Negative Views of Dividend Recaps Misguided

Apr. 3.07 | About: Dean Foods (DF)

I can't believe how many ill-informed comments get posted about the evils of dividend recaps. Consider these salient points:

1. Private equity deals are now all the rage. Investors see these monstrous deal payouts and wish they could participate somehow, explaining the interest in investing in those few public vehicles that actually do private equity. So what do these private equity deals amount to? Investors buy up a business and then borrow against its assets to fund a portion of their investment. Then they hold the investment for awhile until the company pays down some debt, at which time the business has increased in value, compared to the reduced investment (net of dividends).

2. Companies which do these dividend recaps, like Dean Foods (NYSE:DF) and Health Management Association (NYSE:HMA), are essentially providing their own investors with the advantages that might otherwise be gained by the private equity investors taking the assets off the public market. Granted they are usually motivated in part by a desire to protect their own independence and jobs, but that doesn't change the fact that investors stand to benefit greatly when an appropriately chosen business does a dividend recap.

What sort of business fits this mold? One with dependable earnings and cash flow, without the need to invest much of its cash in its business in the near term. In short, a company like Dean Foods, which has a dominant position in the stable US dairy business, and has completed and already funded a round of industry-consolidating acquisitions.

Interest rates remain historically cheap, and the business environment favors deals like this just now. The accounting effect of such deals is significant. Debt goes up, which this raises interest expense (offset by reduced income tax expense); this reduces after tax income slightly, but equity is slashed because investors have been given a huge chunk of their money back. This means that if the stock price were to theoretically stay at the prior level (reduced by dividend), price-to-earnings ratio would go down by 1/3 and return on equity would skyrocket. In practice, investors like me think that the price will rise to reduce the decline in p/e ratio, and that the company will quite quickly pay down debt.

Disclosure: the author has a long position in DF.

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