GainesboroMachineToolsCorporation: PayoutPolicyforaNewIdentity

(Case8Analysis)
PresentedMarch10,2008 toDr.TonyPlath,ProfessorofFinance InPartialFulfillmentofRequirementsfor MBAD6154|GraduateAppliedFinancialManagement TheUniversityofNorthCarolinaatCharlotte

ClayFowler JabbarJamison

Case 8 Analysis: Gainesboro Machine Tools | MBAD 6154 | Spring 2008

Introduction

Profitablecompaniesregularlyfacethreeimportantquestions:(1)Howmuchofour freecashflowshouldwepassontoshareholders?(2)Shouldweprovidethiscashto stockholdersbyraisingthedividendorbyrepurchasingstock?(3)Shouldwemaintaina stable,consistentpaymentpolicy,orshouldweletthepaymentsvaryasconditions change? (Brigham,Ehrhardt,Ch.18.p361) GainesboroMachineToolsCorporationfacesthesequestionsastheircorebusiness evolvestomeettechnologicalinnovationsandincreasinginternationaldemand.For decadestheywereafavoriteofincomeinvestorsfortheirsolidearningsandstrong dividends,butin2005thescenehadchanged.Afteryearsofplanningand restructuring,theynowfindthemselvesasakeyplayerinanewindustry.Going forward,Gainesboroisprojectingthatthreequartersofsalesrevenuewillcomefrom theadvancedtechnologyperipheralsandCAD/CAMsoftwarebusiness,withthe remaindercomingfromtheircorebusinessofold,electricalequipmentandmachine toolsmanufacturing.Gainesborohaspositioneditselfforsuccessinanewindustrybut itsrealignmenthascomewithsignificantcostsnetlossesof$61.3millionand$140 million,in2002and2004respectively.Inthefaceoftheseextraordinarylosses, Gainesborohastappedlinesofcreditinordertocontinuetopayhighdividends, ballooningdebttoitshighestever.In2004,itsuccumbed,cuttingitsdividendpayout, andhasevenfailedtopaydividendsinthelasttwoquarters.Thesetroublingsigns, combinedwiththeoverallmarketlullintheaftermathofHurricaneKatrina,havesent Gainesborossharepricespiralingdownward,currentlyoff25%fromjustoneyearago. So,thequestionremains:CanGainesboroincreaseitsvaluethroughitschoiceof distributionpolicy,definedasthelevelofdistributions,theformofdistributions,and thestabilityofdistributions? Inthisstudywellexplorekeyconceptsinmanagingfirmequityandhowitpertainsto GainesboroTools.Wewillsystematicallyexplorepayoutpolicygoals,distribution theories,dividendandstockrepurchasepolicies,andhowtheseconceptsmayaffect investorandfirmwealth.Wellthenuseandconsumethisinformationtoformulatea payoutpolicyrecommendationforGainesboromanagement. Fowler/Jamison Page2

Case 8 Analysis: Gainesboro Machine Tools | MBAD 6154 | Spring 2008

CaseDilemma (When)askedifthecompanyplannedtostartpayingadividendorinitiateastock buybackprogram,"Atthistime,wehavenoplanstodoeither.Wedon'tthinkit'sour jobtomanageourshareholders.It'sourjobasthemanagementteamtomanagethe company,tomanageitthroughwhenthestockpriceisgoingupandtomanageitwhen thestockpriceisgoingdown. StevenJobs(Hillis,ApplePlansnoDividendorbuyback) Dividendsarerealmoney.That'sthehallmarkofabluechipstock.Ifacompanydoesn't payadividend,it'saspeculation. GeraldineWeiss(Sullivan,DividendStocksPayOff) TheseopinionsareindicativeofthedilemmafacingGainesboromanagement,whoin theirdecisionsmustnotonlyconsidertheirinternalpreferencesfortheuseoffreecash flow,theymustalsoconsiderinvestorspreferences.Theirdecisions,upthispoint,have ledthemtoacorporaterepositioningasahighgrowthfirmintheindustrialsoftware andadvancedtechnologyindustry,maintainingasmallelement(25%ofrevenue)of theiroldidentityinamaturemanufacturingmarket.Inpursuitofthisnewcourse,two expensivereorganizations,slowingsalesintheirtraditionalline,andlowmarginsintheir newlinehadleftthemwithextraordinarylossesandnoexcesscashonhand. Regardless,managementwantedandexpectedtogrowata15%compoundrate annuallyinanticipationofreaching$2billioninsalesby2011andwasconsidering revampingthecompanybrandtoprojecttheirnewlineofbusiness.Gainesborohad paidforanewcorporateidentity,butthemarketwasconfusedastowhatthatimage was:dependableincomestock,or,opportunistichighgrowthstock? Managementisconsideringthefollowingpayoutoptions:(a)azerodividendpayout, optingnottopaydividendstoshareholders,(b)a40%dividendratio,translatingtoan approximate$.20pershareperquartercashdistribution,(c)aresidualdividendpayout, wheredividendswouldbepaidonlyifleftovercashremainedafternewinvestments andcapitalprojectswerefunded,and(d)astockrepurchaseprogram,wherefunds wouldbeusedtorepurchasestockinsteadofpayingoutadividend. Beforearecommendationcanbemade,relevantfinancialconceptsandmarketpayout theoriesshouldbeexplored.

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Case 8 Analysis: Gainesboro Machine Tools | MBAD 6154 | Spring 2008

ConceptsofPayoutPolicy

Thegoalofanearningspayoutpolicyistodistributethefirmsearningstotheowner shareholdersofthecompanywhilemaximizingbothfirmandshareholderwealth.A firmgenerallyhasthreeprimaryoptionsindistributingexcesscashflowsgenerated frominternaloperations:payacashdividendtoinvestors,repurchaseaportionoftheir outstandingstock,andretainearnings.Thefirstoptiontobeconsideredisretention. Retainedexcesscashcanlaterbeusedtoinvestinfuturegrowthopportunitiesforthe firm.Withreinvestments,afirmmayyieldagreaterreturnthaninvestorscould otherwisegenerateinanalternateinvestmentofsimilarrisk.Thisisthestrategyused bythemajorityofgrowthfirmsasanattempttocompeteandgainmarketshareaway fromcompetitors.Aftergrowthopportunitiesandcapitalprojectsareconsidered,the firmcouldpayoutaportionorallremainingexcesscash.Wellexplorethefollowing relevanttheoriesinordertoadequatelyunderstandthereasonsandconsequencesof doingso.
DividendsandDividendTheories

Adividendisdefinedasaportionofcorporateearningspaidouttoshareholders.The relevanceofdividendshasbeendebatedthroughoutacademiaandthecorporateworld butnoconclusiveevidencehasbeenpresentedtonameanyonetheorydominant.For thepurposeofthispaperwewilldiscussthree:dividendirrelevance,birdinhand,and taxpreferencetheory. Thedividendirrelevancetheorem,championedbyMillerandModigiliani,statesthat thevalueofafirmisdeterminedonlybytheincomeproducedbyitsassets,notbyhow thisincomeisdistributed.Ifaninvestordesiresacashpaymentbutthefirmdoesnot paydividends,hehastheabilitytocreateadividendbysellingsharesofstock.Onthe otherhand,ifaninvestordoesnotdesireregularincomefromadividendpayingfirm, hehastheabilitytousehisdividendtopurchaseadditionalsharesofthefirm.In simplifyingthetheory,MillerandModigilianiignoretaxesconsequencesand transactionfeesandpresuppose100%freecashflowpayout,gapingassumptionswhich aresharplycriticizedbymanyandstillarguedovertoday. Anothertheory,theclienteleeffect,isimportanttodiscusswiththedividend irrelevancetheorem.Itexplainsthatdifferentgroupsofinvestors(calledclientele) preferdifferentpayoutmethods.Retirees,pensionfunds,andendowmentsgenerally prefercashpayoutsbecausetheyhavelowornotaxliabilityandseektoavoid unnecessarytransactioncosts.Conversely,peakearninginvestorsinhightaxbrackets wouldprefertodefertaxliabilitybyoptingforincreasedvalueinstockpriceinsteadof cashdistributions.Theclienteleeffectstatesthatnomatterthepolicyacompany adopts,thestockwillattractinvestorsandoneclienteleisagoodasanother. Additionally,ithighlightsthatfrequentchangestopayoutpolicyisunattractiveto Fowler/Jamison Page4

Case 8 Analysis: Gainesboro Machine Tools | MBAD 6154 | Spring 2008

investorsduetoexcessivebrokeragecosts,unnecessarytaxliability,andapotential shortageofinvestorswhopreferthenewpolicy. Thebirdinhandtheorysuggeststhatdividendsarepreferredovercapitalgains.This theorystatesthatstockpriceispositivelyaffectedbydividendpayoutbecauseinvestors aremoreconfidentinreliabledividendsthantheyareofvariablecapitalgains potentiallyachievedfromretainedearnings.Opponentsarguethatifthisweretrue, highdividendstockswouldconsistentlytradeabovetheirzerodividendpeers,which studieshaveshownisnotthecase. Thetaxpreferencetheorystatesthatinvestorsprefercapitalgainsoverdividends.It suggeststhatsomeinvestorsmayavoiddividendsbecauseoftheannualtaxliability. Capitalgainstax,however,canbeavoidedanddeferredbysimplynotselling.Thetime valueeffectsofdeferringtaxesalsomaymagnifythepreferenceforcapitalgains.In theory,thesetaxadvantageswouldcompelinvestorstopaymoreforalowpayout companythanasimilarhighpayoutcompany.
StockRepurchases

Astockrepurchaseoccurswhenafirmbuysbackitssharesintheopenmarketorina tendertransaction.Anopenmarkettransactionisexecutedafterthefirmannouncesits intenttobuybackacertainamountofsharesorpresetamountofdollarsintheopen market.Thefirmmakesopportunisticbuyswhenitbelievesthatitsstockis undervaluedinthemarket.Atendertransactioniswhenthefirmbuysbacksharesata premiumtothecurrentmarketprice.Themajoradvantagesofarepurchaseprogram includeboostingearningspershare(EPS),adjustingcapitalstructure,andsignaling confidenceinfutureearningspotential.Repurchasesarealsoviewedasbeingmore flexiblethandividends,sinceacertainelementoftimingcanbeemployed. Repurchasinghasbecomesoprevalentintodaysmarketthatfinancialexpertshave pronouncedrepurchasesasthedominantformofpayout.DouglasSkinner,ofthe UniversityofChicago,goessofarastoproclaimdividendonlyfirmsasextinct,(Skinner). Repurchasesareincreasinglyusedinplaceofdividendsbecauseofitsflexibilityand signalsofselfconfidence,evenforfirmsthatcontinuetopaydividends.
Signaling

Whenitisdecidedthatacompanyshouldinitiateorchangeapayoutpolicy,potential consequencesoftheannouncementshouldbeconsideredfirst.Changesinpayout policyimplicitlyreveal,orsignal,informationcontentregardingearningspotentialto themarket,andthemarketwillusethisnewinformationtomakedecisionsaboutthe firm.Empiricalstudiesshowthatonaverage,firmsthatreducedividendshavehadpoor earningsinthequartersleadinguptothecut,butmosthaveactuallyimprovedearnings insubsequentyears,(Bernartzi,Michaely,Thaley).Thisusuallyoccursbecausethe excesscashcaninsteadbeusedformoreconstructivepurposes,likepayingdowndebt, makingshortterminvestments,andenteringotheropportunities.Studiesalsoshow thatfirmsthatincreasedividendsarelesslikelythandividendidlefirmstoexperiencea Fowler/Jamison Page5

Case 8 Analysis: Gainesboro Machine Tools | MBAD 6154 | Spring 2008

dropinfutureearnings,and,thatstockpricetendstofallwhenpayoutprogramsarecut butstockpricesdonotalwaysrisewhenpayoutsareelevated.Knowingthis,the markettypicallyexpectsequivalentactivityaftersimilarannouncements.

PayoutEvolution

Anothernoteworthyobservationisthatfirmstoday,regardlessoftheirprofitabilityand othercharacteristics,havebecomelesslikelytopaydividends.Theproportionoffirms payingcashdividendsfellfrom66.5%in1978to20.8%in1999.Morepubliclytraded firmsthaneverbeforearesmallbusinesseswithlowprofitabilitybutstronggrowth opportunities.Itisalsobecausefirmshavealowerpropensitytopaydividendssince thecommonpresumptionisthatvariousfactorsmakedividendslessvaluablethan capitalgains,(Fama).Inarecentsurveyof384financialexecutives,maintaining dividendlevel(fordividendpayingfirms)isfoundtobeequallyasimportantasother investmentdecisions.Fortheexecutives,projectingstabilityofearningsisimportant, buttheyfeltthelinkbetweenearningsanddividendshaswaned.Manynowfavor repurchasesbecauseofitsbuiltinflexibilityanditseffectstoearningspershare.(Brav, Graham,Harvey,Michaely). Recommendation Payoutpoliciesvarygreatlyfromoneindustrytoanother.Maturemarketstendtopay highdividendsbecausetherearefewopportunitiesforgrowth.Forexample,the utilitiessectorisstrictlyregulated,limitingacquisitionsandinnovations,therefore earningsmaybedistributedinlargequantitieswithminimalneedforsavings.The technologysector,ontheotherhand,tendstopaynodividendsbecausethereare considerableopportunitiesforgrowth,includingcontinualresearchanddevelopment, marketshareinitiatives,andacquisitions.Afirminanindustrywithabundantgrowth prospectsmayprefertohaveexcesscashonhandtoexploitthemanymoneymaking opportunities,however,theoptimalpayoutpolicyforeachindividualfirmwillvary. Gainesborohistoricallyemployedhighdividendswhenitscorebusinesswasinmature industries.Themachinetoolsandmanufacturingindustryofferedfewopportunitiesfor growth.Gainesborosnewinitiativestakeplaceinthesoftwareandhightechnology industry,anindustryripewithinvestmentandgrowthopportunities,bothdomesticand international.Gainesborosmanagementengagedintheseexploitswithhighdividend payoutsandhasbeenpunishedforitwithextraordinarylosses.Itiswiththisreason thatwerecommendGainesborointroduceazerodividendpolicy. Wefeelazerodividendpolicycoupledwitharesidualstockrepurchaseprogramisthe optimalpayoutpolicyforGainesboro.Aclear,stablezerodividendpolicyeffectively communicatesthatGainesboroisaggressivelypursuingopportunitiesforgrowthina rapidlyexpandingindustry.Aresidualstockrepurchaseprogramisrecommended becauseofitsflexibilityandsignalingeffects.Announcingsuchaninitiativewould publiclycommunicatethatthecompanyhasfullfaithandconfidenceinfutureearnings. Fowler/Jamison Page6

Case 8 Analysis: Gainesboro Machine Tools | MBAD 6154 | Spring 2008

RepurchasingshareswouldservetoinflateEPS,and,althoughnoassurancescanbe made,mayinfluencethesharepriceupward. Incomeseeksmaybeunattractedtoazerodividendpolicybutthisinvestorgrouphas alreadybeenactivelydivesting.Thefirmstraditionalclientelehasbeenturningover sincetheinitialdividendcutin2004,a30%decreaseasseeninexhibit4.Growth investors,uponhearingthatGainesborowillreinvestinitself,expanddomestically,and pursueinternationalprospects,shouldbereattractedtothestock,assuggestedbythe clienteleeffect. NoneofGainesborospeersintheindustrialhightechsoftwareindustrypaydividends, (Autodesk,withalow6%payout,beingtheonlyexception),asseeninexhibit6. Identifiedalsoinexhibit6areGainesborospeersintheelectricalequipment manufacturingindustry.ItspeersinthisindustrytradewithaP/Eratiointhe1617 range,regardlessofpayoutratio.NotethatbothHubbellandThomas&Bettstradeat 17.6P/EeventhoughHubbellpaysdividendsof52%ofnetincomeandThomas&Betts donotpaydividendsatall.Itseemseithereachfirmhasfounddependableclientele investorsorpayoutformisirrelevanttoinvestorsinthisindustry. Gainesboroshouldalsomoveforwardwithrebranding.Thenewname,Gainesboro AdvancedSystemsInternational,moreaccuratelyrepresentstheirproductsandtheir business,willhelptoprojecttheirgrowthpotentialintheadvancedsystemsindustry.It willalsoassistintheattractionofgrowthinvestorclienteleinthehighgrowthsoftware industry. Gainesborosnewimageandnewpayoutpolicywillpositionthemforsuccessintheir newindustry.

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Case 8 Analysis: Gainesboro Machine Tools | MBAD 6154 | Spring 2008

CitedWorksandRecommendedReadings

Benartzi,Shlomo.Michaely,Roni.Thaler,Richard.1997.Dochangesindividendssignalthe futureorthepast?.TheJournalofFinance.Vol.52,No.3,pg10071034. Brav,Alon.Graham,JohnR..Harvey,CampbellR..Michaely,Roni.2005.Payoutpolicyinthe 21stcentury.JournalofFinancialEconomics.Vol77,pg483527. Brigham,EugeneF..Ehrhardt,MichaelC..Chapter18.DistributionstoShareholders:Dividends andRepurchases.FinancialManagement:TheoryandPractice,11thEdition.2005 Canina,Linda.1999.Themarketsperceptionoftheinformationconveyedbydividend announcements.JournalofMultinationalFinancialManagement.Vol9,pg113. Chen,Chung.Wu,Chunchi.1999.Thedynamicsofdividends,earningsandprices:evidenceand implicationsfordividendsmoothingandsignaling.JournalofEmpiricalFinance.Vol6, pg2958. DeAngelo,Harry.DeAngelo,Linda.2005.TheirrelevanceoftheMMdividendirrelevance theorem.JournalofFinancialEconomics.Vol.79,pg293315. DeAngelo,Harry.DeAngelo,Linda.2008.Replyto:dividendpolicy:reconcilingDDwithMM. JournalofFinancialEconomics.Vol87,pg532533. Fama,Eugene.French,KennethR..2000.Disappearingdividends:changingfirmcharacteristics orlowerpropensitytopay?.JournalofFinancialEconomics.Vol60,pg343. Handley,JohnC.2007.Dividendpolicy:reconcilingDDwithMM.JournalofFinancial Economics.Vol.87,pg528531. Hillis,Scott.ApplePlansnoDividendorBuyback.Reuters.2008March3rd. Http://news.yahoo.com/s/nm/20080304/bs_nm/apple_dc_2.Accessed2008March 8th. Miller,MertonH..Modigliani,Franco.1961.DividendPolicy,Growth,andtheValuationof Shares.JournalofBusiness.Vol.34,No.4,pg411433. Skinner,Douglas.2008.Theevolvingrelationbetweenearnings,dividends,andstock repurchases.JournalofFinancialEconomics. Sullivan,Missy.DividendStocksPayOff.Forbes.2002February12th. http://www.forbes.com/2002/02/12/0212adviser.html.Accessed2008March8th.

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