Dividend Policy at Fpl Group, Inc.

Dividend Policy at FPL Group, Inc. (A)

Fact Pattern

In the spring of 1994, Merrill Lynch’s utilities analyst downgraded their investment rating for the FPL Group, Florida’s largest electric utility. The Merrill Lynch analyst downgraded FPL because he/she believed FPL was on the verge of cutting its dividend for the first time in 47 years. Reacting to this news release, Kate Stark, an electric utilities analyst at First Equity Securities Corporation, faced the decision whether to revise her own current ‘Hold’ recommendation on FPL’s stock.

Diagnostic

To the electric utility industry, the deregulation eliminated the monopoly service rights. Utilities Regulatory Policies Act required local utilities to buy all their electrical output. National Energy Policy Act made it possible for utilities to demand access to another utility’s transmission system. Deregulation of the final segment of the industry (distribution) had begun in early 1994. This brought a proposal by the State of California to the table introducing the notion of retail wheeling. Under retail wheeling, customers would be allowed to purchase power from utilities other than their local utility company. The local utility would be required to open its transmission and distribution network to outside utilities wishing to sell power to consumers in that market. Over time, the other major customer segments, commercial users and eventually residential users would get the right to pick their electricity suppliers.

All these deregulations brought huge competition to FPL Group.

To FPL Group herself, low capacity margin (8.6%) suggests FPL has less room for growth compared to their peer companies. 30% of power purchased outsource made FPL sensitive to fluctuations in power purchase prices, thereby, higher transmission and power costs. Turkey Point nuclear plant is on the Nuclear Regulatory Commission’s watch list for safety concerns. Despite selling / writing off several acquisitions, FPL still maintained ESI Energy, Turner Foods and Qualtec Quality Services, facing the pressure to either justify or sell-off businesses. The high dividend payout ratio requires FPL financing more debt and equity issuance which might cripple the business. If the Group wants to cut the dividend payout ratio, it may hurt the company’s stock.

Options

1. Keep the high dividend payout ratio.

By doing this, the company could keep the investors but will need more cash flow to support this. Since the targeted debt/total capitalization ratio is 44%, keeping current payout level will exceed this level if the plan is financed through debt, debt as a percentage of total capitalization increases to ~52% (or $4.7B). High levels of leverage will prohibit the company from being nimble from a cash perspective (unable to spend as much capex as needed, for instance, which would inhibit growth.  Also, would leave the company cash starved and not able to respond to litigation costs, etc.)

1. Cut the dividend payout ratio and finance with lower cost of debt.

The lower payout ratio would provide the firm with much needed capital in the form of retained earnings. The firm could use this capital to expand and grow the company as well as improve the firm’s capital structure. As stated in the case, the debt rating of FPL has been upgraded. This should make their cost of debt decrease. FPL can now pay off their high cost debt and use the savings created by the lower dividend to obtain debt at a lower cost if they so choose. But also will decrease the stock price and might lose some investors.

1. Slightly cut the dividend payout ratio and buy back the stock.

The company should not worry about a lawsuit against its lower dividend policy as the dividend cut does not affect most of its investors (individual investors). Upon the announcement of dividend cut, the stock price can decrease so FPL should use its excess cash to buy back its stock to increase the stock price whenever it falls.

Recommendation

My recommendation to FPL is cut the dividend and buy back the stocks. FPL should use Buy and Hold strategy to repurchase its stocks and hold them regardless of market fluctuations. This solution as a long term investment can help FPL increase its stock price which has fallen in early 1994. By doing so, FPL can get rid of its excess cash of $150 million per year. FPL also can use this strategy to increase incentive compensation by granting stock options to employees and thus, increase employment commitment and recruiting attractiveness to have competent personnel for future growth. FPL should use its excess cash to invest more in new profitable projects, acquire new companies and profitable assets, and reinvest in financial assets.