Usually, you only hear discussions of special dividends when a country’s tax rates are about to increase and a corporation wants to throw some cash at shareholders before the higher rates take effect.
But there are other situations when special dividends are appropriate, too. Namely, when you have cash on hand that cannot be put to a productive use through repurchases, growth initiatives, or balance sheet improvements.
You don’t see special dividends discussed too often because those three circumstances are rarely present all at once, and there is no long-term shareholder constituency drawn to special dividends and management teams often get bonuses tied to stock price and earnings growth. So when a special dividend is an appropriate use of corporate funds, there is no stakeholder in the business that would naturally clamor for a one-time payment.
I was thinking about this special dividend constituency vacuum when I saw last week’s announcement that Mastercard is repurchasing $4 billion of its own stock.
I understand why Mastercard didn’t want to raise the regular dividend payout ratio above 20%. Financial institutions subject to technological shifts want to maintain their flexibility and not lock-in an expected dividend that could be difficult to maintain in a financial crisis.
With ten-year annual earnings growth of 32%, Mastercard management deserves more than the benefit of the doubt that it is seizing all the growth opportunities that present themselves.
And with billions in excess cash on the balance sheet, I understand why Mastercard didn’t want to move from “great financial strength” to “extreme financial strength” status.
This leaves stock repurchases as a natural default option for excess capital. I understand why it happens. When the balance sheet, dividend, and growth projects are well-funded, reducing the share count seems like a reasonable thing to do with whatever is leftover.
But the wisdom of any share repurchase program is contingent upon the repurchased stock trading at a fair price or better. The stock is valued at $113 billion and trading at 28x earnings. Since its 2006 IPO, this is Mastercard’s highest valuation of record. Seriously. You cannot not find any moment in Mastercard’s existence in which the stock has been pricier than 2016. Mastercard executives didn’t see fit to repurchase ANY stock in 2008, 2009, and 2010. At one point, the stock was trading at 7x earnings, and management did nothing to reduce the share count. Now that the valuation has literally quadrupled, shareholder funds get squandered repurchasing the stock at a record-high valuation.
Mastercard’s current situation is why a management team ought to keep the possibility of a special dividend in its back pocket. Instead of spending $4 billion repurchasing stock at 28x earnings, I suggest using the same money to give Mastercard shareholders a one-time dividend of $3.64. That way, the funds can be deployed any way that the shareholders choose. Yes, there may be a 15% to 23.8% tax obligation attached to the special dividend, but I argue that the overvaluation at Mastercard right now is so extreme that the net-of-tax special dividend is still superior to the repurchase of shares at 28x earnings.
Originally posted 2016-12-10 13:53:11.