Monday, December 3, 2012

Costco's odd fiscal cliff dividend deal

Companies taking advantage of the fiscal cliff to pay dividends. Aivars Lode
By Stephen Gandel, senior editor December 3, 2012: 7:00 AM ET
The giant retailer is borrowing billions to dole out to shareholders in a special dividend before the fiscal cliff hits.
FORTUNE -- If you could afford to borrow $10,000 at an 0.8% interest rate to blow in Las Vegas or on a 5-star meal with your friends, would you? Should you?
That's the question facing shareholders of Costco (COST). Last week, the warehouse merchant said that it was paying out a special dividend of roughly $3 billion to shareholders, or $7 per share. Costco's shares recently traded for $104. To pay for the dividend, Costco is going to sell $3.5 billion in debt. It will buy back some shares as well.
And Costco isn't alone. A number of public companies have been rushing to pay dividends, their regular ones or special ones, before the end of the year, when as part of the so-called fiscal cliff taxes on corporate payouts to shareholders could rise to as much as 39.6% from a recent 15%. What's different about Costco's deal is that the company is borrowing money to pay the dividend. But still the company is far from alone. Cruise ship operator Carnival (CCL), and liquor company Brown-Forman (BFB) are among others that appear to be borrowing funds for shareholder payouts.
On Wall Street, deals like these are called dividend recaps. My colleague Dan Primack has had some things to say about them, not all nice. They typically happen in leveraged buyouts, when private equity investors want some of their money and aren't yet ready to sell the company, or can't. Many of the deals add more debt to companies that already have higher than average leverage. Some people claim the deals lead to more bankruptcies, though there's little evidence that's true. But the deals do appear to be getting riskier lately. Moody's  downgraded the bonds of 27% of the companies that did dividend recaps in the third quarter, compared with less than 15% overall in the same quarter.
But when it comes to Costco, the question of whether it should be doing a dividend recap is trickier to answer.
The deal will more than triple Costco's long-term debt. But the company clearly can afford to borrow the money. Phil Zahn, an analyst at Fitch, did lower Costco's credit rating to A+, which is one notch lower than it had been, but it's still relatively high. Zahn figures that even if you add in all of Costco's lease obligations, the retailer still only has a leverage ratio, which compares a company's cashflow to it debt, of 1.7 times. That's lower than its competitors. Wal-Mart's leverage ratio, measured the same way, is 2 times. Target's is 2.6.

Wall Street analysts have mostly cheered Costco's dividend deal. The stock is up on the deal. Even Robert Willens, a tax expert who has is typically skeptical of corporate accounting maneuvers, says the Costco deal looks like a good one. "It makes a lot of sense," he says.
Still, even if Costco can, should it? If it's willing and able to borrow money, wouldn't it be better for the company if its executives were to invest that money rather than just passing it out? What's more, the deal will take away some of Costco's flexibility.
Before the deal, Costco was paying about 0.4%, after taxes, to borrow. If the company has to borrow more in the future, either because it wants to do a deal or if it runs into a problem, it will now have to pay at least double for a loan, or likely even more. Costco's extremely low leverage ratio was an advantage that the company had versus its competitors. No more.

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