Increasing Payouts – Hard to Defend an Alternative Strategy – Dividend Theme Part 2

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

graham@/lipinski@ssrllc.com

November 9th, 2012

Increasing Payouts – Hard to Defend an Alternative Strategy – Dividend Theme Part 2

  • The Industrial and Basic Materials Sectors could meaningfully increase stock valuation by embracing a defined/formulaic approach to dividend payouts. A high fixed percentage of “normal” EBT as a permanent dividend policy would boost shareholder returns and instill confidence around the discipline in capital spending.
  • The capital spending issue is more relevant for some companies than others and most important where returns on capital have a negative slope over time, suggesting that too much capital has been spent on projects that do not offer adequate returns.
  • In aggregate, the broad group could have more than 90% upside from increasing its dividend commitment to a fixed 70% of “normal” or mid-cycle EBT. At constant P/E ratios and a 10% incremental return on capital (which is the current average), the group would have to maintain current capital spending levels for more than 14 years to get the same result. Extreme opportunities are in Capital Goods, Conglomerates, Metals and Packaging, but company specific opportunities are everywhere
  • Increasing dividend payout rates does not stop investment: but it puts more discipline around the process as you have to borrow or raise equity to do it and be able to maintain the dividend commitment on the new equity.
  • In a low global economic growth environment it is even more important that companies rethink their discretionary expenditures in capital spending (and R&D) so as to increase the proportion of income that is given back to shareholders in the form of consistent dividend.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

Last month we saw some price action in a couple of names in the commodity chemical space based on stories about possible conversion to an MLP structure, following a ruling that processing NGLs to ethylene would qualify. This was closely followed by an agreement from Williams Partners (a pipeline MLP subsidiary of The Williams Companies) to acquire the basic chemical facilities of the parent.

Whether or not this would be possible for a more complex cyclical company a couple of steps removed from the traditional MLP space is debatable, and clearly a machine tool company is far removed from a pipeline company with stable throughput economics and possibly stable earnings.

But it is an interesting subject for a couple of reasons: first, most companies we cover have earnings that are well above their current dividend commitment, suggesting that payout rates could be much higher and share prices would likely rise, in some cases substantially. Second, and equally important, it would be a clear statement that the company or companies do not see material growth opportunities for which they need to hold on to cash. This is important in many Industrial and Basic Material sectors because historically, cash has been used poorly in projects or acquisitions that have often failed to return the cost of capital, destroying shareholder value.

Arguably, the stock reaction for both WLK and LYB was less about whether or not an MLP formation would be possible and more about capital and cash flow strategy. The formation of an MLP structure (if possible) would be a clear signal that cash is being returned to shareholders. However companies do not have to go this far to achieve the same end.

The jump up in Westlake’s share price in August following more than a doubling of its dividend was not because the yield was compelling; today it is only 1.0%. The move was more one of confidence that Westlake’s earnings remained strong and the company was willing to return more to the shareholder, reducing the risk of a major capital spending spree. Sticking with the Westlake example: if the company were allowed to convert to an MLP and pay out 90% of earnings before taxes and then trade to give a yield equivalent to the average of the MLP group today, the stock would have as much as an additional 40% upside. Westlake is not unique, there are plenty more in our universe with much greater opportunities simply by changing their approach to dividend payments.

Many of the sub-groups within the Industrials and Basic Materials group have a poor record when it comes to return on capital, a subject we have discussed on many occasions. Consequently, often investors see increasing cash balances as liabilities rather than assets. LyondellBasell in particular has been rewarded from a share price perspective (Exhibit 2) because of its dividend policy – a special dividend late last year and another one now. There is reassurance that some big deal is not around the corner.

Exhibit 2

Source: Capital IQ, SSR Analysis

For this to work more broadly however, company managements and boards have to accept that value accretive organic growth opportunities are limited, either for their industries or for them specifically within their industries. This is often a hard decision to make and we saw a good example of how painful that process can be with Iron Mountain over the last two years – Exhibit 3. Since the decision was made to restructure IRM into a REIT in June of this year (similar structure to an MLP), the stock has outperformed the market meaningfully. Moreover, the company has paid a meaningful dividend.

Exhibit 3

Source: Capital IQ, SSR Analysis

To restate the argument here: corporate restructuring to declare of a higher dividend payout policy does two things that are positive for multiples and valuation.

  1. Increases the cash returned to shareholders
  2. Decreases the risk of large sale capital destructive investment

For some of our groups and many of our companies with poor capital deployment histories the second point may be the most influential for valuation.

Return on Capital and Impairments – Suggest Overconfidence or a Poor Understanding of Business Dynamics

Companies do not invest to lose money, nor do they generally buy things that they expect to have to write down – but it happens, and in the Industrials and Basic Materials space it happens a lot. The two charts in Exhibits 4 and 5 show the problem clearly. The first shows return on capital for the sector as a whole and the second shows annual and cumulative write downs. All investors are aware of these data points and these trends. During the period covered in the chart in Exhibit 4 we have seen a decline in the cost of capital as interest rates have fallen. As we discussed in our initial research, there are sectors and companies where returns on capital have declined as fast or faster than the cost of capital.

Exhibit 4

Source: Capital IQ, SSR Analysis

The reasons why returns are going down and why there are continual impairments are the subject of much discussion and will be the subject of further research from SSR. Today we are talking about how to reassure investors that lessons have been learned. Given that we show 30 years of a fairly consistent problem, investors are leery of the “we get it now, trust us to do the right thing” story. We have heard it before and we have been fooled by it before.

Exhibit 5

Source: Capital IQ, SSR Analysis

Show Us You Understand

Depending on the sub-industry and company, anywhere from 10% to 75% of capital spending over the last 30 years would have generated better shareholder returns as dividend payments or perhaps share buybacks. Dividend yields have supported valuations in most Industrials sub-sectors over the last couple of years (
see recent research
), but could do more. These industries are unlikely to get better from a structural perspective, so cutting capital spending and increasing cash returns to shareholders is likely to be the best way forward, with the optimum degree of change different industry to industry and company to company.

Equally important today is the idea that we are in a slower growth World. Every company should be rethinking strategic plans and capital expenditures to test whether they make as much sense in a world with 2-3% annual economic growth as opposed to the recent historic average of 4-5%.

In Exhibit 6 we show twenty companies in our coverage who have increased their dividends most meaningfully since the end of September 2010 and the twenty with the smallest increase/largest decline. Over the same period, the green group has outperformed the red group, but only by around 260 basis points, which is less than we would have expected. The analysis is skewed significantly by the performance of KSU, which has outperformed dramatically, while not increasing its dividend. Adjusting for KSU we have an 800 basis point difference between the 2 year stock performances of the companies with the largest increases over those with the most limited.

Exhibit 6

Source: Capital IQ and SSR Analysis

The Upside Could Be Dramatic

Assuming that a tax efficient MLP type structure is not available to these industries, we have modeled a constant 70% payout of “normal” EBT (implying a 30% tax rate). While it is likely that investors would welcome the implied capital discipline in a 70% payout ratio, it is unclear that they would push valuations as high as might be anticipated because of the variable nature of earnings. By assuming a constant payout of mid-cycle or “normal earnings” we drive a more predictable dividend stream and we give companies more investment capital at cyclical peaks and less at cyclical lows, which might be appropriate strategy anyway. On a normalized basis, companies would then be limited to capital spending levels equal to depreciation, or would need to raise debt or equity to invest above depreciation levels in the same way that Williams Partners has done to acquire the ethylene and pipeline assets from Williams Companies.

Exhibit 7

Source: Capital IQ and SSR Analysis: E&C excluded because of revenue variability

Every sector would, on average, be able to raise its dividend by more than 50% on this basis and in some cases they can raise by more than 200%. Possible yields at current pricing were summarized in Exhibit 1 and are repeated above in Exhibit 7 together with the growth the increase represents versus the dividends paid today.

For the group in aggregate we are looking at almost a 200% increase in dividend payments, by adopting a 70% normal EBT payout. If we assume that we only see 50% of this change reflected in valuation – we would be looking at 90% upside for the group.

Interestingly, capital spending is not that high today – across the group on average for 2010 and 2011 it was close to overall depreciation and amortization charges – see Exhibit 8. So where did the cash go – some was used to pay down debt, some was used to pay for acquisitions, not captured in our capital spending numbers, and some sits on balance sheets as cash.

Exhibit 8

Source: Capital IQ and SSR Analysis

Or We Could Just Keep Doing what we Are Doing…..

As an alternative strategy, and for contrast, let’s assume the group was to employ the collective strategy of the last 40 years and spend in the hope to grow earnings. We assume that the industry gets the average return on capital it has seen over the last ten years – 10%. All things being equal, we can argue that we would get the same valuation move as raising the dividends (90%) as we would by increasing EBT by 90%. For our coverage universe that would mean increasing normal EBT from a combined $120 billion in 2011 to $230 billion. At a 10% return on capital the industry would need to spend almost $1.1 trillion in net capital spending (above and beyond covering depreciation) to achieve a 90% increase in EBT (the current market cap of our universe of stocks is $1.7 trillion).

The group spent around $80 billon on capital spending in 2011, but this was close to a cyclical low and probably better represents a good but aggressive net number on a forward looking “normal” basis. So in very simple terms, as an industry group, you can potentially get the same result today by raising your payout to 70% of “normal” EBT as you can in 14 years time by doing what you have been doing for the next 14 years!

In Exhibit 9 we take a more granular look and break the analysis down by sector. We make the following assumptions:

  • The sectors only get half of the upside suggested by the increase in yield – although we are suggesting a fixed dividend payment, this may be a conservative assumption in the sectors where earnings have more limited volatility and where investors therefore have more certainty that a fixed payment is sustainable.
  • The ROC is the current value of the trend lines we created in the first piece of research we published this year, and the follow up on transports – the exception is the Paper sector where we have given the benefit of the doubt around a recovering trend (also discussed in the initial research)
  • We assume that 2011 capital spending (which is below trend for almost all sectors), is a good proxy for net capital spending. The risk here is that we are overestimating net capital spending, in which case the number of years required would increase as capital would grow more slowly.

Exhibit 9

Source: Capital IQ and SSR Analysis

In Exhibit 10, we show the stocks in our coverage that would raise dividend yields above 8% by increasing payouts to 70% of “normal” EBT. LYB is going part of the way there through the special dividends, but could do more.

Exhibit 10

Source: Company Filings and SSR Analysis

©2012, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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