Case:

Dividend Policy

GEORGIA ATLANTIC COMPANY During the depression of the 1930s, Ben Jenkins, Sr., a wealthy, expansionoriented lumberman whose family had been in the lumber business in the southeastern United States for several generations, began to acquire small, depressed sawmills and wholesale lumber companies. These businesses prospered during World War II. After the war, Jenkins anticipated that the demand for lumber would surge, so he aggressively sought new timberlands to supply his sawmills. In 1954, all of Jenkinss companies were consolidated, along with some other independent lumber and milling companies, into a single corporation, the Georgia Atlantic Company. By the end of 1992, Georgia Atlantic was a major force in the lumber industry, though not one of the giants. Still, it possessed more timber and timberlands in relation to its use of timber than any other lumber company. Worldwide demand for lumber was strong in spite of a soft world economy, and its timber supply should have put Georgia Atlantic in a good position. With its assured supply of pulpwood, the company could run its mills at a steady rate and, thus, at a low perunit production cost. However, the company does not have sufficient manufacturing capacity to fully utilize its timber supplies; so it has been forced to sell raw timber to other lumber companies to generate cash flow, losing potential profits in the process. Georgia Atlantic has enjoyed rapid growth in both sales and assets. This rapid growth has, however, caused some financial problems as indicated in Table 1. The condensed balance sheets shown in the table reveal that Georgia Atlantics financial leverage has increased substantially in the last 10 years, while the firms liquidity position markedly deteriorated over the same period. Remember, though, that the balance sheet figures reflect historical costs, and that the market values of the assets could be much higher than the values shown on the balance sheet. For example, Georgia Atlantic purchased 10,000 acres of cut timberland in southern Georgia in 1961 for $10 per acre, then planted trees which are now mature. The value of this acreage and its timber is estimated at $2,750 per acre, even though it is shown on the firms balance sheet at $230 per acre, the original $10 plus capitalized planting costs. Note also that this particular asset and others like it have produced zero accounting income; indeed, expenses associated with this acreage have produced accounting losses.
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TABLE 1 Georgia Atlantic Company Condensed Balance Sheets for the Years Ended December 31 (In Millions of Dollars) 1982 1992 Current assets $125.2 $ 265.0 Fixed assets 241.5 813.4 Total assets $366.7 $1,078.4 Accounts payable Notes payable Other current liabilities Total current liabilities Long-term debt Common stock Retained earnings Total liabilities and net worth Current ratio Industry average Debt ratio Industry average $ 18.0 6.7 18.6 $ 43.3 122.0 25.0 176.4 $366.7 2.9x 2.5x 45.1% 37.9% $55.9 98.3 23.6 $ 177.8 404.0 50.0 446.6 $1,078.4 1.5x 2.4x 54.0% 40.2%

When Georgia Atlantic was originally organized, most of the outstanding stock was owned by the senior Jenkins and members of his family. Over time, however, the familys ownership position has gradually declined due to the sale of new common stock to fund expansion. In 1987, Ben Jenkins, Sr. died; the presidency of the firm was passed to his son, Ben Jenkins, Jr., who was 61 at the time. By the end of 1992, the Jenkins family held only about 35 percent of Georgia Atlantics common stock, and this represented essentially their entire net worth. The family has sought to finance the firms growth with internally generated funds to the greatest extent possible. Hence, Georgia Atlantic has never declared a cash dividend, nor has it had a stock dividend or a stock split. Due to the plowback of earnings, the stock currently sells for almost $2,000 per share. The family has stated a strong belief that investors prefer low-payout stocks because of their tax advantages, and they also think that stock dividends and stock splits serve no useful purposethey merely create more pieces of paper but no incremental value for shareholders. Finally, the family feels that higher-priced stocks are more attractive to investors because the percentage brokerage commissions on small purchases of higher-priced stocks are lower than on large purchases of lowerpriced shares. They cite the example of Berkshire-Hathaway, whose stock price
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has risen phenomenally even though it now sells for over $15,000 per share and pays no dividends. (The family does acknowledge, though, that Warren Buffett, Berkshires chairman, has done a superb job of managing the companys assets, and that the rise of its stock price reflects that factor as well as Buffetts financial policies.) As the date for Georgia Atlantics annual stockholders meeting approached, Mary Goalshen, the corporate secretary, informed Ben Jenkins, Jr., who is commonly called Junior at the company, that an unusually low number of shareholders had sent in their proxies. Goalshen felt that this might be due to rising discontent over the firms dividend policy. During the last two years, the average payout for firms in the paper and forest products industry has been about 35 percent; yet for the 58th straight year, Georgia Atlantics board, under the Jenkins familys dominance, chose not to pay a dividend in 1992. The Jenkins family was also aware that several reports in the financial press in recent months indicated that Georgia Atlantic was a possible target of a takeover attempt. Since the family did not want to lose control of the company, they were anxious to keep the firms stockholders as happy as possible. Accordingly, Junior announced that the directors would hold a special meeting immediately after the annual meeting to consider whether the firms dividend policy should be changed. Junior instructed Abe Markowitz, Georgia Atlantics financial vice president, to identify and then evaluate alternative dividend policies in preparation for the special board meeting. He asked Markowitz to consider cash dividends, stock dividends, and stock splits. Markowitz then identified six proposals that he thought deserved further consideration: (1) No Cash Dividends, No Stock Dividend or Split. This was the position Markowitz was certain that Junior and the family would support, both for the reasons given above and also because he thought the company, as evidenced by the balance sheet, was in no position to pay cash dividends. (2) Immediate Cash Dividend, but No Stock Dividend or Split. This was simply the opposite of the no dividend policy. If a cash dividend policy were instituted, its size would still be an issue. (3) Immediate Cash Dividend plus a Large Stock Split. The stock split would be designed to lower the price of the firms stock from its current price of almost $2,000 per share to somewhere in the average price range of other large forest products stocks, or from $20 to $40 per share.
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(4) Immediate Cash Dividend plus a Large Stock Dividend. The reasoning underlying this policy would be essentially the same as that of Alternative 3. (5) Cash Dividend, Stock Split, and Periodic Stock Dividends. This policy would require the company to declare an immediate cash dividend and, simultaneously, to announce a sizable stock split. This policy would go further than Alternatives 3 and 4 in that, after the cash dividend and stock split or large stock dividend, the company would periodically declare smaller stock dividends equal in value to the earnings retained during the period. In effect, if the firm earned $3 per share in any given period-quarter, semi-annual period, and so on and retained $1.50 per share, the company would also declare a stock dividend of a percentage amount equal to $1.50 divided by the market price of the stock. Thus, if the firms shares were selling for $30 when the cash dividend was paid, a 5 percent stock dividend would be declared. (6) Share Repurchase Plan. This plan is based on the premise that investors in the aggregate would like to see the company distribute some cash, but that some stockholders would not want to receive cash dividends because they want to minimize their taxes. Under the repurchase plan, individual stockholders could decide for themselves whether or not to sell some or all of their hares and thus to realize some cash and some capital gains, depending on their own situations. To begin his evaluation, Markowitz collected the data shown in Tables 2 and 3. As he was looking over these figures, Markowitz wondered what effect, if any, Georgia Atlantics dividend policy had on the companys stock price as compared to the prices of other stocks. Markowitz is also aware of one other issue, but it is one that neither he nor anyone else has had the nerve to bring up. Junior is now 66 years old, which is hardly ancient; but he is in poor health, and in recent years he has been almost obsessed with the idea of avoiding taxes. Further, the federal estate tax rate is currently 60 percent, and additional state estate taxes would be due; so well over half of Juniors net worth as of the date of his death will have to be paid out in estate taxes. Since estate taxes are based on the value of the estate on the date of death, to minimize his estates taxes, Junior might not want the value of the company to be maximized until after his death. Markowitz does not know Juniors view of this, but he does know that his tax advisors have thought it through and have explained it to him.

Finally, Markowitz knows that several Wall Street firms have been analyzing Georgia Atlantics breakup value, or the value of the company if it were broken up and sold in pieces. He has heard breakup value estimates as high as $3,500 per share, primarily because other lumber companies, including Japanese and European companies, are eager to buy prime properties such as those owned by Georgia Atlantic. Of course, Georgia Atlantic could sell assets on its own, but Markowitz does not expect that to happen as long as Junior is in control.
TABLE 2 Georgia Atlantic Company Selected Company and Industry Data Earnings per Share $100 $106 $109 $143 Book Value per Share $ 824 $1,180 $1,769 $2,483 Price per Share $1,253 $1,360 $1,597 $1,902 Industry P/E Ratio 16.8 17.9 19.1 16.5 Industry M/B Ratio 2.5 2.6 2.9 2.5

Year 1977 1982 1987 1992

Industry Average Compound Annual Growth Rate in Earnings per Share 197782 6.2% 198287 7.1 198792 7.9 TABLE 3 Selected Stock Market Data Average Payout 25% 31 40 35 44 42 Average P/E 12.8x 16.6 15.3 17.3 17.8 17.0

Boise Cascade Chesapeake Corporation Georgia-Pacific Potlatch Union Camp Weyerhaeuser

Now assume that you are an outside consultant and have been hired by Abe Markowitz to help him with the analysis and make a presentation to the executive committee. First, Abe is not sure whether an announced dividend policy is a good idea. He believes an announced policy could cause the firm to feel forced to take actions that otherwise would be undesirable. He has also expressed concern about signaling and clientele effects. As old man Jenkins used to say, If it aint broke, dont fix it. Thus, analyze the firms present dividend policy to determine how well the company has performed compared to other firms in the industry before discussing the implications of the alternative dividend policies and making a recommendation. Markowitz also wants you to discuss whether the firms historical rate of return on investment has been affected by its dividend policy, the estate tax issue, and the takeover issue. Junior is famous for asking tough questions and then crucifying the person being questioned if he or she has trouble responding. That is probably why Markowitz wants you to make the presentation. So be sure that you thoroughly understand the issues and your answers so that you can handle any follow-up questions that you might receive.