Scrip dividend pros & cons: how dividend policies change in a crisis

With the coronavirus pandemic causing turmoil on markets around the world, companies need to take a cautious approach to scrip dividends in lieu of cash dividend payments, according to UNSW Business School research

Unprecedented times call for unprecedented measures. With COVID-10 causing uncertainty and market volatility to skyrocket and revenue to plummet, companies all over the globe are resorting to cost-cutting measures such as deferring investments, cutting employee wages, and changing dividend policies.

In Australia, one-third of companies are expected to cut their dividends to cover the revenue shortfalls caused by the COVID-19 pandemic, with similar dividend cancellations occurring worldwide.

Although cancelling or cutting dividends may seem like the most straightforward cost-saving mechanism available when it comes to dividend policy, it comes at a cost. When HSBC announced on 31 March that it would cut its dividend for the first time in 74 years, the bank’s shares dropped 9.5 per cent, causing an uproar among its retail investors who demanded HSBC pay out a scrip dividend instead of cancelling the dividend altogether.

Offering a scrip dividend would not be an unusual step. In recent weeks, many firms have opted to replace their cash dividend payouts with elective dividends such as scrip dividends and dividend reinvestment plans (DRIPs). In France, Total CEO Patrick Pouyanna announced on 29 May that the firm would offer a scrip dividend instead of its usual cash dividend, hoping to save over $1 billion in cash to alleviate the impact of plummeting oil prices. 

Similarly, UK capital provider Duke Royalty Ltd opted for a scrip dividend for the June quarter in order to cope with the shortfall in short-term cash receipts while in Australia, Macquarie Group announced that it would offer a DRIP to raise equity and set up a buffer for potential future deterioration in the global economy.

What are scrip dividends?

Elective stock or scrip dividends give investors a choice between receiving a cash dividend or newly issued company shares, sometimes offered at a discount. Although pure scrip dividends are less popular in Australia, Australian companies offer dividend reinvestment plans which act very similarly by enabling investors to reinvest their cash dividends in newly issued company shares. 

In certain countries such as the UK, scrip dividends were historically subject to favourable tax treatment, providing clear benefits to both corporations and shareholders. However, with the abolishment of such tax incentives in 1999, why do firms pay scrip dividends? And why have they become so popular in recent months?

Why are firms using them?

In a recently published paper, UNSW Business School lecturer Cara Vansteenkiste shows that the use of scrip dividends tends to increase when economic conditions deteriorate: in the wake of the 2008-2009 financial crisis, one in eight UK and European firms offered scrip dividends, enabling them to preserve 34 per cent of their total dividend payout value. By allowing shareholders to forego a cash payment and receive new company shares, scrip dividends provide a way for financially constrained firms to preserve cash and retain or improve their financial position.

Even under normal economic conditions, more than 15 per cent of UK listed firms opted to offer a scrip dividend. This was driven primarily by young firms and by firms with high debt ratios, for whom external financing is more costly to obtain. Even when firms do not face immediate cash shortages or financial constraints, firms often use scrip dividends to cover future debt payments following large investments such as mergers and acquisitions.

Are scrip dividends a perfect solution for cash-constrained firms?

That depends. Although scrip dividends trigger less negative market reactions compared to dividend cuts or dividend omissions, the amount of cash saved in a scrip dividend payment depends on the percentage of investors choosing the stock option relative to the cash payment.

Firms that require more certainty about how much cash they can save may wish to combine a reduction in dividend payout with a scrip dividend offer. They may even attempt to disguise a dividend cut by announcing a scrip dividend, hoping to distract investors from the reduction in total payout. Because they offer a combination of cash and stock dividends, scrip dividends are generally not well understood by retail investors. 

The online trading platform Interactive Investor even labelled scrip dividends as “a dividend conceit every investor should know”, stating that they enabled firms to “create the illusion of retaining high overall dividends even as they slashed cash dividend payments by one-third” and that “the best way to see a scrip dividend is as an additional layer of obfuscation that demands greater shareholder scrutiny”.

What makes a scrip dividend so complicated?

Although the choice between cash or stock may seem fairly straightforward, the issuance of new company shares under the stock offer creates a dilution effect that retail investors may overlook. After all, the newly created company shares are not equivalent to a capital raise: the creation of new shares is equivalent to a small stock split, in which the corporate pie does not increase but is merely cut into more pieces.

As a result, the choice between cash or stock is effectively a trade-off between cash and control. Investors who forego the stock option receive a cash dividend, but their existing stake in the company’s equity is diluted by the newly issued shares. Although the average retail investor may not be particularly concerned about the control-diluting effects of the cash option, many countries allow firms to offer the stock option at a 5-10 per cent discount, adding an additional hurdle to fully understand the value implications of the scrip dividend choice.

Despite the complexity of the underlying wealth effects, there is little evidence that firms can fool the market by disguising reductions in dividend payout with scrip dividends in practice. Markets do not react differently to scrip dividend announcements relative to cash dividend announcements. 

In fact, shareholders appear to learn from the firm’s past actions: markets react more negatively to scrip dividends if the firm has a history of scrip dividend payments.

For more information view the paper on Elective stock and scrip dividends or contact Cara Vansteenkiste directly.