Can you spare a dividend? Bush's tax-break proposal has ignited a debate over how companies use excess cash - Finance

Chief Executive, The, April, 2003 by Gregory J. Millman

The political fight over President Bush's proposed tax break for dividends may be small potatoes compared with the boardroom fights that are sure to erupt if it passes. Some experts-predict that if shareholders no longer face a divided tax, they'll demand that companies pay out cash. However, CEOs fear that if they start paying higher dividends, they'll be admitting their companies can't find worthy growth opportunities.

"The conflict will be between the CEO and the CFO," predicts Michael Mankins, managing partner of Marakon Associates, an international management consulting firm in New York. "The CFO will be pressured by investment banks with an intellectual argument for issuing higher dividends. The CEO will say, 'The second we issue dividends, it's like sending out a mass mailer that we don't have ideas for strategies.'"

The argument will center on whether a company is hoarding its cash and therefore denying investors the opportunity to invest it elsewhere at higher rates of return. Paradoxically, many of the companies most likely to hoard cash are those in mature industries. As Martin Ellis, senior vice president at the consulting firm Stern Stewart, explains: "Many of the more traditional, stable businesses have a lot of cash on their balance sheets. These businesses have the lowest real growth prospects, yet they're sitting with cash."

For their part, shareholders are sure to argue that these companies are wasting the money. Robert Arnott, chairman of First Quadrant, a Pasadena, Calif.-based investment firm managing about $13 billion in assets, believes that in such cases, companies face a reinvestment risk-the possibility that they will plow money into unproductive ventures. "If companies retain a little bit of their earnings, they'll invest in the most important initiative for their long-term competitiveness," he argues. "If they retain a little more, they'll invest in the next best, and so on. It's pretty arrogant for companies to think that their fifth-best idea out of a limited range of choices is better than their shareholders' number-one idea in an unlimited range."

Consider Microsoft's case. Robert J. Schwartz, an analyst with Thomas Weisel Partners in Boston, places a buy rating on Microsoft, but says investors' greatest risk is that the company will continue to pour cash into mediocre investments such as the Xbox game console. In a recent report, Schwartz noted that Xbox has soaked up $2 billion, yet might take eight years just to break even. "X marks the Black Hole," he quips.

It's interesting, Schwartz adds, that Microsoft's stock went down even after the company announced in January that it would start paying a dividend. One reason might have been that the dividend was considered picayune. But another could be that potential and actual shareholders don't have faith that Microsoft knows the best way to invest its capital. That becomes a serious doubt when you consider that Microsoft--with a total of $40 billion--has a great deal of money on hand. So much so, in fact, that it has helped make information technology the S & P's leading industry in terms of excess cash held (see chart, p. 36).

What usually happens when a company announces or increases its dividend is that its stock price rises, says Doron Nissim, an associate professor of accounting at Columbia Business School. "When a company that doesn't have a lot of cash increases dividends, that increase tells investors that the company is optimistic about its ability to sustain the dividend in the future," says Nissim. "But no one expects Microsoft to have difficulty sustaining the dividend, so there's no new information there. You're left with the alternative story--that if they increase the dividend, it must imply they don't have good investments.

Do cash-rich companies get sloppy?

One argument CEOs are likely to hear in any new environment for dividends is that too much cash on hand can lead to management missteps. "If you have a corporation with large amounts of cash sloshing around, it's almost impossible for that corporation to behave," says Michael Jensen, emeritus professor at Harvard Business School and managing director with Cambridge, Mass.-based Monitor Group. "The cash burns a hole in their pockets."

Jensen hopes that eliminating the double taxation of dividends will push shareholders to clamor for tax-free cash. "This might make the demands of equity holders like those of debt holders," he says. "If that were to happen, it would change corporate America in dramatic ways." He likens the possible effect to that of the leveraged buyout boom of the 1980s, which forced corporations to become more efficient in order to meet debt-service requirements.

But many CEOs are sure to resist that pressure. "The reason companies don't pay dividends is because they think they have a lot of brilliant ideas that will generate higher returns in the future," says Marakon consultant Mankins. "It's not because they look at tax rates of the marginal investor and try to determine what is the preferred tax vehicle for them."