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Thursday, October 4, 2012 - 08:30
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Thursday, October 4, 2012 - 08:30
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Thursday, October 4, 2012 - 08:30

A Flood of "Special Dividends" is About to Hit the Market

Thursday, October 4, 2012 - 8:30am

Over the course of 2010 and 2011, we at ran a number of articles focusing on the ever-rising cash balances of corporate America. Companies took the crisis of 2008 and 2009 to heart and started to build up huge reserves of cash for the next rainy day. And in recent quarters, these cash piles have kept on growing.

I recently took a look at 10 companies sitting on combined $762 billion in cash, but it's also possible to find huge cash balances throughout the S&P 500.

Here's a sobering stat: At the end of 2008, companies in the S&P 500 had roughly $900 billion in gross cash. This figure now exceeds $1.3 trillion -- a more than 40% gain in less than four years. Of course some of that is attributable to a recent heavy slate of bond issuance, as companies seize on ultra-low interest rates. Still, net cash levels are more than 25% higher since the end of 2008.

Too much cash might seem like a good problem to have -- but it's not. It drags down key financial measures such as return on equity, and eventually forces management to take action. In some instances, a company might make a bold acquisition, which doesn't always pay off. Exxon Mobil (NYSE: XOM) for instance, likely regrets the $41 billion it paid for natural gas giant XTO Energy in 2009 soon before prices collapsed.

"...the lowest tax environment for dividends for the next 10 or 15 years."
Of course, many companies will look to part with that rising cash through ever-rising dividends. Yet we're just three months from a possible major change in tax policy that could blunt the appeal of high dividends. As of Jan. 1, 2013, the dividend tax rate is scheduled to rise from the current 15% to income-based tax brackets, which in some instances may exceed 40% (when new Medicare surcharges are included).

That's why a number of companies have begun pondering the issuance of "special one-time dividends." It's a phrase you're likely to hear a lot more about as the upcoming earnings season gets underway.

In late July, Choice Hotels (NYSE: CHH) announced a bold one-time dividend of $10.41 a share (the stock trades for around $30), and CEO Steve Joyce didn't mince words on the company's quarterly conference call. "Tax rates on dividends are never going to be better. I don't know how much worse they're going to get, but they are going to get worse. And so, we viewed this as an opportunity to take advantage of what will probably be the lowest tax environment for dividends for the next 10 or 15 years."

What's to gain...
At first blush, there may seem to be little gain in pursuing stocks that are about to deliver a huge cash payout. After all, the soon-to-depart cash is already included as part of a company's value, so any big payout is bound to reduce a company's value by a commensurate amount, right? Well, studies have shown that when a company announces plans to issue a one-time dividend, its stock moves higher (relative to the market) by roughly 3% during the next two trading sessions, eventually positing a near 4% gain after three months. Of course, once the stock goes ex-dividend, its value drops by the size of the dividend, though those just-noted gains remain in place.

If companies are thinking about these special payouts, then why haven't many taken action already? A study by Goldman Sachs found that 50% of all one-time dividend payments in the past 10 years were made in the fourth quarter of the year. This year's fourth quarter starts next week.

Will companies wait until the quarter's end to see whether a last-minute change alters tax policy and preserves dividend tax rates near current levels? History says no. In the final months of 2010, lawmakers hotly debated tax changes (in the end deciding to preserve the status quo). Many companies weren't going to wait and see how those debates played out. "2010 saw the highest number of one-time dividend announcements, more than double the run-rate of 2000-2011 period," note analysts at Goldman Sachs.

A handful of companies have already started to take action. In the past few quarters, we've seen AOL (NYSE: AOL), Booz Allen Hamilton (NYSE: BAH), DSW Inc (NYSE: DSW)., HCA (NYSE: HCA) and Warner-Chilcott (Nasdaq: WCRX), which I recently profiled here, all issue one-time cash dividends. These companies are simply the vanguard of what is likely to become a major theme of the fourth quarter. Many surely note what happened to AOL on Aug. 27, when the company announced a special one-time $5.15 a share dividend.

Naming names
You can dig up your own candidates for one-time dividends by using screening tools. I've started the process by establishing the screening criteria you should use. First, look for companies with free cash flow yields of at least 5%. These are companies that are generating lots of cash and need not worry that cash balances will run into trouble after a one-time dividend payout. Second, look for companies with debt-to-equity of less than 25%. Lastly, find companies that have at least 20% insider ownership. After all, these are the folks who stand to reap some of the biggest benefits of one-time payouts. Here are a few stocks that meet these criteria:

  • Och-Ziff Capital (NYSE: OZM), an asset-management firm with $1.25 billion in gross cash and roughly $700 million in net cash.
  • Franklin Resources (NYSE: BEN), another money manager, which carries more than $500 million in excess cash on its books, after its debts are accounted for.
  • Molex (Nasdaq: MOLX), an electronic components maker that saw cash rise by $100 million and debt shrink by $100 million in fiscal (June) 2012. It now has $400 million in net cash, the highest level since fiscal 2006.

Risks to Consider: Much of the stock price boost form these announcements comes soon afterwards, so you may not need to stick around for an extended period -- especially if you don't actually want to receive the big dividend payment when it comes, typically a month later.

Action to Take --> There could be a wide range of companies looking at special one-time dividends in the coming quarter. So this is a good time to screen for companies that have begun to develop cash balances that are far above historical norms. The companies I mention above are a good place to start looking. They can provide a solid short-term boost and some extra cash for your portfolio.

P.S. -- Regardless of what Congress does about dividend taxes, there's still one investment that makes sense in just about any market environment. It's in a "private" stock market where Mitt Romney, Bill Clinton -- even rock singer Bono -- have made a fortune over the years. And now, we've found a way for regular investors to get in on the action. Go here to see our special report.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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