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Case Analysis - FPL Energy

FPL Energy is one of the nations leading independent generators of electricity. Dedicated to generating clean energy, 80 % of its capacity is fueled by clean and renewable resources. The United States is the nation with the largest generator of wind energy, and it operates the two largest solar fields in the world. FPL Group, with annual revenues of more than $8 billion, is one of the nation's largest providers of electricity-related services. Its principal subsidiary, Florida Power & Light Company, serves approximately 3.9 million customer accounts in Florida. FPL Energy, LLC, and FPL Group energy-generating subsidiary, is a leader in producing electricity from clean and renewable fuels. 2. Historical Overview FPL Group is a far different company today than the one Jim Broadhead joined in January of 1989 when he became president and chief executive officer. FPL Group was then engaged in a number of businesses unrelated to its core electric skills, including insurance and financial services, real estate, cable television, and agriculture. The company's principal subsidiary, Florida Power and Light, was considered a well-managed utility with an emphasis on quality. However, the utility's spiraling costs had resulted in electric rates among the highest in the Southeast. Today, FPL Group is nationally known as a high quality, efficient, and customer-driven organization focused on energy-related products and services. With a growing presence in more than a dozen States, it is widely recognized as one of the country's premier power companies. FPL's rates are among the lowest in the industry, due primarily to a decade-long emphasis on reducing costs. At the same time, the utility's performance is vastly improved with productivity and reliability at all time highs. The transformation of FPL Group from a traditional, old-fashioned utility to a proven winner in both regulated and deregulated markets began soon after Mr. Broadhead arrived. Based on his experience in the natural resources and telephone industries - and taking into account the mood of the nation regarding competition - Mr. Broadhead thought it likely that the electric business would follow other industries previously deregulated. To ensure the company's long-term success, Mr. Broadhead asked employees to focus on four areas: costeffective operations; a commitment to quality; strong customer orientation; and speed and flexibility. In 1991 FPL underwent a top-to-bottom restructuring and re-staffing. The entire organization was streamlined, layers of management were reduced, and bureaucratic procedures eliminated. That same year the sale of the Colonial Penn insurance subsidiary launched the beginning of the company's divestiture program and confirmed its refocus on the power business. In late 1992, passage of the National Energy Policy Act signaled additional changes in the industry, prompting a cost reduction program to be initiated in 1993. Despite the significant

reductions, FPL's performance continued to improve. Most notably perhaps, the Turkey Point nuclear plant, which had been on the Nuclear Regulatory Commission's "watch list" when Mr. Broadhead joined the company, received its best NRC rating ever. In 1994 - in a bold and unprecedented move that took the entire electric utility industry by surprise - Mr. Broadhead announced a new financial policy that included reducing FPL Group's common stock dividend by nearly one-third. This put the company's percentage of corporate earnings paid as dividends in line with other competitive industries. The dividend reduction initially drew heavy criticism, but the financial community quickly endorsed the move as a reflection of FPL Group's emergence as a growth company. As one analyst said, "This early and aggressive action will further enhance an already sound competitive profile." In 1995, Mr. Broadhead's peers selected him Financial World magazine's "CEO of the Year". By that time the actions taken by Mr. Broadhead were producing a multitude of benefits for the company, including improved credit ratings, positive cash flow for the first time in years, and rising stock value. In recognition of the company's achievements, Fortune Magazine in 1998 declared FPL Group "the brightest light in utilities" and America's "most admired" power company. During the remainder of the 90s and into the 21st century, FPL continued to achieve significant improvements in service, reliability, and plant performance while operating and maintenance costs continued to be driven down. In 1999 a rate reduction agreement made possible because of the utility's increased efficiencies - lowered residential base rates by nearly nine percent and provided customer savings of more than $1 billion. Outside of Florida the company was beginning to take advantage of new growth opportunities through FPL Energy, which rapidly established its presence in the independent power business as a leader in the use of environmentally friendly fuels and renewable energy sources. FPL Energy's contributions to earnings increased significantly. And in 2000 a new subsidiary called FPL FiberNet was launched, which soon became Florida's leading wholesale provider of fiber optic services. Jim Broadhead's objective was to build on the solid foundation of FPL and its energy-related expertise to strengthen FPL Group and build long term shareholder value. During his 13year tenure, FPL's power capability expanded by nearly one-third while non-utility power production increased more than seven-fold. Overall, the company's power capacity grew almost 50 percent to nearly 25,000 megawatts. This helped to nearly double the value of FPL Group from $4.7 billion to more than $9 billion and rewarded shareholders with an annualized total return well above the industry average. Customers, meanwhile, were rewarded with the lowest electric rates since 1984. "I think what pleased me most during my time here was our ability to add more than a million new customers without increasing rates," says Mr. Broadhead. "This has made people's lives a little easier and reduced the costs companies pay for energy, making it

possible for them to create jobs. It has made Florida an even more attractive place to live and work." 3.Dividend Policy at FPL Group.Inc. Firms pay dividends to reward their shareholders for investing in the company. Shareholders are the owners of the firm, and the dividends are their share of the firms profits. The dividends induce the shareholders to continue investing in the company rather than investing elsewhere in the market. The advantage of paying dividends is that the dividend signals the firms financial stability. The ability to pay dividends promotes the confidence of the market in the firms prospects. Dividends not only encourage current shareholders to retain their investment in the firm, but also increase the firms attractiveness to potential investors. The disadvantage of paying dividends is that the firm has less money to reinvest. Paying a cash dividend may reflect the firms current success, but it hinders the firms ability to expand. The firm might do better by postponing the payment of a dividend in order to reinvest earnings and take advantage of growth opportunities. A further disadvantage of paying cash dividends is that they are not tax deductible. 4. Factors of Dividend Cut It is instinctive to consider revisiting the FPL experience. 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, and the fact that the dividend payout had grown to a higher than normal level on a historical basis. The reason for this is that the dividends recently had been growing faster than the company's earnings (1). After these issues were taken into account, there were four major factors that led FPL to simultaneously cut the dividend level and announce a stock repurchase program. First, FPL believed that the negative signal from lowering the dividend would be somewhat offset by the positive signal from a stock repurchase program. Second, there was a tax benefit to a stock repurchase because dividend income is taxed more heavily than capital gains income. Third, a repurchase program provided flexibility in distributing capital to investors in case earnings were not as high as expected, which stemmed from deregulation within the utility industry increasing FPL's business risk. Fourth, switching to more repurchases and fewer dividends would strengthen the flexibility in the level of cash reserves (2). There are two theories about dividends that are worth explaining in more detail in this paper. Those theories are the Signaling Hypothesis and the Clientele Effect. The Signaling Theory is based off the idea that managers have better information about a firm's future prospects than public stockholders do. Since future dividends are paid out of future profits, and given that managers are reluctant to cut dividends, any change in dividends to be paid is often viewed as a signal of future profits. Thus, increases in dividends generally result in stock price increases and cuts in dividends generally result in stock price declines (3). The other relevant theory is the Clientele Effect. The basic idea is that different clienteles of stockholders prefer different dividend payout ratios. Firms have different payouts based on

their own internal business needs. Thus, when a firm switches its payout ratio, perhaps due to business imperatives, the current clientele leaves and another clientele must come in to take its place. If more investors leave or if they leave quicker than the new clientele enters, this could lead to a temporarily depressed share price (4). 5. Most Important Issues that Confronted the FPL Group, Inc. in 1994. The most important issues facing the FPL Group in May 1994 are the interrelated concerns of potential competition resulting from industry deregulation and reexamining a high dividend payout ratio. The advent of retail wheeling threatens to reshape the entire electric utilities industry. The Florida Public Service Commission is not considering a retail wheeling proposal currently, but the general trend in the industry is towards increased competition, and the implementation of such a proposal would expose FPL to numerous competitors and potential losses. The implementation of retail wheeling in California had a severe adverse effect on the three major utilities in that state. The necessity of competing with rival utilities must be a primary concern of FPL given the changing landscape of the industry. FPL needs to ensure that it has the ability to meet the challenge of competition from both in state and out of state providers. FPL Group must reconcile the increasing level of industry competition with its dividend payout policy. FPL must decide whether to increase dividends, hold dividends constant, or reduce dividends. The company has a streak of 47 consecutive years of dividend increases. Increasing dividends again would be a sign of FPLs continuing strength in the industry. Increasing dividends seems possible given the companys recent and expected rising sales and declining capital expenditures. However, FPL has a very high payout ratio, and may need to retain a larger amount of earnings than usual in order to prepare for possible entry into the industry by competitors. Keeping the dividend constant would strike a balance between the need to reinvest earnings in order to expand and the need to mollify shareholders who expect a dividend increase. Cutting the dividend would allow FPL to both reinvest a significant portion of its earnings in order to meet the challenges of the industrys future and offer higher rates of dividend growth in subsequent years. However, cutting dividends would alienate shareholders that expected to receive at least the same dividend as last year. The dividend payout decision implicates FPLs past, present, and future, and FPL must reach a decision that is consistent with its goals in all three. FPLs dilemma is exacerbated by the companys interest expense in the face of rising interest rates. FPL has a large amount of debt, and reducing the dividend could facilitate FPLs debt repayment. FPLs stock has fallen dramatically over the period of higher interest rates. Additionally, FPL still holds three unprofitable subsidiaries that detract from FPLs electricity provider service. These ancillary divisions are all the more incapacitating considering the specter of competition in FPLs core business. The concern over the longterm 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. All these issues mean that despite FPLs strength as reflected in its financial statements, the firm faces difficult choices in order to sustain its position as an industry leader.

6. Current Payout Ratio from FPL Perspective . The current payout ratio is too high from FPLs perspective. FPL needs to secure earnings for reinvestment purposes in order to meet the upcoming challenges to the industry. FPL cannot afford to pay out 90% of its earnings given the possible need to expand in the face of newfound competition. FPLs recent success and optimistic outlook does not mask the fact that the possibility of retail wheeling reduces FPLs ability to maintain its consistently high payout ratios. Retail wheeling plans are pervading the nations electric utility sector, and FPL would face serious challenges in the event such a plan was passed in Florida. FPL must be prepared for this eventuality, and preparation entails using current financial stability to protect future profitability. The industry as a whole has a relatively high payout ratio, but FPLs ratio is at the high end of the industrys spectrum, further increasing its vulnerability to prospective competitors. A lower payout ratio would allow FPL to increase its growth potential and insulate itself from competition. 7. Current Payout Ratio from Investors Perspective Now lets revisit the FPL case to see whether coupling the positive stock repurchase signal with the dividend cut had any impact on investor opinion. There were interesting market events surrounding the FPL announcement of the change in dividend policy. On March 3rd, 1994 FPL suggested that it would be difficult to increase the dividend. Then on May 9th, 1994 FPL announced the dividend cut with the stock repurchase program and the stock price fell $4.375 to $27.50 (5). Then on May 31st, FPL's stock closed at $32.17, or about 30 cents higher than the pre-announcement price. One year later, FPL's stock price closed at $37.75, giving stockholders a return of 23.8%. Finally, almost two years later on April 1, 1996 FPL's stock was trading at $45.25, which provided stockholders with a postannouncement return of 52.9%. Thus , when investors see the Incorporation repurchasing the stocks , this gives them the concept that the stocks are healthy and will be increasing in the near future or why repurchasing . 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. Then once they realized that the company made a strategic move, and signaled to the public that the company's basic earning power was still strong the stock rebounded 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. Soon after the old clientele left, a new clientele that desired a lower dividend payout replaced them, and the stock rebounded. Another question is whether companies added an announcement for stock repurchases as they cut the dividend level to appear as if they were making a strategic move as FPL did. In reality however, perhaps the companies were facing problems and the management was trying to appear strong to the public in order to protect their firm's stock price.

8. Recommendation: We would maintain a hold recommendation on FPLs stock. The previous hold recommendation was based on the belief that FPL would keep its dividends at $2.48 per share or increase it slightly, and there little reason to believe that this will not be the case. Merrill Lynchs own downgrade of FLP was based on the belief that FPL would keep its dividend at $2.48. FPLs management has suggested that the dividend payout ratio is excessive given the conditions facing the industry, but has not indicated a bias toward cutting the dividend. FPL could maintain a dividend of $2.48 while reducing the payout ratio provided that earnings increase at a faster rate than dividends, and FPLs strength in recent and expected sales combined with its declining expenditures suggests that earnings will continue to grow. The only evidence arguing in favor of a change in the hold recommendation is the 6% drop in FPLs price, but that drop may be unrelated to Merrill Lynchs report. FPLs stock has already decreased by 19.6% over the past nine months in response to rising interest rates, and the 6% drop may be a continuation of this precipitous decline. A hold recommendation remains the best course of action despite the days events. The uncertainty pervading the electric utilities industry in general and FPL in particular precludes a buy or sell recommendation. The absence of a consensus regarding FPLs future revealed in the analysts reports demonstrates that FPL has a number of upcoming important decisions, and that there is no uniform way to interpret all the relevant information. The fact that FPLs stock has fallen recently coupled with its strong expected future earnings argue in favor of a buy recommendation. However, FPL will face unprecedented challenges if Florida institutes retail wheeling. The company is already hampered by the interest expense on its outstanding debt. Responding to potential competition by keeping dividends constant or cutting dividends will likely produce a market backlash, and rising interest rates have already precipitated a steep decline in the stocks price. A buy recommendation could leave investors with a firm whose stock price is on the decline and is about to face unprecedented challenges. At the same time, issuing a sell recommendation would be impetuous. Managements warning regarding its high payout ratio suggests only that it is aware of the increasing risks it faces, and does not signal a concern over earnings. In fact, the financial statements reveal expected future earnings to be quite strong. Furthermore, there is no current legislation that would expose FPL to competitors. FPLs financial position remains stable and its outlook solid despite the uncertain industry conditions. A hold recommendation is consistent with all the available information. There is no reason to believe either that FPL will undertake a drastic dividend cut or that it is in any immediate financial difficulty. There is also no reason to believe both that FPL does not face the same risks as all electric utilities in the context of industry deregulation, and that FPL will not continue to prepare for threats from competitors. Kate Stark believed that FPL would keep its dividend at $2.48 per share, and issued a hold recommendation based on that assumption. Both that assumption and the consequent recommendation remain sound. Entergy and FPL Group Agree To A $27 Billion Merger Of Equals Creating The Nation's Largest Power Company.

9. Conclusion The significance of this case is that FPL was the first company to drop the dividend payout without the typical negative reasons, but for strategic reasons. Also, FPL supplemented the dividend cut with a stock repurchase in order to boost investors' confidence in the company. Finally, FPL's stock had increased over a long period after the announcement, and has more than offset the temporary price decline from the dividend cutThe new company, which will be named at a later date, will be the largest U.S. electric utility and the largest power producer. Based on the closing stock prices of both companies on Friday, July 28, 2000, the combined company will have a total enterprise value of more than $27 billion, ($16.4 billion in equity market capitalization and $10.7 billion in debt and preferred stock). One conclusion from this study is that FPL was a special case in terms of the results when it announced a dividend cut and a stock repurchase program. FPL was a company that was very strong, and changed its dividends not due to hurt earnings, but an anticipation of the change in the industry. Comparing the cumulative net returns of FPL and the sample shows this. The results show that FPL's returns were stronger than the sample up to announcement, weaker on the day of the announcement, and recovered more than the sample after the announcement. This information lead me to believe that FPL was a strong company that had a clientele switch hurting the stock price on the announcement date. Perhaps investors initially overreacted, but with the positive signal from the stock repurchase, ultimately investors realized that FPL was still a strong firm. Subsequently, a new clientele of investors came in to restore the stock price to its pre-announcement level. The sample had different results as shown by the statistically significant negative return present around the announcement that was not recovered. This shows that the market did not take the announcement for the stock repurchase seriously, and that the effect of the dividend drop was a permanent share revaluation. This concludes that on average, the announcement of a dividend drop and a stock repurchase program results in a permanent drop in the stock price. Also, since the drop in stock price is permanent, the explanation is that the signal of the dividend overpowers the signal from the stock repurchase and not the switch of the clientele. The results also indicate that the rest of the companies in this study were financially weak and may have been trying to appear to be in the same situation as FPL. In my opinion, another study with many companies in the sample should be conducted to generalize the expected results of companies that simultaneously announce a dividend cut and a stock repurchase program. Also, companies who do take on these actions should be looked at on a case by case basis to estimate the effects on the stock price. 10 . General Scheme of FPLs Dividend in 1994 i. FPL Group Incorporation Parent of Florida Power and Light Company. Floridas largest electric utility, and 4th largest electric utility in the U.S. (industry Leader)

ii. Considers to Cut Dividends in 1994, after 47 years of uninterrupted increase in dividends. Increase in competition. Current Payout Ratio of ~90% not optimal for shareholders (payout ratios in the electric utility industry range from 60.8% to 106.2% in 1994). iii. Regulatory changes

1992: Wholesale wheeling -Utility A can sell power to Utility B through Utility Cs transmission system.

1994: Retail wheeling - Utility can sell power to Utility Bs customers using Utility Cs distribution system.

iv. FPLs Competitive Position.

California utilities lost about 8% of their market values. FPL services eastern and southern Florida. - Among the fastest growing markets (2.7% vs 1.8 % rest of U.S). - Location Limits competitive threats. Industrials account for only 4% of total power sales High cost producer

- Power Generation. - Power transmission Competitors have excess generating power S&P had recently upgraded FPLs senior debt rating to A+. Competitive Position: top 10%.

v. FPLs Payout Policy

Increased dividend every year for 47 years. Increases have been getting smaller: 9.6% in 1985, 1.6% in 1993. Majority of returns to shareholders are in terms of dividends. Payout ratio 60-70% before 1989, 90% in recent years. Smooth dividends despite volatile earnings.

vi. FPLs Payout Policy

Year 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 Net Income ($/share) 2.62 3.11 2.90 3.10 3.42 3.12 - 2.86 1.48 2.65 2.30 Dividends ($/share) 1.77 1.94 2.02 2.10 2.18 2.26 2.34 2.39 2.43 2.47 Percentage increase 9.6% 4.1% 4.0% 3.8% 3.7% 3.5% 2.1% 1.7% 1.6% Payout Ratio 67.6% 62.4% 69.7% 67.7% 63.7% 72.4% N/A 161.5% 91.7% 107.4%

vii. Majority of Returns to Shareholders Are in terms of Dividends.

Expected Return = Dividend + Expected Capital on equity Yield gains

Expected Return = 7.3% + 0.6% x ( 14.8 7.3 % ) on Equity

Dividend Yield = Dividend per Share = $ 2.47 Average Share price $ 34

11.8% = 7.3% + 4.5%

viii. Competitors Payout Ratio

FPL Group 91 % Carolina Power 74 % Duke Power 68 % Florida Power 87 % SNANA Corporation 74 % The Southern Co. 75 % TECO Energy 73 %

ix. FPL Cash Needs in the Future Net Income is expected to Increase. Capital Expenditure is expected to decline.

x. Cash Flow Forecast ( 1994 1998)

Year 1992 1993 1994 1995 1996 1997 1998 Net Income Depreciation 467 429 527 557 576 596 615554 598 665 711 741 778 795 Sources of Cash 1,021 1,027 1,192 1,268 1,317 1,374 1,410 capital Expenditure Maturing debt Dividends 1,270 1,337 901 831 743 769 624 152 11 2 81 101 4 185 431 461 466 471 475 480 485 Users of Cash 1,853 1,809 1,369 1,383 1,319 1,253 1,294 Free cash flow - 832 - 782 - 177 -115 -2 121 116

xi. Dividend Recommendation for FPL

Arguments in favor of dividend cut Taxes FPL has diverse group of shareholders Individuals - 65% Tax-exempt institutions - 30 % Corporation - 5% Share price is at a one-year low ( favors repurchase) Transaction costs

FPL pays dividends and raises equity ( 3% underwriter fee) Corporation position

Arguments in favor of continuation of dividend policy Dividend clientele - Dividend yield is very high. Current investors are probably o.k. because otherwise they would not hold FPLs stock.

Signaling - Consolidated Edison (1974) and Sierra Pacific (1992) experienced significant Price declines when dividends were cut. - 47-year old dividend policy. Probably severe market reaction. Agency problems - Managers own only 0.1% of FPLs equity. - New compensation scheme based on net income. - Diversification efforts in 1985/86.

xii. FPLs Dividends Decision in 1994. May 9, 1994: FPL announces new financial strategy - 32% reduction in quarterly dividend - Dividend payout targeted at 60-65% - Repurchase 10 million shares over 3 years

- Reduce debt levels Stock price falls to $27.50 (down 22.3% since rumors of dividend cut surfaced).

xiv. Conclusion: Evaluated dividend decision at FPL Group - taxes, transaction costs, competitive position - Dividend clienteles, signaling, agency costs, (current share price).

Combine dividend cut and share repurchase - Reduces negative signaling effect of dividend output. - Increase returns to shareholders to make opportunistic use of signaling effect Timing matter Transparency pays off Case highlights the trade-off between short-run and long-run share price maximization.