Do Mothercare really care about the dividends?

Mothercare recently announced that they intend to shut 170 UK stores over the next three years; bringing their store total down to 200 (BBC News, 2012). Mothercare has been on a gradual decline in recent times so this news does not necessarily come as a big shock to many. Shareholders are likely to be particularly disappointed as it was announced that dividend payments would be suspended as the company concentrated on refinancing its current bank borrowings (Financial Times, 2012). After being such a successful chain for so many years, where did it all go wrong? Had dividend payments dried up in recent years?

Mothercare reported that the company was debt free in May 2011, had refinanced its bank facilities and made increased dividend payments totalling £15.5m (Mothercare, 2011). The company was aware that it was struggling at the time so why did it make these payments? Some may suggest that Mothercare could afford to make this payment at the time as dividends can only be paid out of realised profits. The problem here is that it does not necessarily have to be the realised profits from that particular year. The dividend payments could be based on realised profits from a few years ago when the company was much more stable and successful.

Market value may have been one reason why Mothercare persisted in paying handsome dividends under the circumstances. As the company continued to increase their dividends, shareholders would hopefully stay invested in the company rather than selling their shares. A share price can decrease for a company if they do not make regular dividend payments. Some investors judge the performance of a company on the dividend payments. This suggests why some companies continue to make these payments when they actually cannot afford to.Making dividend payments for this reason does not solve the financial situation in any way. It just avoids the inevitable downfall that will occur in the future

As the graph below shows, the share price of the company remained high until October 2011 when the company issued its second profit warning of the year (BBC News, 2011). This suggests that the company did not maybe concentrate on its profits and margins as much as it should have. If this had been more of a primary focus then the profits may have remained higher and therefore the share price would not have dropped dramatically. .

(Yahoo Finance, 2012)
 

Porterfield (1965) argued that dividend payments should be used to maximise shareholder wealth. Modigliani & Millar (1961) countered this statement with ‘Dividend Irrelevance’. They suggested that in the short term dividend payments were not all that important and that the long term growth of a company is what would lead to shareholder wealth maximisation. If Mothercare had followed this advice then maybe they would not find themselves in this current predicament. An argument against this is how long is it possible to not make dividend payments for and when does the long term no longer become the long term? Surely there comes a point where shareholders would become disgruntled at not receiving any form of payment on their investment. Mothercare investors may accept not being paid dividends now but only on the basis that the company will repay them for this patience in the future.

                      

In February it was announced that Simon Calver would leave Lovefilm to take over the reign at Mothercare (BBC News, 2012). He will have been fully aware of Mothercare’s financial turmoil as they announced two profit warnings last year. Mr Calver must feel that he knows what needs to be done at the company in order to regain stability and move the company forward. However, many other senior figures have taken over at other struggling companies in the past and have failed to deliver what they promised; Woolworths being a perfect example. If the company does not succeed then some may argue that appointing Mr Calver will have cost money that could have been used more appropriately elsewhere in an attempt to save the company.

It is most likely that the new Chief Executive was the person who decided to not make dividend payments; this may well have been his first major decision in this role. This shows how dividends can play a key role in the success or failure of a company. It is important to notify shareholders as to why dividends will not be paid. If they are not informed then it is more likely that they will sell their investment and move elsewhere. If the message is communicated properly and the reason is justifiable then it is more likely that the shareholders will appreciate the honesty and maybe not sell after all.

UK companies currently pay dividends to their respective shareholders twice a year. An interim dividend is paid during the year and then a final dividend is paid after shareholder approval is given at an annual general meeting (AGM). I believe that this could be one of the main problems to why dividend payments made can be misjudged. Some companies may feel pressurised to make a payment even if they realistically know that they cannot afford to at that moment in time. If a company could choose to make dividend payments at any given time then surely this would be more appropriate. Companies would be able to assess all of their financial and investment options accordingly before deciding how much to pay in dividends and when to make this payment. It would become more apparent that companies were making dividend payments because they were in a position to do so rather than feeling that they had to because it was that time of the year. Companies could operate more efficiently in this manner and therefore the dividend payments may be more generous as the companies become more successful.

It is possible for companies to recover and be successful again but the right people need to be in place for this to happen. Strong characters are needed and these strong characters need to make the right decisions at the right time. Neil Harrington, the finance director of Mothercare, left the company in April (Telegraph, 2012) and this may be a blessing in disguise. One reason contributing to why that individual left may have been to avoid the tough times that lay ahead for the company.

Putting a stop to dividends in the short term may well be what saves Mothercare in the long term. Arnold (2008) states that dividends are “that part of profit paid to ordinary shareholders, usually on a regular basis”. This definition may not be appropriate in the near future if many other companies follow the trend of Mothercare.

Sources used:

Arnold
BBC News
Financial Times
Modigliani & Millar
Mothercare Annual Report
Porterfield
Telegraph
Yahoo Finance

Where did Peacocks get it wrong?

Optimal capital structure is the concept that a company can benefit from continuing to increase its debt through financing. As the gearing level continues to increase, the cost of the financing can actually begin to decrease. Companies have to be careful and try to avoid creating too much debt as the consequences can be drastic.

Peacocks has been in financial turmoil since last year and as a result of this the company ended up in administration. Recently the company came out of administration as it was sold to Edinburgh Woollen Mill. From this purchase 6,000 jobs were saved but 3,100 members of staff were made redundant (BBC News, 2012). How did Peacocks end up in this mess in the first place and why were the problems not prevented earlier?

Like many other companies, Peacocks suffered from the decrease in spending by customers during tough economic times. Mr Pope, joint administrator and associate partner at KPMG, suggested that the company also had “a surplus of stores and unsustainable capital structure” (BBC News, 2012). This comment suggests that it is possible for companies to take on too much debt therefore exceeding optimal capital structure. This is one factor towards why some companies have gone into administration in recent years. Peacocks went into administration in January 2012 as it failed to restructure £240m of its £750m debt (Financial Times, 2012). The levels of debt spiralled out of control and therefore the capital structure of the company collapsed.

Lots of companies become geared by borrowing money and building up debt. This can actually have a favourable effect on share prices. Maximising shareholder wealth is very important to most companies which may be why so many become highly geared. There is also a risk to shareholders in the long term and this should be taken into account. If their invested company begins to falter then the interest payment may become difficult to pay. The interest payments will remain the same even if a company begins to produce less profit. Peacocks could not make the necessary payments on the £750m debt as they were not producing the profits that had been expected.

Modigliani and Millar (1958) proposed an alternate theory to optimal capital structure. They suggested that there was no such thing as optimal capital structure and that the value of a company related directly to the risks to the business. If this concept were true then this would mean that many companies, including peacocks, may have altered their capital structure on false pretences.

Companies cannot just expect to be successful on a regular basis. Almost every company has moments when it may struggle; these factors may be an external effect that a company cannot control. Peacocks struggled because of the economic downturn. They probably did not envisage that spending would decrease as much as it did; this is a sign of over optimism. Companies such as Peacocks have to be more realistic in what can be achieved in the short term and the long term. If a company folds then many people suffer. Customers lose products they liked, shareholders lose investments and members of staff lose jobs as shown in the picture above. Companies need to be aware of the financial risk to the company for each proportion of debt that is attained. It is ok for companies to finance debt as long as it is within moderation. Each company should set itself a maximum gearing percentage that it can reach. This would hopefully avoid companies relying on this form of money too much and therefore survive in challenging times.  

Sources used:

BBC News

Financial Times

Modigliani and Millar