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Prepared by: Professor Charisa Asbury Bachhawat, Vivek Hadgis, Demetrios Tsoka, Katerina Uccellini, Jessica

Dividend Policy: The FPL Group, Inc. (“FPL”) I. Executive Summary

A. Current Situation: In the spring of 1994, Merrill Lynch’s utilities analyst downgraded their investment rating for the FPL Group, the parent company of Florida Power & Light, Florida’s largest electric utility. The Merrill Lynch analyst downgraded FPL because he/she believed FPL was on the verge of cutting its dividend for the first time in 47 years. Reacting to this news release, Kate Stark, an electric utilities analyst at First Equity Securities Corporation, faced the decision whether or not to revise her own current ‘Hold’ recommendation on FPL’s stock. Following chairman Marshall McDonald’s retirement in 1989, FPL experienced a streamlining of its businesses and operations under his successor, James Broadhead. At FPL, Broadhead implemented a commitment to quality and customer service, increased its focus on the utilities industry, expanded capacity, and improved its cost position. In the 1990’s, Broadhead sold off several of FPL’s non-utilities businesses.1 In May, 1994, one of the most important issues confronting the FPL Group was the decision whether or not to decrease their dividend payout ratio as a result of an evolving competitive market place.

B. Competitive Position: Chairman James Broadhead’s vision for the electric utilities business was one of free and open competition, and he intended to better position FPL for such a marketplace.2 Initially, under chairman Marshall McDonald, FPL underwent a period of diversification and expansion in the 1970’ and 80’s, acquiring major companies in various industries, such as real estate, insurance, and information services.3 Later, under Broadhead, FPL reversed that trend of diversification and instead focused on streamlining their business and operation in order to improve efficiency and lower costs.

1 Harvard Business School, Dividend Policy at FPL Group, page 4. 2 Harvard Business School, Dividend Policy at FPL Group, page 4. 3 Harvard Business School, Dividend Policy at FPL Group, page 3.

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Low capacity margin (8.6%) suggests FPL has less room for growth compared to their peer companies.4

FPL’s Transmission and Power costs far exceed those of their

competitors.5

o FPL’s 1993 Transmission Costs are at the higher range compared to that of their peer companies. (FPL = $.0019 compared to an industry average of $.0010.) High transmission costs place FPL at a competitive disadvantage in a deregulated industry (Exhibit A below).

o Power generation costs are high because FPL purchases 30% of

power used in the generation process from outside sources, thereby making FPL sensitive to fluctuations in power purchase prices (Exhibit A below).

Regulatory Changes

o 1992, Wholesale Wheeling enabled one utility to sell power to another utility company using third-party transmission.

o 1994, Retail Wheeling allowed customers to buy power from

utilities other than the local monopoly supplier through third-party transmission.

Credit Risk

o Concerns by rating agencies of FPL’s interest expense given the 140 basis point increase in long-term interest rates since 1993.6

4 Case Exhibit 7, Investor-Owned utilities in the Southeast United States in 1993. 5 Case Exhibit 7. 6 Harvard Business School, Dividend Policy at FPL Group, page 6

Exhibit A

FPL Group Carolina Power Duke Power Florida Progress SCANA Corp Southern Co. TECO Energy

Transmission Cost/ KWH* $0.0019 $0.0009 $0.0010 $0.0010 $0.0007 $0.0008 $0.0006

Percent Of Power Purchased* 30% 11% 1% 15% 26% 7% 3%

* Case Exhibit 7: Investor Owned Utilities in the Southeastern United States in 1993.

Competitive Position

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C. Recommendation: Dividend Policy

It is our recommendation that FPL reduce its payout ratio to 60% because such a ratio would place them at the lower end of the range of that of their peer companies, better positioning FPL for future performance and growth in a recently deregulated industry.7 Additionally, reducing the payout ratio reduces taxes for their shareholders.

Buy back shares subsequent to dividend cut.

o In order to counteract negative market reaction to dividend cut. o Make firm less of a target for acquisition.

II. Key Assumptions

Our analysis is based on the following key assumptions:

The Efficient market hypothesis applies. Analysts’ investment rating recommendations are limited to three options:

o Buy o Sell o Hold

Analysts use public information to formulate their recommendations, and

make every effort to use reliable, comprehensive information. Signaling exists in the marketplace.

III. Analysis: Dividend Policy Dividends are a share of a company’s profits distributed to its shareholders. Companies, such as FPL, pay dividends to attract shareholders. Traditionally, utilities, with their large dividend payments, attract an ‘income’ investor base, one less focused on growth and more focused on receiving steady cash.8 Conversely, ‘growth’ investors generally seek to invest in companies with long-term capital appreciation prospects. Typically, such firms retain more of their earnings instead of distributing them in the form of dividends.

7Dividend Payout ratio range was 60.8 – 106.2%, Case Exhibit 9. 8 Individual investors hold approximately 51.9% of FPL’s shares.

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Advantages of Reducing Current Dividend Policy:

Reduced payout ratio helps reduce exposure to increased industry risks,

such as market volatility and deregulation. This suggests that FPL’s current dividend policy is too high (<90% in 1993).

Dividends are taxed more than capital gains (almost double); therefore by reducing or not issuing dividends a firm can save investors money in terms of the amount of taxes they will pay.

Results in excess cash, which can then be used for future growth through acquisitions. (Current capacity is close to being maximized.)

Disadvantages of Reducing Current Dividend Policy:

Reducing its dividend would be seen as signaling in the marketplace, resulting in lowered stock price.

Negative market reaction. Lesser share of the profits to shareholders by means of dividends. Dividends inject cash into the market, improving the macro-economic

conditions.

Despite a history of volatile earnings, FPL has maintained an inappropriately high payout ratio, thereby creating additional risk for the shareholders. Dividend cuts are not uncommon for utilities except in situations of financial trouble, and even then, are not well accepted by the market.9 According to the Miller-Modigliani theory, dividend policy should not matter since the returns that investors would earn would be the same as the return that the firm would receive if the cash were reinvested.

III. Conclusion The recently deregulated electric utility industry introduced new market competitiveness. FPL’s current dividend policy is inappropriately high for such a market environment. FPL must reduce its payout ratio to 60% because such a ratio would place FPL at the lower end of the range of that of their peer companies, better positioning FPL for Broadhead’s vision of future performance and growth. Kate Stark should revise her investment recommendation from “hold” to “buy,” upgrading her rating because the value reflected after the decrease in payout ratio is lower than the intrinsic value of the stock ($42.16, see Exhibit B). The lower value reflected by the decreased payout ratio is the result of the effect of signaling in the market. 9 Harvard Business School, Dividend Policy at FPL Group, page 6

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Exhibit B

Key Ratios

Current TargetPayout Ratio 90% 60% aDividend $2.48 $1.65 b

Change in Dividend (!d) -$0.83 cReturn on Equity 12.50% d

Dividend Yield 6% 4% eEffective Price per share $41.33 $42.16 f

a: Current: Exhibit 7, Target: Case assumption; such a ratio would place FPL at the

lower end of the range of that of their peer companies

b: Current: Exhibit 7, Target: Dividends = (Change in Payout Ration) * Current Dividends

c: Change In Dividends = Current Dividends - Target Dividends

d: Exhibit 7

e: Current: Exhibit 7, Target: Dividend Yield = Annual Dividend / Price Per Share

f: Current: Price Per Share = Annual Dividend / Dividend Yield