Employing a variable dividend policy encourages an ‘ownership mentality’ in the shareholder base, reflects a management approach that is forethoughtful and affords financial versatility from cyclical downturns/economic shocks.
Progressive Corporation and Cal-Maine Foods use what I believe is one of the smartest business policies for dividend-paying public companies, the variable dividend. The concept is as simple as it sounds. It is predicated on a willingness to return a portion of earnings directly back to shareholders on a consistent but not necessarily uninterrupted basis. Here is a quick summary of how each policy fits the unique needs of each business.
Progressive Corporation background
Progressive sells automobile and specialty property-casualty insurance policies. The overall industry for such services is characterized by cyclicality; during the period from 1976-2005 (see A.M. Best chart here) the private passenger auto industry only had 6 profitable years in that 30 year period. Thus there will always be years of underwriting losses for some participants.
Impressively Progressive has had only 1 underwriting loss in the recent past (FY 2000) and their consistent profitability compares favorably to GEICO. Nonetheless while their underwriting losses may be few Progressive will still incur future losses from time to time. Additionally unfavorable loss reserve developments, litigation, weather-related catastrophes and investment-market corrections can all quickly diminish a capital base as well. Not to be forgotten is also that the timing of Investment income and gains (or losses) can be lumpy and unpredictable. This doesn’t even account for periods with irrational pricing trends (i.e., soft markets). It is this dynamic that makes having capital base flexibility very important.
Perspective on Progressive’s variable dividends
Here is the gist of the new policy:
- If they incur an underwriting loss in one year, then no dividend.
- If there are extraordinary circumstances that make a dividend irresponsible, then no dividend.
- If the taxation of dividends were to increase beyond some reasonable rate, then no dividend.
In his 2005 shareholder letter CEO, Glenn Renwick explains his thoughts brilliantly on the matter:
Progressive’s business model is designed to produce profitable growth over any reasonable period and support that growth from underwriting results…With this as a backdrop, we have challenged ourselves to develop a more comprehensive view of capital husbandry that is more aligned with our business model. In 2007, we will replace modest quarterly dividends with an annual variable dividend payable after the close of the year…This adds a significant dimension to our ability to return capital to shareholders in balance with performance and our expected future capital needs. In addition, it provides for an ownership proposition well aligned with company-wide performance management incentives.
Lumpy dividends are not necessarily inconsistent, nor are they bad
I give Progressive and Glenn Renwick a lot of credit for thinking independently, ceasing to conform with traditional practices and introducing a dividend policy that is directly tied to its core business. Less talked about but worth mentioning is that at the same time a versatile dividend policy was introduced Renwick also decided to cease automatically splitting Progressive’s stock when it exceeded $100; he thought it unwise to make such a permanent commitment to stock-splitting and in 2006 formally removed that precept from its Financial Policies.
All in all Progressive increased its financial versatility, and thus decreased their risk, by constructing a dividend policy that more closely aligns the AMOUNT and FREQUENCY of dividended earnings with their underwriting performance, which, as previously mentioned, is remarkably consistent as evidenced by incurring only 1 underwriting loss in the past 10 years.
Additional Renwick commentary on both these areas can be found in his 2005 annual letter to shareholders which I highly recommend reading. The Progressive dividend policy, with its exact mechanics, can be found here.
Cal-Maine Foods background
Cal-Maine is a producer and marketer of shell eggs in the United States. Input prices can fluctuate widely thus making the business highly cyclical AND seasonal whereby small increases in production or small decreases in demand can have outsized, adverse impact on shell egg prices. This excerpt from the company characterizes their industry well:
Shell egg prices trended upward from 2002 until late 2003 and early 2004 when they rose to historical highs. In the early fall of 2004, the demand trend related to the popular diets faded dramatically and prices fell. During the time of increased demand, the egg industry had geared up to produce more eggs, resulting in an oversupply of eggs. Since 2006, supplies appear to be more closely balanced with demand and egg prices again reached record levels during 2007 and 2008. Egg prices have since retreated from those record price levels. Retail sales of shell eggs are greatest during the fall and winter months and lowest during the summer months. Prices for shell eggs fluctuate in response to seasonal factors and a natural increase in shell egg production during the spring and early summer.
Can you imagine the headaches involved in trying to manage the financial ebbs and flows of that type of business?! Needless to say extra flexibility in the capital base is EXTREMELY important for such a cyclical business.
Perspective on Cal-Maine’s variable dividends
The Cal-Maine dividend policy is formulaic with the following details:
- Paid on a quarterly basis ONLY during quarterly periods when the Company reports net income on a GAAP basis; the dividend payout is 1/3 of such GAAP net income
- No dividend paid when a GAAP quarterly net loss is recorded
- Following a period(s) of net loss, a high-water mark is used whereby no dividend is paid for a subsequent profitable quarter until the Company is profitable on a CUMULATIVE basis computed from the date of the last quarter for which a dividend was paid
The Company sums it well by saying, “Management and Board of Directors of Cal-Maine believe the variable dividend policy will more accurately reflect the results of our operations while recognizing and allowing for the cyclicality of the egg industry.” Word.
Conclusion: Being forethoughtful means being less conventional
My concluding thoughts on Cal-Maine mirror the sentiments of my earlier comments regarding Progressive. I suspect the main reasons variable dividends are not used more often is from some combination of blind adherence to convention, the false belief that the presence of dividends means the absence of financial insecurity and the preference for a predictable dividend instead of a sustainable one. Basically there are no good reasons.
The use of variable dividends makes so much financial sense its usage should be the rule not the exception; but sometimes in order to be forethoughtful you have to be less conventional.
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