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Is There a Dark Side to the Recent Glut of Special Dividends?

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To avoid expected tax rate increases in 2013, many companies issued special dividends before the end of 2012. Was that smart?

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MINYANVILLE ORIGINAL The drama over the fiscal cliff is finally over, and stocks are soaring as a result of the deal reached between Democrats and Republicans to avert the series of automatic tax increases and spending cuts set to kick in at the start of 2013.

Indeed, the fiscal cliff has been the major market mover in the past few months, with US stocks rising each time Democrats and Republicans appear to have made progress and falling when talks fall through.

The fear of falling over the fiscal cliff has also affected the behavior of businesses. Dozens of public companies have made the move to either pull forward their quarterly dividend payments from early 2013 to December or issue one-time special dividend payments to shareholders this month.

Companies that have issued special dividends or moved payments up include Wal-Mart (NYSE:WMT), Oracle (NASDAQ:ORCL), Tellabs (NASDAQ:TLAB), Wynn Resorts (NASDAQ:WYNN), and Las Vegas Sands (NYSE:LVS).

Ostensibly, companies have done so to help their shareholders avoid the increase in the dividend tax rate. In the eleventh-hour fiscal cliff deal signed by President Barack Obama, the dividend tax rate for households making more than $450,000 per year will rise from 15% to 23.8%, which includes a 3.8% Obamacare investment surtax. However, before this agreement was reached, the country's highest earners were set to pay 43.4% in dividend taxes, which prompted companies to take action.

"It's like a nice end-of-the-year gift," Jay Wong, a Los Angeles-based portfolio manager for money manager Payden & Rygel, said of Wynn's special payout, according to the Wall Streeet Journal.

But is a special dividend always a good thing? Companies typically issue them when they have extra cash sitting around, but because of the fiscal cliff situation, many have actually borrowed money to do so.

Costco (NYSE:COST), for example, borrowed $3.5 billion to issue its special dividend of $7 a share, or some $3 billion. Rating agency Fitch subsequently downgraded Costco's Issuer Default Rating (IDR) to a still relatively strong A+.

Similarly, after Brown-Forman (NYSE:BF.B) said it would sell some $750 million in bonds to issue a $4-per-share, or $800 million, one-time dividend, its debt was downgraded to A-. Suzanne McGee of YCharts explained why it did not make sense for Brown-Forman to issue a special dividend:

The idea behind special dividends is that they are great when a company has a bunch of idle cash cluttering up its balance sheet for which it can't find a way to deploy it that would generate a higher return than the cost of capital. With rates as low as they are, that's a pretty low threshold, so it's unlikely that many companies – unless they are as cash-rich as, say, Apple (NASDAQ:AAPL), are wary of rushing into an ill-considered merger, or are in a slow-growth business – can truly believe that paying out cash is better than looking for a way to deploy it themselves. Especially when they are pondering paying out cash that they don't even have, and committing themselves to paying interest on debt for years to come.

Companies are taking on debt they do not necessarily need to, just to best provide value to shareholders, said one investment banker at a mid-sized bank Minyanville spoke to, who added that the firms borrowing to issue dividends would not lever up to a level that markets or banks would not support, but they would nonetheless increase their risk profiles.
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No positions in stocks mentioned.
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