When The Aggressive Distribution To Shareholders Is Promising

Aug.13.14 | About: Viacom Inc. (VIAB)


Some companies offer a very high distribution (in the order of 10%) to their shareholders. However, this does not guarantee a great profit to the shareholders.

Investors should check some elements in the balance sheet to determine whether the company can maintain its high distribution rate.

Philip Morris has stretched its balance sheet to the extreme and hence it cannot maintain its past rate of share repurchases.

On the other hand, Viacom has a healthy balance sheet so its shareholders can rely on the stock to maintain its exceptional returns for many years.

It is well known that stocks with aggressive distribution (dividend plus share repurchases) to their shareholders can lead to great profits. However, while there are various companies offering extreme distribution yields to their shareholders, investors should perform their due diligence before they invest in such stocks.

More specifically, when a company has exhausted its balance sheet, its stock may not prove a good investment even if it offers an extremely high total yield. Initially, the aggressive distribution markedly boosts the stock price, thus leading the investors to build up their expectations but, unfortunately, the past performance of the stock can be very misleading in such cases. This is actually a good place for the well-known disclaimer "Past performance is not indicative of future returns."

For instance, Philip Morris (NYSE:PM) has been offering an exceptional total yield since its spin-off from Altria (NYSE:MO) in 2008. In this way, while its earnings increased 45% from 2007 to 2012, the earnings per share (EPS) almost doubled during that period, thus leading the stock price to almost double during that period. Many investors may have thought that the same pattern would continue but it has paused since then even though the company is still offering an exceptional total yield of about 8% (4% dividend plus 4% share buybacks). To be sure, the stock has lost 9% in the last 2 years, while the S&P (NYSEARCA:SPY) has advanced 37% during that period.

The problem is that the company has stretched its balance sheet to the extreme. More specifically, the book value has become negative (about $6 per share) and the current assets ($14.7 B) are only slightly higher than the current liabilities ($13.6 B). Moreover, the interest expense will exceed $1 B this year for the first time, though it currently eats only 8% of the operating income. Finally, the payout ratio stands at 70%.

All these numbers do not mean that the company will face any solvency problems or that it will stop raising its dividend. However, they mean that the management has very limited resources to continue rewarding its shareholders at the recent exceptional rate. To be sure, the management has already announced that it will curtail its share repurchases this year. Moreover, the extreme distribution reveals the view of the management that there is little room for growth and hence it prefers to minimize its investments and instead use the whole profit plus some of the equity to reward its shareholders. This is also proved by the absence of EPS growth in the 3-year period from 2012 to the end of 2014 despite the pronounced share repurchases.

Based on the above, investors should select companies that still have ample room to maintain their aggressive distribution. A great example is Viacom (NASDAQ:VIAB), which has been repurchasing its shares at an almost 10% rate in the last 4 years while it has also been paying a dividend (currently 1.5%). During that period the equity has decreased from $8.7 B to $5.2 B, which means that the company pays more than it earns to its shareholders (like Philip Morris). However, the still appreciable positive equity means that the management can keep buying back its shares at the recent rate for many years to come. This is also confirmed by the level of the current assets ($5.7B), which are much higher than the current liabilities ($3.4 B). Therefore, the company seems 100% capable of maintaining its exceptional rate of share repurchases and the resultant performance of its stock for many years.

The best part is that the remaining amount for share repurchases ($7.15 B on August 5th) is sufficient to purchase 20% of the outstanding shares of the company at the current stock price. Therefore, the benefit from the current buyback program will be very beneficial to the shareholders, let alone the fact that the management is likely to announce a new buyback program before the current one is completed.

In the last 8 years, the company has doubled its earnings and has almost tripled its EPS thanks to its aggressive share repurchases. Moreover, these repurchases offer great downside protection in the case of a general market correction or a specific headwind for the company. As the company buys back its shares during a correction, it provides a floor to its stock price and also guarantees that the next rebound will be greater, as the number of shares will be lower.

DirecTV (DTV) followed a similar distribution policy with very aggressive share repurchases (no dividend though), which greatly rewarded its shareholders. To be sure, the EPS more than quintupled in the last 4 years and the company was recently reported to be a takeover target by AT&T (NYSE:T) at a record stock price. One should not be surprised that Warren Buffett has a stake in DirecTV and Viacom.

To sum up, investors should check the balance sheet of a company to determine whether the management can maintain its aggressive distribution to its shareholders. As is evident from the balance sheet and the announcements of its management, Viacom has ample room in its balance sheet to maintain its aggressive share repurchases (about 10% per year) and its dividend (1.5%). The current buyback program, which covers 20% of its market cap, is very promising for its stock performance while it also offers great downside protection. I will look for a top on the stock price when the current liabilities exceed the current assets, which will not happen any time soon.

Disclosure: The author is long VIAB. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.