Market Watch: Eliminating tax on dividends will boost government IT stocks

Jerry Grossman

The Bush administration's controversial proposal to eliminate the "double taxation" of dividends would impact capital market investors and influence the decisions of corporate executives and boards of directors. But whether the impacts are negative, neutral or positive will vary by industry and company and depend upon the strategy and stage of development of each business.

For government information technology and defense services companies, the dividend tax measure in its present form would have a positive effect on the equity value. Fundamentally, a company's value increases when surplus capital is paid out to shareholders quarterly instead of being retained in the business. Surplus capital is defined as free cash flow produced by the business exceeding the amount needed to support asset growth. This growth is produced by organic business growth and acquisition activity.

With few exceptions, government services companies generate more capital than their operating requirements. For example, at a 6 percent to 7 percent operating profit margin range, a company functioning within normal performance parameters can grow revenue at up to 25 percent annually without increasing the company's financial leverage.

With longer-term industry demand growing at a 5 percent to 10 percent annual pace, most companies' growth rates are well below this threshold. Accordingly, capital retained in the company will produce substandard returns with today's low interest rates.

For those companies in the public market, pursuing aggressive acquisition strategies, investors anticipate that capital generated by the business will be re-invested, providing an equity-funding source for acquisitions. Where this strategy is accomplished successfully, this re-invested capital will produce nice returns to investors, many of whom have been attracted to the prospective growth to be achieved by increased customer demand and accretive acquisitions. The small proportion of government IT companies that meet this definition have a different investment profile than most of their private market peers.

Most government services companies with growth rates below 25 percent can support their internal growth while providing investment liquidity to shareholders. For many shareholders owning or investing in these businesses, dividends are attractive for diversification and estate planning purposes. And, by the way, these dividends would be tax-free distributions, adding to their glow.

These dividends, invested with the expectation of producing typical equity returns, might generate 10 percent or greater annual returns, several times those achieved with this same capital, held inside the company and invested in low-risk instruments.

The tax- free dividend proposal would offer government services companies, their executives and owners the option of adopting either a higher risk, high-growth strategy and re-investing the earnings in more rapid growth, or a lower risk, low-growth strategy and making tax-free distributions to shareholders, quarterly or annually. Equity interests within the industry could, therefore, be growth stocks or income stocks.

When stock values, relative to company earnings, are in the upper end of the historical range, as is now the case (price-earnings multiples well over 20 times), the value enhancement produced by tax-free dividends is less significant, perhaps 5 percent to 10 percent. When price-earnings multiples are in the 15 to 20 times range (the longer term historical norm), the value enhancement from the tax-free dividend can easily exceed 10 percent.

In addition, when companies within the industry can offer investors both growth and income alternatives, this may provide the foundation for expanded investor interest in both public and private investor groups. *

Jerry Grossman is managing director at Houlihan Lokey Howard & Zukin in McLean, Va. He can be reached at jgrossman@hlhz.com.

About the Author

Jerry Grossman is managing director at Houlihan Lokey Howard and Zukin.

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