We believe that Ms Stark should not revise her recommendation regarding FPL. The HOLD recommendation seems to be the most appropriate. Our judgement assumes a dividend cut from FPL. However, this dividend cut would be a precise strategic choice rather than one dictated by financing difficulties. Specifically, the dividend cut will raise future growth, with little effect on the stock price. By cutting dividends, FPL can react better to future threats.
After an initial panic selling triggered by the news shock (FPL never cut its dividend in the past 47 years), investors will process the new information realized that the dividend cut is balanced by an increased growth rate in the future.
To justify the HOLD recommendation on the stock, we need to figure out what is the necessary increase in the growth rate to compensate a specific dividend cut. Assuming a risk free rate of 7. 5% (30 years Treasury yields in May 1994) and a market premium of 6%, we estimated an expected return on equity for FPL of 11.
Using a Dividend Discount Model and given the current stock price of $32, we can imply a growth rate of 3. 14%. With these estimates, we can have an idea of the necessary growth rate for each dividend cut (as a % of current dividend assumed at $2. 47) to sustain a stock price of $32. The results of this exercise are in Figure 1. Figure 1 Dividend cut scenario analysis For example, a 25% decrease in dividends would correspond to a new dividend per share of $1. 853. In order to sustain a share price of $32, FPL needs to convince investor it can grow dividends at roughly 5% per year.
This analysis assumes that the leverage ratio of the company does not change, so that the return on equity remains constant. We believe that the likely dividend cut would be in the region of 20%. Such a cut implies a payout ratio of 72%, putting FPL below the industry average. The implied growth rate of 4. 64% seems achievable. During the period from 1984 to 1989 inclusive, FPL delivered and average dividend growth rate of 5% at a time where its payout ratio was, on average, close to 70%. Question 2 In May 1994, the most important issues confronting FPL are competition and margins.
Deregulation of power distribution is a major industry topic, and plans to adopt retail wheeling in neighbouring states like California will be high on FPL’s agenda. If such changes were to take place in Florida, FPL would face increased the levels of competition. With some of the highest prices in the industry (Exhibit 7) FPL will undoubtedly see margin compression as deregulation continues. As was the case in California, if retailing wheeling is adopted in Florida major players in the energy industry (including FPL) can be expected to lose a portion of their market value.
However, as evidenced by FPL’s low beta since September 1993, it may be that FPL will suffer less in this regard than its competitors. FPL has clearly not adapted well to increasing deregulation in the industry. Indeed, they are still negotiating with the Florida Municipal Power Agency over a fair price to charge for use of FPL’s transmission systems. This does not bode well for their ability to deal with further deregulation, when it inevitably. Despite their historical issues with deregulation, FPL’s customer mix puts them in a stronger position than others with regard to the challenges posed by retail wheeling.
All proposals for retail wheeling discussed in the case are multi-year, phased implementations which implement the plan first for large industrial companies, then for business and finally for residential users. With 56% of FPL’s sales coming from residential users and only 4% coming from Industrials, FPL’s key source of revenue may not be at risk for several years after retail wheeling is first introduced. Indeed, FPL’s management may see this as an opportunity to gain more share in the Industrial and Commercial segments, making it a positive change, at least in the short-term.
In order to access this opportunity however, FPL would need to address its prices and costs. Exhibit 7 shows FPL to have low some of the highest rates (per KWH) in the industry for every market segment. These high prices are unlikely to win many new customers if retail wheeling is introduced. Unfortunately for FPL, they also have some of the highest costs (per KWH) in the industry, which means any reduction in prices will only see margin compression and lower their profitability further.
Lowering costs will be difficult for FPL. Since James Broadhead took over as CEO his focus on cost reduction and quality maintenance have led FPL to achieve record results. However it may be that all the costs which can be removed from the system have already been removed. And yet, FPL still has some of the highest costs (per KWH) in the industry. Finally, while it is not mentioned in the case, it may be that FPL could use the rise of retail wheeling to expand its market outside of Florida itself.
With low projections of capital expenditure anticipated for the following years, and an ensuing dividend cut, FPL could choose to invest significantly in increasing capacity so as to be ready to serve the peak needs of other markets as they become increasingly deregulated. Question 3 Payout policy seems to be based on Earnings before Exceptional (E-BE) items. Over the last four years FPL has adopted a pretty stable payout ratio of 90% ca. of E-BE items. Before 1990, the payout ratio was well below 80%.
In 1993 the company paid out about 91% of E-BE. Reason 1 By changing the payout FPL can increase its level of sustainable growth and free more money to reinvest in the business. On a CAGR basis, aggregate growth in E-BE was lower than the growth in Dividends. The former over the 5yr period 1988-93 grew at 4. 72% while the latter grew at 10. 9%. When the growth in number of shares outstanding is taken into account the EPS and DPS growth comes down to -2. 42% and 2. 53%. The average payout ratio over the period is 87%.
Given the financials over the last five years, we can calculate the average ROE over the period multiply it by the retention ration (1-payout) and compute the sustainable growth rate in earnings (and dividends) over the next cycle. We assume that the average would be representative of long term growth rates given the fact that operational improvements could be offset by competitive pressures. The average ROE of 12. 31%, combined with the average payout of 87% gives a sustainable growth rate of earnings of 1. 59%. The improvement in ROE over the last five years is mainly due to improved Net Income (BE) margins.
The NI margin improvement offset the lower leverage and lower efficiency of asset utilisation over the period. Reason 2 If FPL increases, over the next five years, E-BE at the g level and pays out a constant 87% of these earnings, it may have to cut the dividend if it continues growing the number of shares outstanding. In the past five years FPL has issued large numbers of shares, and we assume dividend growth was high during this time to avoid dilution of existing share-holders. We also know from the case that the number of shares to be awarded to directors is going to increase given the maximum bonus size increase and stock/cash split.
These factors add weight to the validity of a dividend cut. Based on a range of calculations of # shares outstanding growth as % of last 3 years average growth, the dividend cut would range from 0% to 20%. Question 4 According to the arguments stated in question 3, we believe that the current payout ratio set by FPL is excessive. Resorting to the Dividend Discount Model used in question 1 and given current data, we estimated a required growth rate of 3. 14% to sustain the current stock price. This implied growth rate is higher than the sustainable growth rate computed in Question 3.
Hence, it makes sense to lower the payout ratio to deliver a higher growth rate. This growth rate should be higher than 3. 14% as to make sure that stock price is not severely affected by the dividend cut. On a more qualitative basis, it is true that increasing competition in the industry will change the rules of the game and will affect FPL’s business. The current payout ratio is the result of a particular condition in which FPL still enjoyed a “de-facto” monopolistic status. As a matter of fact, the impact of PURPA on FPL business had been marginal.
However, with the introduction of NEPA the likely impact will be much greater. What really worries us is the possible adoption of “retail wheeling” in a number of States, including Florida. Retail wheeling constitutes a major threat to FPL. In order to fight back, FPL needs to free up some additional resources to increase its investing possibilities. The estimated $150m a year from dividend cuts may be a small amount compared to the $6b invested in capex in the past five years however, these $150m may be a good buffer to give FPL the ability to react if retail wheeling it’s indeed implemented in Florida.
Cite this Dividend Policy at FPL Group, Inc.
Dividend Policy at FPL Group, Inc.. (2017, Mar 29). Retrieved from https://graduateway.com/dividend-policy-at-fpl-group-inc/