Should We Worry About Debt-Financed Special Dividends?

Anh is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Before year end, many major corporations are busy preparing special dividends for shareholders, in order to avoid the effects of the “fiscal cliff” next year. They choose different methods of paying dividends, either with their cash on hands or with the newly issued debts. It would be advantageous for the company as it can take advantage of ultra low interest rates. However, investors need to be careful, as debt could be advantageous to one company, but it might be harmful to another. It depends on the business operation, existing leverage, debt terms, and return on the employed cash to determine whether it’s advantageous or harmful. 

Costco (NASDAQ: COST) is an outstanding example of issuing debts to pay dividends. For Costco, the debt is divided into three tranches due in December 2015, 2017 and 2019, with an equivalent amount of principals. The interest is low, at only 0.65%, 1.125%, and 1.7%, respectively, much lower than its return on invested capital of 9.1% - 12.25% in the last 10 years. By taking $3.5 billion in debt on its balance sheet, the total amount of long-term debt is estimated to rise to $4.9 billion, with the D/E around only 0.4x. In addition, this amount of debt would cost Costco $40.58 million more in terms of interest expense annually. The interest coverage would still quite comfortable for Costco, of 20.3x. So Costco’s debt issuance to pay special dividend is the right act for both shareholders and the company itself.

Brown-Forman Corporation (NYSE: BF-A) (NYSE: BF-B), the alcoholic beverage manufacturer, has announced that it will pay a special dividend of $4 per share. The special dividend would be paid on Dec. 27 to shareholders on record as of Dec. 12. With more than 210 million shares outstanding, the amount for the special dividend is approximately $815 million. Interestingly, Brown-Forman would finance this special dividend amount with its cash and newly issued debts. Cash to be used would be $100 million, and the newly issued senior unsecured notes would be $750 million for this purpose, in three equal tranches due in Jan 2018, 2023, and 2043, with the interest rates of 1%, 2,25%, and 3.75%, respectively.

As of October 2012, Brown-Format had around $501 million in long-term debt. With the newly issued debt, the total long-term debt would increase to $1.25 billion. The debt/equity ratio at that time would be 0.53x. The interest expense would increase by nearly $18.13 million to about $50 million. With the trailing twelve month operating income of $840 million, the interest coverage would be very comfortable at 16.8x. 

Furthermore, in the last 10 years Brown-Forman has consistently delivered a double-digit return on invested capital, in the range of 15% - 21.1%. Trailing twelve months, its ROIC was nearly 20%. So it is better for both company and shareholders if the company employs cash in the business operation to earn a high return on invested capital. So issuing low cost debts to pay dividends is a good move, which ultimately benefit Brown-Forman’s shareholders. 

Other companies, such as Limited Brands (NYSE: LTD) and Carnival Corporation (NYSE: CCL), also announced their special dividends of $3 per share and $0.5 per share, respectively. For Limited Brands, the special dividend would cost  around $864 million, higher than its $547 million cash on hand. So I expect that Limited Brands would issue debt to partially fund for its special dividends. With negative equity, increasing amounts of long-term debt over time, and fluctuating operating performance, investors would expose to more risks if more debt were issued.

For Carnival, the special dividend would be amount to more than $388 million, less than its cash on hand at $568 million as of August this year. However, it also issued $500 million in notes due 2017 for general corporate purposes (might include special dividend payment). After issuance, the long-term debt would increase to nearly $8.8 billion, accounting for only 36.4% of its equity, a comfortable level. With the dominant market leader position (50% global market share), this largest global cruise operator would be in a very good shape after special dividends and only a small amount of newly issued debts.

Foolish Bottom Line

Investors couldn’t go wrong when investing in the well-established market leaders. Looking deeper, Costco, Brown-Forman, and Carnival took advantage of the low cost debt financing to finance special dividends and general corporate purposes while maintaining strong balance sheets to further enhance shareholders’ value.





hoangquocanh has no positions in the stocks mentioned above. The Motley Fool owns shares of Costco Wholesale. Motley Fool newsletter services recommend Costco Wholesale. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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