It can be a ghastly business being an investor today. Where once upon a time there were natural laws that governed the survival of companies, when markets penalized firms for bad management decisions and rewarded those with innovative ideas, that’s not always the case today.
The unintended consequence of the Federal Reserve’s extraordinary stimulus has been that some businesses (including some utilities) should not have survived the downturn, but are being sustained by cheap debt and other artificial means that may mask terminal business weakness. We like to call them corporate zombies.
And given peak earnings season’s proximity to Halloween, it’s eerily appropriate for investors to wonder whether it will be marred by a parade of corporate zombies. Even as many cheer the S&P 500′s new highs, there is concern that the market may be significantly overvalued when viewed from the standpoint of corporate earnings estimates.
The S&P is up 24.9 percent so far this year, which is its best gain since 2009, when the index began its bull run. Since the bear market bottom in March 2009, the S&P has soared 158 percent, driven largely by the Federal Reserve’s economic stimulus program, greater investor confidence, a rebound in earnings at some firms, and a housing recovery, according to various market analysts.
Chart A: Third-Quarter Earnings Growth Estimates
But earnings for S&P 500 companies are expected to have grown between 3.4 percent and 3.8 percent from a year ago (See Chart A), according to various estimates, which would be the smallest quarterly increase in a year, according to S&P Capital IQ. At the start of 2013, by contrast, third-quarter earnings were expected to grow at nearly three times that pace.
According to Thomson Reuters, there have been 99 negative earnings per share (EPS) preannouncements issued by S&P 500 corporations for the third quarter, compared to 19 positive EPS preannouncements. Of the 29 companies in the S&P 500 that have reported third-quarter earnings thus far, 52 percent have reported earnings above analyst expectations. This is lower than the long-term average of 63 percent and is also below the trailing-year average of 66 percent.
In this article, we’ll first review the ways in which capital allocation decisions can affect a company’s earnings per share, and then drill down into how utilities themselves are deploying their capital. And we’ll look at how these actions can ultimately deliver value as expressed in the measure known as shareholder yield.
The Federal Reserve’s unprecedented monetary easing has forced interest rates to historic lows, which has been a boon to borrowers of all stripes. Indeed, some companies have used cheap debt to goose their valuations by buying back stock or paying dividends.
Of course, buying back or selling stock is not always a negative, and must be viewed in terms of the company’s overall growth and income prospects. Nor is the use of debt to pay shareholders necessarily a negative if it’s a bridge to future income-producing opportunities, such as when utilities build plants and other infrastructure and must make significant capital expenditures that will later be recovered in rates.
The Many Ways to Deliver or Destroy Value
What many investors sometimes don’t understand is that if the stock is trading at intrinsic value, buybacks and dividends are pretty much the same thing, except dividends have worse tax treatment. However, if the stock is trading below intrinsic value, there is no better use of cash than for a company to repurchase it own shares. Indeed, Warren Buffett is a huge proponent of this.
Unfortunately, given the huge divide between earnings and valuations, many stocks are likely trading above intrinsic value. And buybacks at these levels could actually destroy shareholder value. Since 2009, companies have bought back more than $1 trillion of their own stock, according to Rosenblatt Securities.
Another big question is whether valuations are derived from true earnings (i.e., income) or some form of leverage that could impact future growth. While debt can help fuel growth, excessive borrowing can put companies and their shareholders at greater risk if income growth subsequently fails to materialize due to botched business ventures, reduced demand, or cost disallowances, among other reasons.
Moreover, the low interest rates resulting from the Fed’s monetary policy have essentially forced income investors to pile into riskier asset classes, such as high-yield equities, to replace the income they’d normally get from bonds. That’s helped push up valuations of normally staid dividend stocks and given some firms carte blanche to conduct serial equity issuances that could eventually dilute shareholders and impair future earnings growth.
And the stock market is starting to feel frothy as a result: At the start of 2013, investors were paying $14 for every $1 of S&P 500 earnings, according to S&P Capital IQ. They are now paying a whopping $16.
According to a Meridian Compensation Partners report, “Most companies keep a close watch on their dilution to ensure costs to shareholders are kept within acceptable limits. This is typically done through a comparison of dilution levels to a group of similarly sized peer companies within the same general industry. If potential dilution (overhang) is kept within a reasonable range (25 percent to 30 percent) of the 50th percentile of peers, it will likely remain acceptable from a shareholder perspective.”
But how can the average investor know when a firm is being attentive to the issue of dilution–or raising capital to respond to a fundamental business weakness that could eventually come at the expense of shareholders? According to Thomson Reuters data, a total of $491.2 billion has been raised in equity capital so far this year, up 17 percent from the same period last year. Equity financing is sometimes considered a last resort for funding, as the “pecking order” theory of corporate finance gives first preference to an internal source of funds, such as retained earnings, then debt, and finally secondary equity issuances.
As a review, there are five ways that management can choose to spend a company’s earnings: They can pay out a cash dividend, buy back stock, pay down debt, reinvest in the business, or acquire other companies. The first three give cash back to shareholders, while the latter two are efforts to invest for growth.
Utilities and Shareholder Yield
In the utilities industry, there are a number of firms that are issuing stock or buying it back to various degrees–paying or earning as little as a couple of million to hundreds of millions (See Chart B).
While we believe the best way to know if these transactions are good for shareholders is to undertake an individual company Dupont analysis or breakdown of return on equity, as detailed in the upcoming issue of Utility Forecaster, shareholder yield is another tool that can show a firm’s commitment to increasing shareholder value. It captures the three ways in which a company’s management can distribute cash to shareholders: cash dividends, stock repurchases and debt reduction.
Though shareholder yield is helpful in identifying promising names, it shouldn’t be used as the sole criterion for stock selection, as it can’t detect sudden changes in the overall health of a company. Indeed, there’s no substitute for thoroughly researching a firm’s financials.
Dividends are the most obvious form of distributing cash. Buybacks also increase shareholder value, provided the shares repurchased are cancelled or held in treasury, and not used as a device to offset dilution from stock option grants to management and other employees. Reducing debt can also produce a de facto dividend; assuming the value of the firm remains the same, shareholder value is increased as debt is reduced.
Companies that compensate shareholders via all three distribution channels could be indicating significant corporate strength. And companies whose shareholder yield is driven by just one factor could be implicitly suggesting certain worthwhile areas of inquiry–such as whether a firm is signaling its shares are overvalued.
According to one dividend analyst, “Another good use of shareholder yield is that it tells you approximately what rate of return you can expect if the company doesn’t grow at all and if the stock valuation remains static. The shareholder yield is an internal use of cash, so as long as the company maintains the status quo, they can keep growing dividends and buying back shares. So, the shareholder yield is your baseline rate of return; any core growth is added onto that and results in the total return (along with changes in stock valuation).”
Chart B: Utility Stock Issuances and Buybacks
Created with YCharts
In examining the top two stock sellers and top two stock buyers listed above, we illustrate how these companies are managing their efforts to return cash to shareholders (See Chart C). The chart clearly shows that those firms that were making stock buybacks had better shareholder yields than those that were making stock issuances, namely Otter Tail Corp (NYSE: OTTR) and The AES Corp (NYSE: AES).
Chart C: Utility Stock Buyers and Sellers: Shareholder Yield Comparison
Created with YCharts
When breaking down the components of shareholder yield, we found both AES and Otter Tail distributed cash to shareholders via all three channels: cash dividends, stock repurchases and debt reduction. And these positive practices appear to have flowed through to total return: AES is up 34.8 percent over the last year, while Otter Tail is up 30.7 percent. Both results exceed the S&P 500’s 24.8 percent total return over that same period.
Though both firms’ recent performances are impressive, this analysis is only a precursor to the thorough investigation necessary to determine their potential as long-term investments. Otherwise, we’d be guilty of being the investment zombies that we hope to avoid.
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