Making A Case For Special Dividends

Includes: DO, TNH
by: E. Hunter

My Investing Philosophy

When I purchase shares in a public company, I'm purchasing an ownership stake in that company. I'm looking for a firm that will provide me with stable, growing returns over time. I try to find management with the same long-term vision for the company that I have. In essence, I'm looking for public companies that are run the way I would run a private company.

If I were to own a stable and profitable private company, free from the perception and volatility of the market, my mantra would be that cash is king. I would keep debt to a minimum; operations and expansion would be funded from internally generated cash flows. I would routinely evaluate my cash on hand relative to the cash requirements over the next several periods. If I have less cash on hand than is required in the near term, I would not pay myself a dividend. If I have more cash on hand than will be required in the near term, I would pay the excess to myself in the form of a dividend.

Most public companies in mature markets pay set, quarterly dividends. As a private business owner, I would never implement quarterly dividend payments. It would make no sense for me to pay myself a dividend, while at the same increasing my debt or equity to fund capital projects or operations. Fixed quarterly dividend payments would require me to generate sufficient earnings to fund the dividend, and effectively act as perpetual debt to the company. I might feel pressured to maintain this dividend; after a couple of bad quarters I might pursue risky ventures just to maintain that dividend, as opposed to waiting for better opportunities or a better business environment.

Fixed dividend payments are an even larger problems for companies in the commodities sector. These companies often have very little autonomy in setting the prices at which their products are sold. When oil prices plunged in 2008 and 2009, there was little the oil producers could do. Having a fixed dividend payment was very dangerous for these producers. Although management and the board are able to reduce dividend payments, this is often viewed as a last resort.

Fortunately, not all public companies are hamstrung by fixed quarterly dividends. Some companies pay special dividends that are adjusted regularly, and still average a healthy yield. Consider Diamond Offshore Drilling (NYSE:DO) and Terra Nitrogen (NYSE:TNH).

Diamond Offshore Drilling

Diamond Offshore Drilling is a contract driller. The company owns a fleet of offshore drilling rigs that include 32 semi-submersibles, 13 jack-up units and four drillships. Although headquartered in the U.S., 90% of its revenues are earned outside of the country.

Diamond, like most offshore drillers, suffered a drop in its share price in the wake of British Petroleum's (NYSE:BP) Deepwater Horizon oil spill in spring 2010. Although the share price has yet to recover, the financials of the company remain strong. Compared to a market cap of $9.54 billion as of Wednesday's close, earnings of $963 million and operating cash flows of $1,420 million appear large.

Diamond has a history of exceeding analysts expectations. The company's quarterly earnings vs. analyst estimates for the prior three quarters are as follows:


Median analyst expectation

Reported EPS

% surprise

September 1, 2011




December 1, 2011




March 1, 2012




Diamond pays a fixed dividend of $0.125/share, which is hardly substantial. The company also pays a special dividend that is adjusted every quarter. The special dividend has ranged from a low of $0.75/share to a high of $1.875/share in the past five years. The previous four dividends, regular and special, total $3.50, providing a dividend yield of 5.1% given Wednesday's closing share price of $68.62.

I am of the opinion that this dividend has room to grow. As seen in the 2011 annual report, Diamond has been pouring money into expanding and upgrading its fleet as follows:

  • 2009: $412 million
  • 2010: $434 million
  • 2011: $775 million

This level of capital expenditures positions Diamond well for the future. It is also unreasonable to expect this level of capital expenditure to continue in perpetuity. 2011 capital expenditures of $775 million plus dividends of $490 million is still $155 million less than 2011 operating cash flows. At historical levels of capital expenditures, the company is generating hundreds of millions of free cash flow. Diamond has only $1.5 billion in long-term debt and $73 million interest expense in 2011, meaning debt will not be a drag on future cash flows. Expect Diamond to increase the special dividend over time as capital expenditures return to historical norms.

Terra Nitrogen

Terra Nitrogen is an American producer of fertilizer structured as a master limited partnership. The company's primary products are urea ammonium nitrate solutions and ammonia.

Terra Nitrogen has a very clean balance sheet, with $31.4 million of liabilities compared to $300.7 million of assets, $179.8 million of which is cash. From this net asset base of just $269.3 million in 2011, the company generated $508 million in net earnings and $513 million in operating cash flows.

The company targets minimum quarterly distributions of $0.605/share; however, it also has a mandate to distribute 99% of available cash to unit holders. Available cash is determined by cash flows generated less expected future cash requirements. Because Terra Nitrogen is structured as a master limited partnership, the distributions are taxed differently than dividends. The previous four quarters have generated $17.08 in distributions/share, good for a yield of 6.1% based on Wednesday's closing price of $278.65. Note that this stock is extremely volatile, and could have been purchased for less than $247 in the last five days, which would have generated a 6.9% yield on cost.

Terra Nitrogen has enjoyed a significant increase in its share price over the last several years for primarily two reasons. First, the company's products are primarily used for fertilization of corn, of which American production is increasing and, as of recently, supplies are decreasing. The second reason is the bulk of the expenses for producers of urea and ammonia is natural gas purchases, which due to advances in shale drilling technology, is priced at near a 10-year low. This has resulted in Terra Nitrogen being able to sell more of its product at a higher price, and to produce that product at a cheaper price. As such, what was a $20 stock six years ago is now a $280 stock.

I remain bullish on Terra Nitrogen despite it's recent run-up. I hold this stock for the yield it generates, not for the capital appreciation I might realize. Given the North American glut of natural gas, the increasing demand for food, and the increasing demand for corn and corn-based products -- such as ethanol -- the company's products will be in demand for a long time. There are strong barriers to entry in the industry given the large capital costs. Furthermore, given that farmland cannot be created in North America, greater demand is going to need to be met by more efficient farming practices, an area that its products can help.

Although the stock price is volatile, I foresee Terra Nitrogen continuing to produce greater than 8% distributions, which it was consistently producing before the recent run-up in share price after the release of the 2011 10-K. If I you are interested in purchasing this name, I would wait for shares to take a significant dip due to the volatility of the stock price. At this point, I would consider establishing a position.

Disclosure: I am long TNH, DO.