ANALYSTS DEBATE MERITS OF DIVIDENDS IN INDUSTRY

Elliot Zwiebach

The decision by Safeway to institute a dividend last month has revived the debate over whether companies ought to use free cash flow to reward investors immediately or to invest in other strategies with longer-term paybacks.

It has also shifted Wall Street's attention to Kroger to see if it will follow Safeway in declaring a dividend. Industry analysts contacted by SN were divided on whether they expect Cincinnati-based Kroger to do so.

Mark Wiltamuth, an analyst with Morgan Stanley, New York, said the investment community has been asking Kroger to declare a dividend for quite a while, "and there's reason to assume Safeway's actions will result in an increase in that pressure. But Kroger has traditionally favored share repurchases over dividends, so I don't anticipate any change in Kroger's policy in the near future."

Two other analysts disagreed.

Mark Husson, New York-based managing director and global head of consumer research for HSBC Securities, London, said he believes Kroger will definitely opt to pay a dividend "and it will be soon, probably sometime this year."

Gary Giblen, principal in GMG Capital, Darien, Conn., also said he expects Kroger to declare a dividend. "It's kind of a monkey-see, monkey-do situation where Kroger is similarly situated to Safeway in terms of cash flow, and it's seen Safeway's stock go up following de-claration of the dividend. Kroger has made a lot of noise indicating it's not going to copy Safeway, but at the end of the day, it probably will."

Bryan Hunt, an analyst with Wachovia Securities, Charlotte, N.C., said he does not anticipate a dividend from Kroger, saying the company has consistently made its intentions clear. "It has said over and over to the financial community that it will use one-third of excess cash flow to buy back stock, one-third to pay down debt and one-third to invest in its store base," he said.

As a fixed-income analyst, Hunt said he favors the idea of paying down debt before paying out dividends, "and it's reassuring to know Kroger has been reducing debt at a fairly consistent rate over the last three years and that it plans to continue to reduce debt on a constant basis," he said.

Andrew Wolf, an analyst with BB&T Capital Markets, Richmond, Va., said he doubts Kroger will declare a dividend, despite the pressure. "For Kroger to declare a dividend now would be OK, however, as long as it does it in a small way as Safeway did. I think small dividends -- like Safeway's 5-cents-a-share quarterly payout -- is the way for companies to go.

"But cash is an asset, and companies are not banks," he added. "If a company has excess cash flow, then it's got to return it to shareholders rather than building a cash reserve on the balance sheet."

A CYCLICAL PROCESS

Returning excess cash flow to shareholders in the form of dividends has been a cyclical process that tends to dwindle when the economy is booming and companies are investing more in their businesses, Giblen pointed out. That was the case during the tech boom of the late 1980s and early 1990s, Wiltamuth added, "when the market focused more on stock growth than total returns. But there's been a reconsideration in the last few years, motivated in part by a change in government policy that lowered the tax rate on dividends."

That tax benefit prompted Weis Markets , Sunbury, Pa., to add $1 per share to its dividend in August, 2004 -- boosting it from $1.12 to $2.12 for the year -- on the chance that John Kerry would be elected president and the Democrats would opt to reverse the benefit, a spokesman for Weis told SN. This year the company went back to its normal payout.

During 2004, two major companies -- Costco Wholesale Corp., Issaquah, Wash., and Whole Foods Market, Austin, Texas -- opted to institute dividends, with both having already boosted their initial payouts. Safeway, Pleasanton, Calif., declared its first dividend late last month.

Costco initiated a dividend of 10 cents per quarter and raised the quarterly payout to 11.5 cents a share earlier this year, while Whole Foods moved from a 15-cent quarterly payout in January 2004 to 19 cents in January 2005 and then 25 cents in April.

"At $1 a year, that's a pretty good-sized dividend [for Whole Foods]," Wolf said, "especially given two impressive increases of 30% each. But Whole Foods has a low debt to pay down and the cash flow to back up the dividend, with enough left over for 13% to 15% annual square footage growth."

"A growth company like Whole Foods normally would not have a dividend because it's expanding so rapidly," Giblen said. "But its profitability is so strong that cash is piling up, and it figured it could give some of that back to shareholders."

Husson said he thought Whole Foods' decision was ill-advised. "Growth companies shouldn't pay dividends, and the returns on store openings at Whole Foods is so attractive that shareholders would probably be very willing to do without dividends so the company could open more highly productive stores," he noted.

Regarding Safeway's dividend, Wolf said its quarterly payout of 5 cents per share is fairly modest, "and the market kind of shrugged it off because it didn't involve investing a lot of income. If a supermarket company is going to pay a dividend, Safeway went about it the right way."

Hunt also said the amount of the dividend makes it a non-issue. "At 20 cents per share, that's only $90 million annually, which is relatively negligible for a company that generated $1.2 billion in cash annually. Safeway has long-term borrowings of $6.7 billion, and if it used that extra $90 million to reduce debt, it wouldn't make much of a dent at the end of the day."

SIGNAL OF CONFIDENCE

The analysts told SN dividends usually serve as a signal to investors that management has confidence in a company's cash-flow outlook. "Shareholders like dividends because they have permanence," Wiltamuth pointed out. "Share repurchases can come and go at management's discretion, but dividends are a permanent commitment by a management team that it will be more disciplined in its use of capital because it knows it has an obligation to return some of that money to shareholders. By committing to a dividend, managements are less likely to pursue acquisitions that are a stretch or to put cash into projects with lower returns."

Wiltamuth said he believes more supermarket operators should consider dividend payments. "Higher dividends would be welcomed by the Street because they are return-friendly -- they put constraints on managements and on the uses of cash flow."

High-yield analysts, on the other hand, typically prefer to see companies use excess cash to pay down debt or reinvest in growing the business, Hunt pointed out. "I see nothing wrong with dividends, as long as the payout is not exorbitant," he said. "Healthy free cash flow is a cushion to pay down debt, but as long as there's sufficient cash flow to make debt payments on a consistent basis, even under the kind of stressed conditions in which the industry operates today, I have no problem with dividends or stock repurchase activity."

Some analysts expressed concerns over Albertsons' dividend payout.

According to Hunt, Albertsons' annual dividend of 76 cents per share amounts to $280 million a year, "which is 4% of its debt, and while nominally that's a bigger number than Safeway is paying out, I'd prefer to see a lower dividend at Albertsons to give it more flexibility for reinvesting back in the business or reducing debt. In 2003 Albertsons spent $970 million buying back stock, which amounted to 14% of total debt. But for Albertsons to manage its borrowing capability and balance sheet, I'd rather see it repurchase shares than pay a dividend."

Wolf said the dividend is too high, "and if Albertsons had it to do over again, I believe its dividend would probably be smaller."

Husson said Albertsons can still afford to pay the dividend it's paying, "but with business lagging, Albertsons still needs money to pay the rent and interest expense and other obligations, and if money gets tight, it may need to cut back on the dividend. It's not close to that stage yet, but unless sales pick up soon, it could begin to approach that point."

RISKS IN CUTTING DIVIDENDS

But cutting a dividend can be risky, Wiltamuth pointed out. "The market doesn't take kindly to reduced dividends because that often is interpreted to mean a management team is concerned about a company's cash flow," he explained.

At least two supermarket retailers have reduced and then suspended dividends in the last few years -- A&P, Montvale, N.J., and Winn-Dixie Stores, Jacksonville, Fla.

A&P suspended its dividend payments in 2000, the company said, and Winn-Dixie suspended dividend payments indefinitely early in 2004 after 52 years. "A company can hold onto a dividend for too long and be too generous with it for too long," Husson said. "The dividend at Winn-Dixie got up to a double-digit yield in the late 1990s, which means the company was paying more than 10% of the cost of shares back to shareholders."

Ingles Markets, Ashe-ville, N.C., has one of the highest yields in the industry at 5.2%, Giblen pointed out, "because it's extremely cash-flow efficient, with stores that operate profitably in small towns where there's not any undue competitive pressures. It doesn't have to invest much in fancy new stores, and the majority of shares are held by Bob Ingles, the chairman, so it's an income stream for him."

Husson said Supervalu, the Minneapolis-based distributor, requires only low levels of capital for its wholesale business, "so dividends are a good use of its cash." Giblen offered similar comments about Nash Finch, Minneapolis, noting that a dividend makes sense there "because as a food wholesaler it has limited reinvestment opportunities."

Hunt was critical of Marsh Supermarkets, Indianapolis, "which has been doing sale-leasebacks to create off-balance sheet liabilities so the total debt on its balance sheet has been going down while it continues to borrow money without commensurate increases in cash flow. Marsh has actually been generating negative cash flow over the last couple of years, yet it's still returning cash to shareholders in the form of a dividend, which is not a positive event for bondholders."

Food Retailer Dividend Payments

(Ranked by percentage yield)

Company: Year Dividend Instituted; Annual Dividend Per Share*; Dividend Yield

Ingles Markets: 1993; 66 cents; 5.2%

Marsh Supermarkets: 1960; 52 cents; 4.7%

Albertsons: 1960; 76 cents; 3.5%

Weis Markets: 1965; $1.12; 3.5%

Nash Finch: 1926; 72 cents; 2.0%

Ruddick Corp.: 1995; 44 cents; 1.9%

Supervalu: 1936; 61 cents; 1.9%

Costco: 2004; 46 cents; 1.0%

Safeway: 2005; 20 cents; 0.9%

Whole Foods: 2004; $1; 0.8%

*Based on quarterly payouts at outset of 2005.