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Florida Power & Light Company Essay Sample

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Florida Power & Light Company Essay Sample

Dividends are set by the firm’s board of directors and can come in the form of cash or stock dividends. Instead of retaining earnings for expansion or investment in growth opportunities, the profits of the firm are converted into dividends for the shareholders. This means that high payout ratios are often paid by mature companies with limited opportunities for more growth, while zero to low payout ratios are paid by younger firms that are expanding and investing. This ratio can be found by dividing the number of dividends by the net income. Dividends can also be classified as ordinary (paid on a regular basis), or extraordinary (paid out as a one time occurrence without commitment).

While these dividends can come in cash form, they can also be offered as stock dividends. This type of dividend, however, can lead to dilution of equity and a reduction of value per share. A stock dividend is recorded as a transaction from retained earnings to equity capital. Repurchase of stock is yet another form: the firm repurchases its own stock, which, unlike dividends, is only taxed on the capital gains of the shareholders. This one time event also allows the company to put cash back in the hands of investors without making a long term commitment.

Dividends also help to provide confidence in the company´s financial well being. The dividend policy can provide investors with a signal regarding the firm: if dividends are increased, for example, it can be seen as a signal that management is confident in future cash flows and believes the increased dividend can be sustained. On the other hand, if dividends are cut, it can be seen as a decrease in the firm’s quality and lead to a decline in share prices.

Taking this information into consideration, there are three schools of thought that argue for or against dividends: rightists, leftists, or the middle of the road school. Rightists assume no tax effects, which could make stock repurchases more attractive. They believe that dividends can add to a firms value and generally prefer high dividends because of distrust of management and prefer to decide on reinvestment with retained earnings instead of leaving the decision to managers. The leftists are mainly concerned with taxes; if there is a tax benefit for capital gains over dividends, the company should retain earnings or buy-back shares instead of distributing dividends. However, pension funds are tax exempt and in some instances dividends may be taxed less than capital gains. The middle of the pack school believes that the company’s dividend policy does not affect firm value, and that the policy is affected by the structure of the firm’s shareholders.

Company’s Background

Florida Power & Light Company, major subsidiary of FPL Group (“FPL”) was formed in 1925 through the consolidation of numerous electric and gas companies. The company enjoyed steady growth until the 1970s when rising fuel costs and construction cost over-runs reducing its profitability. Instead of focusing on improving efficiency and lower costs, Chairman Marshall McDonald decided to diversify into higher growth businesses. This strategy performed well until the 1980s when demand for utilities grew faster than expected requiring more investments in nuclear power plants to increase generating capacity. Also, safety concerns from the Nuclear Regulatory Commission and low employee morale due to the quality program imposed combined with growing competition brought James Broadhead to succeed McDonald in 1989. Broadhead decided that FPL would need to have increased its focus on the utilities industry, expand capacity, and improve its cost position.

Broadhead sold and write-off some of the non-utility businesses for a total of $888 million after tax loss staying with only 3 non-utility subsidiaries that contributed 2% of total revenues. At the same time he commenced an aggressive capital expenditure program ($6.6 billion, spread over five years) designed to meet projected demand into the next decade funded through internal profits, and by issuing $3.7 billion of long-term debt and $1.9 billion of common stock. Also, Broadhead managed to reduce costs by re-engineering the firm’s organization eliminating 4,000 positions at an after-tax cost for $141 million lowering operating and maintenance expenses and increasing efficiency.

What are the most important challenges FPL faces in 1994?

By 1994, Broadhead strategy showed signs of success. FPL was the largest utility in Florida (4th in the country) providing power to 3.4 million customer accounts, and had a service territory covering almost 28,000 square miles. FPL expected 1994 to surpass 1993 success due to decreasing capital expenditures and increasing sales. Hence, several major events had taken place over the past year among them retail wheeling, letting potential competitors enter the electric utilities industry.

This becomes an extremely important issue. The company will be facing more competition and more uncertainty about what could happen in the future. Therefore, the company needs to set a strategy to be more competitive and be able to continue its success in a more competitive environment. For this reason the company needs to be more conservative and increase its liquidity to be able to invest in projects to become more efficient and continue its profitable trend.

Based on the new industry events, in May 5, 1994, Merrill Lynch’s utilities analyst downgraded FPL investment rating. ML believes FPL will choose not to raise its dividends per share from $2.48 and will need to review its dividend policy at the time. FPL management had stated that he company’s payout ratio was too high particularly given an uncertain and more competitive business environment; therefore breaking its record of 47 year streak of dividend increases.

As a result, FPL not only has to let know the market that the company is not having any financial problem and that everything is under control, but also has to show that it is the leader in the sector and where the company is heading in the future in order to prevent a negative reaction from the share holders. As we saw in class dividend policy should not prevent the FPL from taking on good investment projects nor deviate it from its optimal capital structure

In Table 1 we benchmark FPL with competitors’ average and conclude that the main concerns for FPL management are additional cost reduction and probably more power capacity required. FPL capacity margin of 8.6% indicates less room for growth when compare to the 11.4% of its competitors. The percent of power purchase indicates more dependence on power purchased from external sources. And even though all cost ratios are higher than its peers, significantly higher transmission costs, more than double when compare to competitors, give FPL less competitive advantage.

Table 1 (Adapted from Exhibit 7 Investor-Owned Utilities in the Southeast United States in 1993)

Data from Electric Subsidiaries FPL Group Competitors Average

Total KWH produced (millions) 72,454.7 49,957.2

Total Assets ($ millions) 13,078 9,851

Capital Structure

Long Term Debt/Total Capitalization 46.4% 46.9%

Common Stock/Total Capitalization 47.3% 48.3%

Profitability

Return on Common Stock 12.5% 12.9%

Earnings per share $ 2.75 $ 2.31

Cash Flow per share $ 5.85 $ 4.73

Dividend per common stock $ 2.47 $ 1.71

Dividend Yield 6% 5.2%

Payout Ratio (all dividends) 91% 75.2%

Capacity Utilization

Annual Load Factor 57% 57.2%

Capacity Margin 8.6% 11.4%

Percent of Power Purchased 30% 12.5%

Costs

Operation/Maintenance Costs/KWH $0.0075 $0.0067

Busbar Cost/KWH $0.0366 $0.0341

Incremental Generation Cost/KWH $0.0187 $0.0176

Transmission Cost/KWH $0.0019 $0.0008

Explain if you consider the current payout to be adequate assuming…

1. You are a potential investor.

2. You are FPL.

A potential investor may find the current payout to be adequate in the short run. It is important to point out that, because of clientele effect, this investor is most likely to be one looking for steady dividends (instead of capital gains) and therefore prefers a high payout ratio. In this case, FPL is attractive to the potential investor. In comparison with other investor-owned utilities in the Southeast U.S. in 1993, FPL offers the second highest dividend per common share ($2.47) and the highest payout ratio of all (91%). Because FPL is a mature company and has limited growth opportunities, the potential investor would probably prefer to have the retained earnings in his or her hands instead of in the hands of management.

While this may seem highly attractive in the short run, the potential investor must also take into consideration the long term effects of such a high dividend in a changing industry. Although we established that this investor is looking for dividends and not capital gains, the long term consequences of straying from the optimal capital structure to sustain the payout could lead to problems for FPL in the future, which could possibly result in lower dividends. That said, in the present moment the potential investor would find the current payout to be adequate and quite attractive.

From the point of view of FPL, on the other hand, may find the payout ratio to be too high. A simple comparison of the total cost of dividends ($460,440) and the net income ($428,749) shows us that the dividends are higher, and the data demonstrates that the recent dividends are higher than the earnings per share. While this is merely a superficial comparison of only a few figures, the current payout ratio also illustrates little financial flexibility for an uncertain future if we consider the changes in the industry such as deregulation, increased competition, and increasing interest rates.

California’s recent proposal on “retail wheeling,” which allowed customers to buy power from utilities other than the local monopoly supplier, was not currently being considered by Florida at the time. However, it was being considered in 23 other states, and there was a great chance that the trend would reach Florida in the near future. The current 91% payout ratio does allow FPL much flexibility to meet these potential challenges while maintaining its optimal capital structure at the same time. The changing market may also encourage FPL to look into other options for growth, in which case the current high payout would create an obstacle for investment in new projects.

If you were stark, what would you recommend: Buy, Hold or Sell the stock?

Our recommendation for the moment would be HOLD. Stark needs to wait until the FPL management informs the market what are the plans of the company, and what will they be doing with the 150 millions that they are retaining. After this we could change our recommendations to:

Buy

If the company shows that it will use in a good way the resources in order to be more competitive and efficient increasing potentially its future success. Companies usually let know the market what are their plans in the future (investments, acquisitions, strategy, etc), showing its potential.

If the company announces, that with the retained 150 millions, it will do a share buyback. With this the stock price would be expected to increase.

Sell

If the company does not give any valuable information concerning its financial situation and future strategies. This would cause uncertainty

If company reveals critical financial situation

If the company doesn’t show a good strategy plan explaining how they will face the new competition giving more uncertainty to the market.

So, at this point we know that the company is doing well, and that is facing big challenges in the near future. We need more information to make a good decision. It is better to hold right now and wait to see what the management of the company have to say to make a more precise move.

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