BP vs Logica Essay

A short discussion paper analysing the dividend policy of the following two companies over the last 5 years: Logica plc and BP plc

Introduction

Brealy and Myers (2000) define dividend policy as the trade-off between retaining earnings on the one hand, and paying out cash and raising capital on the other. Firms have to plan in advance how much profits they want to retain for future investments and growth. If they retain too much, then sooner they would face calls for higher dividends. If they retain too less, they may have to go to capital markets for funds. Dividend levels are also based on managements’ thought about the dividend sustainability in future.

Table I shows the profit and dividend payouts by LogicaCMG in the last five years. LogicaCMG was formed after merger of Logica and CMG in 2002. The audited records of the combined company are available for 2003 onwards only. Only one page financial five year summary is available. As two companies merged, it is better to use total dividend rather than dividend per share.

Table I: LogicaCMG - Five year summary

£ ‘m

2000

2001

2002

2003

2004

Profit after tax

132.6

-503.7

-754.2

-43.7

14.4

% change

-

-

-

-

Dividend

34.8

41.8

42.5

41.9

42.7

% change

20%

2%

-1%

2%

Retained profit, %

74%

-

-

-

-

Source: LogicaCMG (2004)

LogicaCMG’s profits swung a lot in the last five years. From £132 million profit in 2000, LogicaCMG made a loss of £754 million in 2002. The company is moderately profitable now. Dividend, on the other hand, has remained almost constant in the last four years. Companies don’t like to surprise markets by abrupt change in dividend, especially if they have to reduce it. Inspite of severe losses in 2001 and 2002, LogicaCMG has maintained the dividend level. Its dividend policy is to increase dividend to match inflation. As a result there is no relationship between dividends and profits in case of LogicaCMG. The company paid more dividend than profits and hence there was no retained profit in the last four years.

LogicaCMG had significant amount of goodwill amortisation and exceptional items each year. The swings in profits were mainly due to goodwill amortisation and exception items. Goodwill amortisation is a non-cash item. We don’t have separate figures for goodwill amortisation and exceptional items and have assumed that goodwill amortisation was major component of goodwill amortisation and exceptional items. We have added goodwill amortisation and exceptional items to profits after tax to arrive at cash available for distribution (Table II). If we look at dividend as a percentage of cash available for distribution, we see that LogicaCMG did generate more cash to pay dividends even though cash retained has decreased over years.

Table II: LogicCMG - Five year financial summary with goodwill and exceptional items

£ ‘m

2000

2001

2002

2003

2004

Profit after tax (A)

132.6

-503.7

-754.2

-43.7

14.4

Goodwill amortisation and exceptional items (B)

32.7

658.7

825.9

129.5

41.6

C = A + B

165.3

155

71.7

85.8

56

% change

-6%

-54%

20%

-35%

Dividend

34.8

41.8

42.5

41.9

42.7

% change

20%

2%

-1%

2%

Retained profit, % of C

79%

73%

41%

51%

24%

Source: LogicaCMG (2004)

Table III shows the profit and dividend payouts by BP in the last five years. Except for the decline in 2001, BP’s profits have increased every year with the last two years showing more than 50% increase. BP is in oil exploration and production business and its profits are directly related to oil prices. Oil prices have increased significantly in the last two years resulting in higher profits.

Table III: BP - Five year summary

2000

2001

2002

2003

2004

Basic earnings per share, cents

46.77

29.21

30.33

47.27

72.08

% change

-38%

4%

56%

52%

Dividend per share, cents

20.5

22

24

26

29.45

% change

7%

9%

8%

13%

Retained profit, %

56%

25%

21%

45%

59%

Source: BP (2004)

BP has adopted a progressive dividend policy. It will increase dividend each year. The increase may not be related to the change in profits in that year but would follow a pattern of stable growth. Even though the profits declined in 2001, BP still increased the dividend. Similarly even though the profit levels were up more than 50% in the last two years, the company increased dividend by 8% and 13% in 2003 and 2004 respectively. So there is no relationship between profit and dividends.

If BP adopts a policy of certain percentage payout of earnings, it is likely that investors will see widely fluctuating dividends over years. BP’s policy of progressive dividend allows it to set market expectations and match it.

But this policy results in retained profit fluctuations. Retained profits were 21% and 59% in 2001 and 2004 respectively. As and when BP retains larger profits, it rewards its investors by share buyback. This helps the company on one hand to return excess cash to investors and on the other hand follow a dividend policy.

Both LogicaCMG and BP are trying to set market expectations about the future dividend payouts. Companies recognise the need to keep investors informed about future dividend levels. Many investment funds and investors rely on dividend income and would probably avoid stocks with wide dividend fluctuations.

LogicaCMG has now adopted the policy of increasing dividend to match the change inflation. By doing this, the company is conveying what dividend level its investors should expect next year. Otherwise the past changes in profit levels would make it very difficult for investors to judge future dividend yields. By tagging dividend policy to inflation growth, the management is conveying two messages. First it will maintain stable dividend over the medium term even though profit after tax may fluctuate. Second management believes in the ability of the business to generate sufficient cash to pay dividends

It is very unlikely that BP will have earnings reversal similar to those experienced by LogicaCMG. But its profits are dependant on the high volatility of oil prices. BP’s board appears confident of increasing profits over the medium term and hence it has adopted a policy of progressive dividend payout. The company has increased dividend regularly over the last five years, even though the percent change in dividend bears no resemblance to the percent change in profits.

LogicaCMG dividend growth is dependant on inflation and is now like a inflation hedged bond. On the other hand BP’s dividend policy allows it some flexibility as it can vary dividend growth based on profits.

Corporate dividend policy has been debated for a long time and the main question is whether a dividend policy is relevant or not. Management’s capability is most frequently measured by change in share price. If increasing or decreasing dividend can lead to change in share price, then it is relevant for both management and investors.

Miller and Modigliani (1961) first proposed the irrelevance of dividend policy in a world without taxes or market imperfections. They pointed that once a company has fixed its investment and borrowing policy, increase in dividend may necessitate raising additional equity to finance investments. Increasing dividends would just result in distribution of value between existing and new shareholders rather than creation of value. Their conclusion was that the firms should not worry about dividend policy and let it fluctuate as a by-product of investment and financing decision. Increase or decrease in dividends should only depend upon whether company has enough cash to meet investment requirements.

It makes sense in an ideal and perfect world. There is no point in paying dividend and then raising cash through equity sale. But the financial world is not without imperfections. First of all dividend and capital gains are taxed at different rates. So cash distributed as dividend or retained in the company will have different value for different investors. Capital gains and dividends are not perfect substitutes.

Second, there is a clientele for high-payout shares. Many funds and individual investors invest for a steady stream of cash. They would value stocks with known dividend policy more than the ones with unpredictable dividends. At the same time there is significant proportion of investors who are more interested in capital growth rather than dividend income. Modigliani (1982) concluded that clientele effect has only a minimal impact on valuation.

Third, WorldCom and similar instances have shown how managements like to increase their business by acquiring businesses at high valuations. Investors worry that if managements are left with more cash, they would purchase businesses at unreasonable prices just to satisfy their personal ego.

On the other side of spectrum is the view that having a dividend policy is of relevance and changing it increases or decreases share price. Healy and Palepu (1988) concluded the first dividend announcements resulted in an abnormal rise of 4 % in the stock price.

The main rationale behind linking dividend policy with change in share price is the signalling impact of dividend. Not all investors have sophisticated knowledge and skills to evaluate stocks and one of the best ways to segregate marginally profitable firms from good ones is through their dividend policy. Marginal firms can pay higher dividends in short run to match the higher paying peer companies. But if they are not hopeful of generating enough cash in future, they risk antagonising share holders by lowering dividends in future. The advocates of signalling theories believe that a dividend policy used as a means of putting the message of quality across has a lower cost than other alternatives (Frankfurter and Wood).

Companies normally have a dividend policy and most of the companies follow a constant increase policy. Security markets like companies with less uncertainty. Cyclic nature of many industries would make it difficult for investors to predict dividends. By adopting an increasing dividend policy, management points to investors its capability of generating higher profits in future. Baker and Powell (1999) surveyed 170 senior managers and concluded that the most important determinants of a company’s dividend policy were the level of current and expected future earnings and the pattern or continuity of past dividends.

Continuing on the managements’ desire to meet investors expectations, Frankfurter and Wood said that the current models of dividend policy by and large ignore behavioural and socioeconomic influences on managerial and shareholder activity. Managers deciding dividend levels are also motivated by behavioural and socioeconomic influences and hence absence of these from dividend models restricts their applicability.

We saw that both LogicaCMG and BP have dividend policies to help investors predict future dividends. This shows that their management believes that dividend policy does have some relevance. Managements have set market expectations and taken out the uncertainty element as markets don’t like uncertainty related to decrease in dividends. LogicaCMG and BP use the signalling impact of dividend policy to set investors expectations.

Conclusion:

This assignment was useful in understanding the theoretical and practical aspects behind dividend announcements. Though there is a strong case of dividend policy irrelevance in the perfect world, yet we see companies adopting a dividend policy. Companies don’t want to surprise markets with wide dividend fluctuations. Many investors seek a regular dividend and would value companies with predictable dividends more than the companies with unpredictable dividends.

Also, theoretical financial models are not always fully equipped to explain market reactions. Dividend policy decision is now equally due to financial models and behavioural finance. It is important to understand and incorporate expected behaviour of investors in making financial decisions. Managements pay attention to anticipated investors reaction before taking dividend decisions.

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References

Baker, H.K. and Powell, G.H. (1999). “Dividend Policy Issues in Regulated and Unregulated firms: A Managerial Perspective.” Managerial Finance 25 (6)

BP (2004). BP Annual Report 2004

http://www.bp.com/sectiongenericarticle.do?categoryId=2010204&contentId=2014557

Brealey, R.A. and Myers, S.C. (2000). “Principles of Corporate Finance”, The MCGraw-Hill Companies Inc., New York, Sixth Edition.
Frankfurter, G.M. and Wood, B.G. Jr. “Dividend Policy Theories and Their Empirical Tests”. www.departments.bucknell.edu/management/ apfa/Hamburg%20Papers/Frankfurter.pdf

Healy, P. and Palepu, K. (1988). “Earnings Information Conveyed by Dividend Initiations and Ommissions”. Journal of Financial Economics 21 (1988)

LogicaCMG (2004). Annual Report 2004 http://www.logicacmg.com/countries/Investor_Relations/Sublevel/page101009

Miller, M.H. and Modigliani, F. (1961). “Dividend Policy, Growth and the Valuation of Shares”, Journal of Business 34 (October 1961)

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