements made in Net Income (BE) margins.
The decrease in leverage and efficiency of asset utilization during the period was counterbalanced by the improvement in the NI margin. If FPL’s E-BE increases at a certain rate over the next five years and pays out 87% of these earnings, it may have to reduce dividends if it continues to increase outstanding shares. In the previous five years, FPL issued a substantial number of shares, and we assume that dividend growth was high during this time to maintain existing shareholders’ ownership percentage. Additionally, based on the information provided in the case, there will be an increase in the number of shares awarded to directors due to the maximum bonus size increase and stock/cash split.
The validity of a potential dividend cut is supported by various factors. Our calculations indicate that the dividend cut may range from 0% to 20%, depending on the growth of outstanding shares compared to the average growth over the past three years. Furthermore, we consider the current payout ratio set by FPL as excessive, as explained in question 3. By utilizing the Dividend Discount Model and incorporating the most recent data, we have determined that a required growth rate of 3.14% is necessary to maintain the current stock price. This growth rate surpasses the sustainable growth rate computed in question 3.
Lowering the payout ratio is a logical move in order to achieve a higher growth rate, ensuring that the stock price is not significantly impacted by reducing dividends. Additionally, the increasing competition in the industry will alter the business dynamics for FPL. It is important to note that the current payout ratio reflects the unique circumstances in which FPL operated with a virtual monopoly. In fact, the effect of PURPA on FPL’s business has been minimal.
However, the introduction of NEPA will significantly increase the likely impact. Our concern lies in the potential adoption of “retail wheeling” in several States, including Florida, which poses a major threat to FPL. To counter this, FPL must allocate additional resources to expand its investment options. While the $150m annual dividend reduction may seem insignificant compared to the $6b invested in capex over the past five years, it can serve as a valuable buffer, enabling FPL to respond effectively if retail wheeling is indeed implemented in Florida.
