How long will Costco's dividend pop last?

Experts say the gains from Wednesday's announcement will dissipate after the payout. But Costco's rise may have some staying power.

By Jim J. Jubak Nov 28, 2012 4:57PM
Image: $100 dollar bills -- Image Source, age fotostockShares of Costco Wholesale (COST) were up 6.1%, or $5.89 a share, Wednesday afternoon on news that the company will pay a special dividend of $7 a share on Dec. 18 to shareholders of record on Dec. 10.

The company also announced that U.S. comparable store sales for November climbed by 6%. Total company sales, after subtracting for currency effects, were up 5% in November from November 2011. And, by the way by the way, the company lowered revenue guidance for the first quarter of its 2013 year -- the quarter that ends on Nov. and that will be reported on Dec. 12 -- to $23.21 billion from the Wall Street consensus of $23.43 billion.

Financial theory, as taught to me in business school, says that a special cash dividend like this should have a minimal effect on a company’s share price in the long run. If it is simply shifting cash from the company’s balance sheet to the pockets of investors, it’s only a positive if investors think they can invest that cash for higher returns than the company (a dubious proposition in the case of Costco) or if they have some extraneous reason to like cash distributed now. That second reason -- cash now avoids the uncertainty of tax increases on dividends in 2013 -- has some value to short-term investors, but if you own Costco because of the company’s ability to grow its business, the value seems small at best.

In other words, the stock should move up in the short term as investors buy to capture the $7 special dividend -- after all, earning 7% of so for owning the shares for less than three weeks would be quite a nice rate of return -- but then the shares should move back to their pre-dividend level or lower since the company has distributed part of its assets to shareholders.

But this gets a little more complicated because it looks like Costco intends to borrow the $3 billion so that it can distribute $3 billion to investors. The company plans to issue $3.5 billion in debt in its first debt offering in almost six years. Standard & Poor’s is reporting that Costco will sell three, five and seven years of senior unsecured debt. The offering won’t push Costco’s debt into the danger zone -- the company had only $1.6 billion in debt outstanding at the end of September. But still at least one of the ratings companies isn’t totally amused. Fitch Rating downgraded Costco’s issuer default rating to A+ from AA- on the news.

It might be best to think of the package as a complicated arbitrage on interest rates and (potential) taxes. By borrowing now, the company says that it will be able to take advantage of current extremely low interest rates. And by issuing the special dividend now, the company saves shareholders from potentially higher tax rates in 2013 -- if the company were to pay out that same $7 special dividend next year. (The special dividend comes on top of regular dividends that totaled $500 million in the fiscal year that ended in August 2012. Costco’s regular dividend yield was 1.1% in fiscal 2012.) The company could argue that it is realizing for shareholders the value in its under-leveraged balance sheet in an era of ultra-low interest rates.

Of course, there is no requirement that the company make a special dividend payment at all. So the savings on higher 2013 tax rates is, well, all in the minds of investors.

Which may be the company’s ultimate point. The financial markets are currently rewarding companies that are pushing up dividends on the calendar or declaring special dividends. With a lot of investors looking to head off higher taxes on dividends in 2013, companies that make a move like this one are getting a good pop on their shares.

It remains to be seen how long that pop lasts (and how much of it lasts) after the record date on Dec. 10 and the payable date on Dec. 18. Financial theory suggests that the stock should give up all the gains from this announcement after the dividend is paid. In my experience, though, the effects of the dividend on the stock price don’t dissipate all at once when the dividend is paid.

We’ll see. I’m certainly going to hold onto shares of Costco added to my Jubak’s Picks portfolio on Oct. 24, but I don’t see any reason to raise my current $110 target price on this news.

At the time of this writing, Jim Jubak didn't own shares of any companies mentioned in this post in personal portfolios. The mutual fund he manages, Jubak Global Equity Fund (JUBAX), may or may not own positions in any stock mentioned. The fund did not own shares of Costco Wholesale as of the end of September. For a full list of the stocks in the fund as of the end of the most recent quarter, see the fund's portfolio here. 
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