CASE STUDY ON FPL(Florida Power Limited)

Analysis on FPL’s stock and giving appropriate recommendations to different kind of investors.

Compiled by :

Amogh GuptaAnup KaurBhupesh MalakarJaptej SinghNavendra

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Case Study: Dividend Policy at FPL Group, Inc.

Electric Utility Industry: Since its inception in 1878, the US electricity industry became an important part of life because of the facts that:

Electricity can be transported from one place to another rapidly It can be converted into other forms easily (mechanical, light energy etc.)

In the late 19th century, the concept of “public utility” developed to establish monopoly supplier of a “vital public service.”(Generation, transmission & distribution of electricity) such that in exchange for the monopoly right to supply electricity, power companies agreed to let government agencies regulate their prices and returns.

Timeline:

Federal Power Act (1935): Federal Energy Regulatory Commission (FERC) received the authority to oversee wholesale electricity transactions.

Public Utilities Holding Company Act (PUHCA, 1935): Securities and Exchange Commission (SEC) received the authority to regulate utilities with interstate systems or substantial diversification.

Public Utilities Regulatory Policies Act (PURPA, 1978): It encouraged the creation of power plants using renewable fuels such as geothermal, solar and wind power (known as qualifying facilities or QFs) and authorized FERC to regulate them. Also the act required local utilities to buy all of their electrical output.

National Energy Policy Act (NEPA, 1992): This act required utilities to make their transmission systems available to third party users at the same quality and cost enjoyed by the utilities themselves. Shortly after NEPA took effect, legal disputes arose over transmission access.

Retail Wheeling (1994): customers would be allowed to buy power from utilities other than the local monopoly supplier. The local utility would be required to open its transmission and distribution network to outside utilities wishing to sell power in that market.

FPL: Company Background

1925: Florida Power & Light Company (FP&L), FPL Group’s major subsidiary was formed through the consolidation of numerous electric and gas companies.

The Company enjoyed steady growth until 1970s when rising fuel costs and construction over-runs reduced its profitability. Also FPL began facing problems of frequent power outages and customer complaints about service.

Marshal McDonald Era: In order to increase the profitability, then Chairman Marshal McDonald decided to diversify into higher growth businesses and to establish a holding company structure to manage the new businesses.

Over the next several years, FPL made four major acquisitions:

1. Colonial Penn Life Insurance Company2. Telesat Cablevision Inc.3. CBR Information Group Inc.4. Turner Foods Corporation

Also FPL established a real estate development subsidiary called Alandco and an alternative energy development subsidiary called ESI energy.

A program of Japanese inspired quality control was also instituted. Therefore, FPL customer complaints fell by 60% asd unscheduled downtime

fell from 18% to 4%

But still FPL had problems as:

In 1986, the Nuclear Regulatory Commission put its Turkey Point nuclear plant on its watch list for safety concerns.

Demand was growing faster than expected in late 1980s Colonial Penn had lost more than $250 million since being acquired Low employee morale due to burdens imposed by the quality control

program

The Broadhead Era: James Broadhead was hired as Chairman in 1989 to address above mentioned problems as well as growing competition level. He developed a long term strategic plan involving regular employee interaction. Various steps in the process were:

Environmental scan to understand industry better Streamlining of quality control program Reversal of FPL’s diversification program Capital expenditure program to meet projected demand Re-engineering of firm’s budgeting and procurement procedure to reduce

costs

As a result by 1994, FPL became the largest utility in Florida, providing power to 3.4 million customer accounts.

Recent Events in the Electric Utility Industry:

More and more states were opting for “retail wheeling.” If and when Florida regulators authorized retail wheeling, FPL would have many potential competitors.

Standard & Poor’s Rating Group (S&P) changed its guidelines for evaluating investor owned electric utilities in October 1993 according to changing competitive landscape. It placed FPL in top 10% of investor owned utilities and also improved FPL’s debt ratings.

As there was a 140 basis points increase in long term interest rates since September 1993, FPL’s interest expenses were mounting. During this period (from September 1993 to May 1994), FPL’s stock price had fallen by 19.6% while S&P’s Electric Utilities Index had fallen by 22.1%

FPL, like most utilities was a low beta stock, over the prior year, its beta was 0.60

Analysis & Recommendations

Problem definition(What is the case all about):

As described above lot of things are happening in FPL as well as in the utility Industry as a whole. We are in the shoes of Stark i.e. electric utilities analyst and suppose to give a decision on the FPL stock taking all the above factors into consideration.

Dividend Fundamentals:

There are three main factors that may influence a firm's dividend decision:

Free-cash flow Dividend clienteles

Information signaling

Free –cash flow:

Under this theory, the dividend decision is very simple. The firm simply pays out, as dividends, any cash that is surplus after it invests in all available positive net present value projects.

Dividend clienteles

A particular pattern of dividend payments may suit one type of stock holder more than another. A retiree may prefer to invest in a firm that provides a consistently high dividend yield, whereas a person with a high income from employment may prefer to avoid dividends due to their high marginal tax rate on income. If clienteles exist for particular patterns of dividend payments, a firm may be able to maximize its stock price and minimize its cost of capital by catering to a particular clientele. This model may help to explain the relatively consistent dividend policies followed by most listed companies.

Information signaling:

A model developed by Merton Miller and Kevin Rock in 1985 suggests that dividend announcements convey information to investors regarding the firm's future prospects.

Dividend PolicyFactors Affecting Dividend Policy:

1. External Factors2. Internal Factors

External Factors Affecting Dividend Policy

1) General State of Economy:

2) State of Capital Market

3) Legal Restrictions:

4) Contractual Restrictions:

Internal Factors affecting dividend decisions

1) Desire of the Shareholders

2) Financial Needs of the Company

3) Nature of earnings

4) Desire to retain the control of management

5) Liquidity position

Dividend policy at FPL:

The new policy consisted of 3 changes:

1) Reduce the dividend by 32% from $2.48 to 1.68 per share which will improve cash flow by approx $145 million.

2) Establish a new target dividend payout ratio of 60 to 65%.

3) Share buyback option i.e. FPL will buy 10 million shares.

4) Move the dividend review from the annual meeting in May to Feb in order to link the dividend and annual earnings announcements more closely.

4. Factors of Dividend Cut

The two reasons that led FPL to cut its dividend were:

The recent speed of deregulation in the utilities industry that forced FPL to start thinking about the impact of not being a regulated company.

The fact that the dividend payout had grown to a higher than normal level on a historical basis.

Important issues confronting FPL:

Impact of retail wheeling in electric utility industry and how FPL will deal with it.

FPL Group must reconcile the increasing level of industry competition with its dividend payout policy. The dividend payout decision implicates FPL’s past, present, and future and FPL must reach a decision that is consistent with its goals in all three.

FPL’s dilemma is exacerbated by the company’s interest expense in the face of rising interest rates. FPL has a large amount of debt, and reducing the dividend could facilitate FPL’s debt repayment.

FPL still holds three unprofitable subsidiaries that detract from FPL’s electricity provider service. These ancillary divisions are all the more incapacitating considering the specter of competition in FPL’s core business.

The concern over the long-term sustainability of supply is another issue facing FPL in light of the fact that Demand grew faster than expected in the late 1980s, and existing capacity is deemed sufficient only through 2002.

Current Payout Ratio from FPL Perspective:

The current payout ratio is too high from FPL’s perspective.As FPL is grappling with legions of issues .As mentioned above it needs to secure earnings for reinvestment purposes in order to meet the upcoming challenges to the industry. A lower payout ratio would allow FPL to increase its growth potential and insulate itself from competition.

Current Payout Ratio from Investors Perspective:

As mentioned in the case soon after the announcement of Dividend policy market effectively over punished FPL’s stock

As it fell to $27.50 or 13.7% to close at $27.50. One explanation would be that the market effectively over punished the stocks of companies when they announced both a stock repurchase program and a dividend cut as they did with FPL.

Another possible explanation is that when the company cut the dividend, the clientele of investors who desire a high dividend payout left and the stock dropped.

Recommendations and Analysis:

Some Assumptions:

As in the case it is mentioned that the dividend is going to be in the range of 60-65% and in the year 1994 it reduced to 61.4%* .Assuming for the future years the same payout ratio of 61.04%.

We get the following graphs for DPS (dividend per share) & EPS (earnings per share)

*61.04% is assumed taking the worst case scenario for future years.

Figure 1

Figure 2

Final Recommendations:

Based on the following graphs and future growth prospects of the company following recommendations are suggested for the stock.

As from the graphs it is clearly visible that this is an Income stock i.e. a stock with stable dividends.

Recommendation for short term investors:

Retired people, pension funds, and university endowments usually demand high dividend so if the payout ratio is decreased individual shareholder may prefer to sell their shares and invest in other high yielding securities or in shares of other utilities which are more profitable.

But since the declaration of the new dividend scheme FPL’s stock price has fallen by 13.7% so the investors should hold this security in spite of selling it as in case of sale it will result in high capital losses, moreover the company’s announcement to repurchase the 10 million common shares in next three years and at least 4 millions in next 12 months will help to offset the fall in price to some extent, as buy back of shares indicate that the company feels that its stock is undervalued and also indicates that the firm anticipates high growth opportunities in future.

Recommendation for long term investors

High payout ratio means low funds for investment by decreasing this ratio FPL can retain a higher proportion of funds. As per the CEO’s statement the retained amount will be used to repurchase the shares from the market, to reduce the debt level. This will lead to overall strengthening of company’s financial position and moreover these funds can also be invested in other growth oriented projects or can be kept aside as a safeguard to competition.

Conclusion:

Case highlights the trade-off between short-run and long-run share price maximization.