March 14, 2003 — Microsoft startled market analysts when it announced in January that it would start paying a dividend to its investors in the first quarter, relinquishing at least some of the tens of billions of dollars of cash on the company’s books.
Now the question investors are asking their advisors is how many technology companies — historically reluctant to pay out dividends — might follow suit, and how they can profit from any trend that might take shape. The trick may be to identify those companies that are best positioned to pay dividends, and then the funds that have significant stakes in these enterprises, analysts agree.
The most likely candidates are technology companies whose businesses are profitable, generate consistently strong cash flows, have large cash balances, and whose businesses aren’t cyclical and don’t need that cash to finance capital projects. Those least likely to start issuing dividends still view themselves as high-growth companies.
“Executives will be cautious about signaling to the market that their growth rate is slowing, which is what a dividend is usually seen as doing,” says David Readerman, growth stock strategist at Thomas Weisel Partners, a San Francisco-based investment bank.
Software companies are likely to be among the biggest dividend-payers going forward, says Brooke Dane, a member of the technology stock research team at Putnam Investment Management. These companies typically generate large amounts of cash, but their businesses are maturing, and they face a slower rate of growth in the core businesses. Microsoft is by far the best example of this, with more than $40 billion in its war chest. Traders refer to its new dividend policy as a fraction of what the company should be paying out, and Readerman, for one, says if the company were serious about dividends, it would be paying five times as much, or about 72 cents a share annually.
Software companies as diverse as BMC Software (BMC), CheckPoint Software (CHKP), Oracle (ORCL) and Siebel Systems (SEBL) may begin paying dividends in the not-too-distant future, analysts say. A number of large technology funds maintain substantial positions in Oracle, which has a $5.5 billion pool of cash from which dividends could be paid. These funds include MFS Technology Fund/A (MTCAX) with a 5.55% interest, and Firsthand Funds:Technology Leaders Fund (TLFQX) with 5.14% of its assets in Oracle. A handful of software firms, like Veritas (VRTS), which has $2.2 billion in cash on hand, has indicated it won’t start paying dividends.
The best strategy may be to identify funds that have stakes in a number of these companies. For instance, the AXP Global Technology Fund/A (AXIAX) has large positions in Microsoft, Oracle and Cisco Systems. The Hartford Global Technology Fund/A (HGTAX) also has stakes in Microsoft, Intel (INTC) (which already pays a small dividend), and Cisco Systems (CSCO), whose shareholders previously rejected a dividend, but whose top executives are now reconsidering their opposition to dividend payments. The IDEX Great Companies-Technology/A (IGTAX) has substantial positions in many current and potential dividend-paying technology companies, including a 6.65% stake in Dell Computer Corp. (DELL). At last report, more than 35% of its holdings were in large, cash-rich companies that are considering dividend payments, or already pay at least a small dividend. MFS Technology Fund has about 32% of its assets in a similar group of companies.
Though President Bush’s economic stimulus plan is seen in jeopardy, if passed by Congress, the nature of these funds could well undergo a fundamental change, should dividend payments to investors become free of income taxes. Until now, analysts and investment advisers have been accustomed to regarding technology funds as a source of capital gains — or capital losses — rather than a source of dividend income. That’s due to the fact that, of the 75 technology companies in the Standard & Poor’s 500-stock index, only 17 pay dividends. While the average yield as on the 358 companies in the S&P 500 index that do pay dividends is 2.70%, and the average yield for the index as a whole is 1.91%, the yield generated by these technology stocks is a mere 1.01%.*
But capital gains are scarce these days, and even if the economy rebounds, they may not be as easy to find in the future. That means that a growing number of large institutional investors are pressing companies like Dell, Cisco and Oracle to implement dividends.
“Many of the major technology stocks of the last 15 years are clearly maturing,” says Erik Gustafson, a portfolio manager for Stein Roe & Farnham in Chicago. “They have become so large that they won’t be able to grow their earnings as fast as they did in the past, and therefore dividends will become ever-more important to investors like myself.”
If the growing number of technology companies now pondering the idea of paying dividends decide to act, these technology funds with the largest stakes in these firms may become a source of investment income as well as capital gains: a dramatic shift in the way technology stocks are now viewed.
It remains to be seen whether the presidents proposal regarding dividends will receive Congressional approval, given that the plan was dealt a blow after four pivotal senators put in writing that they wouldn’t support a tax-cut package larger than $350 billion, as reported today by The Wall Street Journal. But since the legislative process is likely to be a long and complex one, there can still be unexpected twists and turns along the way when it comes down to whether or not a dividend proposal is passed in some form or another.
In the meantime, technology companies are at least considering dividends, and some are already acting. In addition to Microsoft, cell phone manufacturer Qualcomm (QCOM) announced its first dividend earlier this year, while Dell and Oracle have both said they will revisit the issue of whether or not to pay a dividend.
“The reality is that dividend yields are going to play an increasing role in the total return for technology investors in a market environment where we might see the market gain only 8%,” says Readerman. “In the very battered technology sector, this might be some kind of bromide for investors, giving them something to offset the downward slide in valuations.”
Until now, companies have preferred using their cash to buy back stock rather than pay dividends. But while share buybacks are discretionary — and once announced, may not always be fully implemented — dividends “tell the market that there’s a confidence about earnings forecasts and cash flow, and confidence is much sought-after by investors these days,” says Brooke Dane, a member of the technology research team at Putnam Investment Management. Tom Smith, director of information technology research at Standard & Poor’s, agrees, adding that companies paying dividends “get pulled up on a lot more screens by investors looking for certain growth characteristics and income.”
Still, analysts warn investment advisors that while the type of returns that can be derived from technology stocks and funds is changing, it’s important not to over-emphasize the degree of that change.
“The bottom line is that capital gains will provide the majority of gains for growth stocks and technology,” says Readerman. “But the focus on dividends will have the effect of putting pressure on companies to deliver that growth if they’re not going to be delivering a dividend.”
*Source: Standard & Poor’s. S&P 500 dividend data as of 3/11/03.