FIN 470 If Google were to pay $20 billion as a special dividend, what would be the effect on market value

Question
4 Case Study: Google’s Payout Policy
160 points
Read:Payout Policy at Google Case on the next page
and answer the following questions
a.) What
are Google’s financing needs? Will it
need the $20 billion in cash?
b.) Why
do firms pay dividends? What are the
disadvantages of paying dividends? How do these considerations change if the
payout is a share repurchase?
c.) If
Google were to pay $20 billion as a special dividend, what would be the effect
on market value? On the share
price? On net income? On earnings per share? What if Google repurchased shares
instead? Assume a 1% rate of interest on
any cash balance and a 3% interest rate on the debt. Also assume that the deal
takes place in early October 2014.
Estimate the impact on the Sept. 30, 2014 balance sheet and the income
statement for the next 12 months. (HINT:
Solve this problem in the Modigliani-Miller setting, and think
qualitatively about what would change in the real world.)
d.) What
should Patrick Pichette recommend to Google’s board?

Payout
Policy at Google

‘Decades ago, we used to be
worried about companies taking on too much debt,’ said Ryan Jacob, manager of
the $45 million Jacob Internet Fund, which includes Google shares. ‘Now, we’re worried about companies taking on
too much cash.’.docx#_ftn1″ title=””>[1]

In November 2014, Google Chief
Financial Officer Patrick Pichette pondered recent payout decisions by some of
his competitors, including Apple. Google
was sitting on over $60 billion in cash and marketable securities, an amount
exceeding 17% of firm market capitalization. Should he consider following in
Apple’s footsteps, and start a payout plan for Google?

Google
Inc.

Headquartered in Mountain View,
California, Google is a technology company focused on products and services to
organize information. According to the company website:.docx#_ftn2″ title=””>[2]

Larry Page, our co-founder and
CEO, once described the “perfect search engine” as something that “understands
exactly what you mean and gives you back exactly what you want.” Since he spoke
those words Google has grown to offer products beyond search, but the spirit of
what he said remains. With all our technologies—from search to Chrome to
Gmail—our goal is to make it as easy as possible for you to find the
information you need and get the things you need to do done.

Google was founded in 1995, when
founders Larry Page and Sergey Brin met as doctoral computer science students
at Stanford University. Incorporated in 1998 in California, the “Google Guys”
started with $1 million in seed capital from family and friends such as Sun
Microsystems co-founder Andy Bechtolsheim. Subsequent private equity investors
included the well-known Silicon Valley venture capital firms of Kleiner Perkins
and Sequoia Capital, who each invested about $13 million in 1999.

Google went public in August 2004
at a price of $85 per share. Stock price performance since then has been
exceptional, with total returns approaching 500%, relative to about 125% for
the NASDAQ index (see Exhibit 1).

Since its IPO, Google’s financial
performance has also been stellar. From
a base total revenue of $3.2 billion in 2004, sales have grown at a compound
annual rate of almost 40% a year, approaching $60 billion by the end of 2013.
(See Exhibit 2 for summary historical financials.) Net profit margins exceeded 20% for most of
the last decade. By Sept. 30, 2014,
Google’s total net assets had grown to $126 billion, of which $62 billion, or
49%, was cash and marketable securities. Analysts expect Google’s growth to
continue, with earnings before interest and taxes (EBIT) for the next 12 months
reaching $15.2 billion.

Google has 678.3 million shares
outstanding..docx#_ftn3″ title=””>[3] With
a stock price of $535 per share, its total equity market capitalization exceeds
$360 billion. To date, Google has never paid a dividend, although it has
modestly repurchased shares (generally in connection with either acquisitions
or employee compensation).

Payout
Policy

Dividends come in and out of
fashion. Total payout (dividends and
share repurchases) decreased substantially during the dot.com bubble. Since
2001, however, total payout as a percent of assets more than doubled, from 1.7%
in 2001 to over 4.4% in 2007 (see Exhibit 3).
Payout declined during the recent financial crisis, but has since recovered
close to its 2007 levels.

Repurchases are usually much more
variable, and depend strongly on market conditions. Stock buybacks totaled $116.2 billion in the
second quarter of 2014, down from almost $160 billion in the first quarter (the
second highest level on record)..docx#_ftn4″ title=””>[4]

Dividend-paying firms have
traditionally been larger, more profitable firms with slower growth and fewer
internal investment opportunities. As
Exhibit 4 shows, dividend yields are lowest for companies in riskier industries
such as biotech, internet services and healthcare. Yields for utilities and
commodity-based industries are much higher, averaging over 4% in some
industries.

Investment
Opportunities

Google has been accumulating cash
at the rate of $2 to $3 billion per quarter. Before deciding on any payout,
Pichette wanted to make sure Google retained the cash it needs to grow Google’s
existing businesses. Google historically reinvested a substantial portion of
its cash flows in its operations. For example, research and development
spending at Apple recently amounted to about 3% of sales, and capital
expenditures were about 5%. At Google,
both numbers were much higher, closer to 13%.

Google has also acquired over 170
firms since 2001 (and more than 30 so far in 2014)..docx#_ftn5″ title=””>[5] Notable acquisitions (those of about $1
billion or more) include home automation firm Nest Labs for $4.3 billion in
January 2014, GPS navigation software company Waze in June 2013, $12.5 billion
for Motorola Mobility in August 2011, the $3.1 billion acquisition DoubleClick
in 2007, and $1.65 billion for YouTube in 2006.

Analyst reaction to Google’s
acquisitions was generally favorable:

Google has been ‘pretty successful’ with
acquisitions, says Jason Helfstein, an analyst at Oppenheimer & Co. For example, the company has emerged as a
dominant force in mobile software thanks to its purchase of Android in
2005. It’s also benefitted in display
advertising and user growth from its acquisition of video-sharing site YouTube
in 2006..docx#_ftn6″ title=””>[6]

Excess
cash sometimes tempts managers to make bad acquisitions, or overpay for good
ones.
Google could make an argument for holding on to its
cash, by saying it needs the money for deals or investing in new businesses.
Still, a dividend or buyback could assuage investor concerns that Google might
instead make an unneeded, large acquisition, said Tim Ghrisky, who as
co-founder of Solaris Group helps oversee about $2 billion in assets, including
Google shares..docx#_ftn7″ title=””>[7]

Pichette was also aware of other
issues at neighboring Silicon Valley firms.
Venture capital had been pouring into startups during 2014. This trend
was causing concern among venture capitalists about wasteful expenses such as
luxurious office spaces, high salaries and extravagant, catered lunches. “Andreessen Horowitz co-founder Marc
Andreessen has warned entrepreneurs about overspending, punctuating a string of
tweets with the word, ‘Worry.’”.docx#_ftn8″ title=””>[8]
Similar problems can easily occur at larger, more established companies with
high free cash flows.

Pichette wondered whether he
should be concerned about these issues at Google. Google’s perquisites for
employees, such as the well-stocked cafeteria at many of its locations, were
famous. Pichette was convinced that these benefits helped Google attract and
retain the skilled technical employees who are in such high demand in its industry. He also understood that dividends represented
a stronger pledge:

‘Dividends are reliable,’ notes Robert Arnott,
chairman of Research Affiliates, a money manager in Newport Beach, Calif. ‘You
cut them at your peril. But you can cut
a buyback and hardly anybody notices.’.docx#_ftn9″ title=””>[9]

If he really wanted to let
analysts know that Google had no intention of wasting cash, committing to a
large dividend payout would be a stronger way to send his message.

Signaling

Although dividends used to be
rare for technology companies, they have become increasingly more common.

Technology companies for years resisted paying
dividends on the theory that their earnings growth would reward shareholders
with higher stock prices. But share
price appreciation ended for many companies after the stock market bubble burst
in 2000..docx#_ftn10″ title=””>[10]

How would the market react to
announcement by Google of a dividend or stock repurchase? Many investors and analysts worry that
returning cash to investors means that the company does not have good growth
opportunities within the firm, or that management isn’t reinvesting as much as
it should to sustain long-term growth.
On the other hand, the decision to repurchase company stock would signal
that management views the stock as undervalued, and therefore a good investment
opportunity.

Dividend
Taxation

Pichette also considered the tax
consequences of potential payouts for Google’s shareholders. (Exhibit 5 has a list of Google’s 10 largest
shareholders as of year-end 2013). In
the U.S., corporate profits are taxed twice.
Payout is made from after-corporate-tax dollars, and investors must pay
taxes on the income. Historically, tax
rates on dividends have been higher than tax rates on capital gains (see
Exhibit 6)..docx#_ftn11″ title=””>[11]

In 2003, tax reform passed under
President George Bush reduced tax rates on both capital gains and dividends to
15%. Although the Bush tax cuts were
originally set to expire at the end of 2010, they were temporarily extended in
2010 and made permanent by the American Taxpayer Relief Act of 2012. Uncertainty leading up to the 2012 act
prompted a flurry of last-minute special dividends by companies trying to take
advantage of the lower tax rates before they expired. For example, discount retailer Costco sold
$3.5 billion of bonds in November 2012 to finance a $3 billion special
dividend. Although the 2012 Act made
favorable tax treatment permanent for qualified dividends, it raised tax rates
on both dividends and capital gains to 20%.

Google has not previously paid a
dividend. Pichette imagined that many Google’s major investors bought Google
stock precisely because it was a non-dividend paying, high growth company. He worried about the impact of a large change
in payout policy on the portfolios of his investors.

Executive
Compensation

As was common at technology
companies, many Google executives and employees had equity-based
compensation. Google founders Larry Page
and Sergey Brin each owned over 46 million shares of Google’s Class B stock.

Companies regularly repurchase
stock to offset new shares issued as part of employee compensation. “Many
buyback programs appear to be prompted less by a company’s enthusiasm for its
own shares and more by a desire to offset the dilution caused by executives
exercising stock options.” .docx#_ftn12″ title=””>[12]

Employee options are typically
not adjusted for dividends, to the detriment of employees who own options
rather than actual shares. Also, “there’s an incentive for companies to buy
back stock, rather than pay dividends.
Buybacks can push up share prices, making management’s stock options
more valuable.”.docx#_ftn13″ title=””>[13]

Cash
Balances and Repatriation Taxes

Many companies, including
technology companies, have accumulated large cash balances in part because of
successful overseas operations. (Exhibit 7 lists the top 6 in terms of cash and
equivalents as of fiscal-year-end 2013.) In early 2013, shortly before it
announced a large payout, Apple had $145 billion in cash, only $45 billion of
which was in the U.S..docx#_ftn14″ title=””>[14]
About 50% of Google’s cash is overseas..docx#_ftn15″ title=””>[15]

Given current tax laws, companies
pay taxes on foreign earnings at the tax rate of the country in which they earn
the profits. However, if they bring the
cash back to the U.S. (for example, to use it to pay a dividend), they will owe
“repatriation taxes” on these profits equal to the difference in taxes owed at
the U.S. corporate rate (now 35% for most large companies) and the typically
lower rate in the foreign country.
Companies with large overseas operations often choose to leave the cash
abroad and avoid paying the repatriation tax penalty. They may use their
overseas cash to invest overseas (such as Microsoft’s $8.5 billion deal to
acquire Skype in 2011 or its $7 billion purchase of Nokia’s core cellphone
business in September 2013). Also, “overseas” cash need not be invested abroad;
it may be held in U.S. assets. But it must be repatriated before it can be used
to fund a payout.

Interestingly, cash and
“equivalents” are often invested in very risky securities. In a recent working
paper, Duchin, Gilbert, Harford and Hrdlicka (2014) show that risky securities
(including assets such as mortgage-backed securities, which are clearly not
“cash equivalents”) comprise 27% of corporate cash holdings..docx#_ftn16″ title=””>[16] To
manage its substantial cash and short-term investment portfolio, in 2010 Google
hired professional investment managers, including bond traders and portfolio
managers, to set up a new trading floor in the company’s Mountain View
headquarters..docx#_ftn17″ title=””>[17]

Payout
Policy at Other Tech Companies

Over the past two decades, several
other large tech companies initiated dividends (see Exhibit 8). Apple paid
dividends in its earlier years, but cancelled them beginning in 1996 as the
company went through a difficult financial period. Intel’s dividend dates back
to 1992, and Microsoft initiated dividends in 2003, right around the time of
the Bush tax cuts. After long resisting dividends, Cisco paid its first-ever
quarterly dividend in March 2011. So
far, other tech giants including Yahoo, eBay and Amazon have yet to join the
dividend party.

Apple’s
Payout

In March, 2012, Apple announced
plans to initiate a dividend and share repurchase program. The initial quarterly dividend of $2.65/share
would begin in July of that year. The repurchase program would consist of $10 billion,
executed over the next three years, for a total payout of $45 billion over that
period.

In early 2013, Apple increased
its quarterly dividend to $3.05 a share, bumping its total payout up to $100
billion. To avoid repatriation taxes on its overseas cash, on April 30, 2013
Apple sold a record-setting $17 billion in corporate bonds. As described by Bloomberg:.docx#_ftn18″ title=””>[18]

Apple issued $3 billion of floating-rate notes and
$14 billion of fixed-rate securities in six parts with maturities from three to
30 years…Proceeds may help the company avoid repatriation taxes on its $102.3
billion of funds held overseas as Chief Executive Officer Tim Cook returns an
additional $55 billion to shareholders through 2014 to compensate for a stock
that’s been hammered by signs of slowing growth.

Interest rates on the debt ranged
from 0.45% on the three-year debt to 3.85% on the 30-year bonds. The bonds were rated AA+/Aa1, despite Apple’s
large cash balance of over $145 billion.
Rating agencies may be reluctant to give firms full credit for their
cash when rating debt, because companies can pay out cash or use it for other
purposes such as acquisitions before the maturity of the debt.

Apple again announced in April
2014 that it would increase its share repurchase program by $30 billion, boost
its dividend, and split its stock 7 for 1. However, this increase was still not
enough to satisfy some of its investors.
In an open letter to Apple CEO Tim Cook
posted on his website in October 2014, activist investor Carl Icahn
(owner of about 1% of Apple stock) urged Apple to increase its payout even
further..docx#_ftn19″ title=””>[19]

We are simply asking you
to help us convince the board to repurchase a lot more, and sooner.We feel
compelled to do so because we forecast such impressive earnings growth over the
next few years, and therefore we believe Apple is dramatically undervalued in
today’s market, and the more shares repurchased now, the more each remaining
shareholder will benefit from that earnings growth.

The
Decision

After watching recent events at
Apple, Pichette pondered Google’s next steps. In 2010, Bloomberg ranked Google
as the most well-positioned company in the Standard and Poor’s 500 to initiate
a dividend..docx#_ftn20″ title=””>[20] Fortunately, Google was not yet on the
receiving end of strong activitist-shareholder pressure to increase its payout.
But its cash balance had almost doubled since 2010. With current cash and equivalents of over $60
billion and strong operating profits, such pressure could be imminent.

As a first step, Pichette
contemplated distributing a third of Google’s cash, or $20 billion. Given
Google’s ample cash balances, he should be able to fund that amount without
issuing debt or triggering any repatriation taxes. Should Google proceed with a transaction like
this? If so, what would be the impact on
Google’s financials? And what form should the payout take: dividend, share repurchase, or a combination?

Exhibit
1. Google’s Historical Stock Price Performance
Relative to the NASDAQ Index.

Source: Google Finance,accessed Nov. 11, 2014
.google.com/finance?chdnp=1&chdd=1&chds=1&chdv=1&chvs=maximized&chdeh=0&chfdeh=0&chdet=1416438973392&chddm=980237&chls=IntervalBasedLine&cmpto=INDEXNASDAQ%3A.IXIC&cmptdms=0&q=NASDAQ%3AGOOG&ntsp=0&fct=big&ei=tSRtVIDzLYaaiQLrwYG4Dw”>http://www.google.com/finance?chdnp=1&chdd=1&chds=1&chdv=1&chvs=maximized&chdeh=0&chfdeh=0&chdet=1416438973392&chddm=980237&chls=IntervalBasedLine&cmpto=INDEXNASDAQ%3A.IXIC&cmptdms=0&q=NASDAQ%3AGOOG&ntsp=0&fct=big&ei=tSRtVIDzLYaaiQLrwYG4Dw

.docx#_ftnref1″ title=””>[1]“Google
Investors Seek Apple-Like Dividend as Cash Piles Up: Tech,” Brian Womack, April 12, 2012,.bloomberg.com/news/2012-04-12/google-investors-seek-apple-like-dividend-as-cash-piles-up-tech.html”>http://www.bloomberg.com/news/2012-04-12/google-investors-seek-apple-like-dividend-as-cash-piles-up-tech.html
.docx#_ftnref2″ title=””>[2].google.com/about/company/products/”>http://www.google.com/about/company/products/

.docx#_ftnref3″ title=””>[3]Google completed a 2
for 1 stock split on April 3, 2014. All per
share numbers in this case have been adjusted for the split. Google currently has three classes of common
stock outstanding, Classes A, B and C.
They differ primarily in their voting rights. For additional information, see.wsj.com/moneybeat/2014/04/03/what-googles-stock-split-means-for-you/”>http://blogs.wsj.com/moneybeat/2014/04/03/what-googles-stock-split-means-for-you/.
.docx#_ftnref4″ title=””>[4]“Companies Reduced
Stock Buybacks in 2nd Quarter;
Buybacks Declined 1.6% from a Year Earlier,” Tess Stynes, The Wall Street Journal, Sept. 23, 2014.
.docx#_ftnref5″ title=””>[5]Source: Wikipedia,.wikipedia.org/wiki/List_of_mergers_and_acquisitions_by_Google”>http://en.wikipedia.org/wiki/List_of_mergers_and_acquisitions_by_Google
.docx#_ftnref6″ title=””>[6] “Google
Investors Seek Apple-Like Dividend as Cash Piles Up: Tech,” Brian Womack, April 12, 2012,.bloomberg.com/news/2012-04-12/google-investors-seek-apple-like-dividend-as-cash-piles-up-tech.html”>http://www.bloomberg.com/news/2012-04-12/google-investors-seek-apple-like-dividend-as-cash-piles-up-tech.html
.docx#_ftnref7″ title=””>[7]Ibid.
.docx#_ftnref8″ title=””>[8]“Feeling Flush,
Startups Spend Away,” EvelynRusli, The Wall Street Journal, Oct. 6, 2014,
pp. B1, B4.
.docx#_ftnref9″ title=””>[9]“The Downside to Stock
Buybacks; There Could Be Better Uses for the Money,” Jonathan Clements, The Wall Street Journal, Oct. 25, 2014.
.docx#_ftnref10″ title=””>[10]“Microsoft Sweetens
Payout,” Don Clark and Ben Fox Rubin, The
Wall Street Journal, Sept. 18, 2013, pp. B1, B2.
.docx#_ftnref11″ title=””>[11]Also, shareholders must pay taxes on dividends
as ordinary income when the dividends are received, but they don’t pay capital
gains taxes until the gains are realized, which is when the stock is sold.

.docx#_ftnref12″ title=””>[12] “The
Downside to Stock Buybacks; There Could Be Better Uses for the Money,” Jonathan
Clements, The Wall Street Journal,
Oct. 25, 2014.
.docx#_ftnref13″ title=””>[13] Ibid.
.docx#_ftnref14″ title=””>[14]“With All of Apple’s
Cash, Why Is It Issuing Bonds?,” Tim
Worstall, Forbes.com, April 30, 2013.

.docx#_ftnref15″ title=””>[15]“Google Ripe for a
Stock Buyback or Dividend,” Douglas MacMillan, Bloomberg Businessweek, July 27, 2010.
.docx#_ftnref16″ title=””>[16]“Precautionary
Savings with Risky Assets: When Cash is
Not Cash,” RanDuchin, Thomas Gilbert,
Jarrad Harford and Christopher Hrdlicka, Working Paper, 2014.
.docx#_ftnref17″ title=””>[17]“Google Ripe for a
Stock buyback or Dividend,” Douglas
MacMillan, July 27, 2010, Bloomberg Businessweek,.businessweek.com/technology/content/jul2010/te20100727_799534.htm”>http://www.businessweek.com/technology/content/jul2010/te20100727_799534.htm
.docx#_ftnref18″ title=””>[18] “Apple
Raises $17 billion in Record Corporate Bond Sale,” Charles Mead and SarikaGangar, Bloomberg.com,
April 30, 2013.
.docx#_ftnref19″ title=””>[19].shareholderssquaretable.com/sale-apple-shares-at-half-price/”>http://www.shareholderssquaretable.com/sale-apple-shares-at-half-price/
.docx#_ftnref20″ title=””>[20]At that point, there
were 118 companies in the index that had never declared a dividend. Source:
“Google Ripe for a Stock buyback or Dividend,” Douglas MacMillan, July 27, 2010, Bloomberg
Businessweek,.businessweek.com/technology/content/jul2010/te20100727_799534.htm”>http://www.businessweek.com/technology/content/jul2010/te20100727_799534.htm

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