What Costco's Special Dividend Means for Shareholders

Costco Wholesale issued two related press releases Wednesday, announcing that it would pay a special dividend before the new year, and that it would fund this special dividend with a new debt issuance at very agreeable rates. The company also announced strong November sales. This news was somewhat undercut by a slight downgrade to Costco's credit rating.

According to a statement, Costco will pay $7 per share on Dec. 18th, representing a 7.25% yield on Tuesday's close price of $96.51. Accordingly, shares rose 6.3% in Wednesday's trading. CFO Richard Galanti also affirmed that the company would be paying its regular quarterly dividend, and that the special dividend would have no effect on planned share buybacks or capital expenditures.

The move to pay a special dividend is a direct response to the "fiscal cliff," the austerity package of spending cuts and tax increases scheduled to come into effect on Jan. 1 unless a divided, polarized Congress can act to prevent it. Since 2003, qualified dividends have been taxed at the same rate as long-term capital gains -- 15% for most taxpayers. However, this policy is set to expire with the fiscal cliff, allowing dividends to be taxed as regular income. This means that high-income earners will see the tax on their dividends more than triple, from 15%, to 39.6%, if the cuts expire as scheduled.


Even if Congress decides to cushion or defer the cuts in the fiscal cliff, many companies expect that any deal will result in higher taxes on dividends. The result has been a flurry of activity to return money to shareholders before the deadline. Costco competitor Wal-Mart moved its regular dividend from Jan. 2 to Dec. 27, marking a departure from the company's traditional January dividend payment. Department store Dillard's adopted both strategies, moving its regular fourth quarter payment to December, and offering a special dividend, as well.

Often, these moves are self-serving by management or board members. In Wal-Mart's case, the Walton family owns over half of all shares, while members of the Dillard family make up three of the 11 largest shareholders. Paying special dividends and adjusting regular payment dates in these cases amounts to these insider, concentrated shareholders paying themselves.

At Costco, however, no member of the executive team or board of directors owns more than a quarter of one percent of shares. This indicates that the special dividend is meant as a shareholder-friendly move rather than a method of self-enrichment.

Generally, I like dividends because I view them as the most effective way to return money to shareholders if the company can't put that money to work growing the business. Costco did have a formidable amount of cash on its balance sheet: $4.8 billion. In a conference call to discuss the special dividend, CFO Richard Galanti pointed out that about $2 billion of that total is highly variable, representing items like the float from uncashed checks, or receipts booked before expenses; but that still leaves plenty of cash.

However, what concerned the Fitch ratings agency, as well as me, was that Costco didn't choose to employ that free cash to pay the dividend. Instead, Costco issued $3.5 billion in new debt in three tranches, due in December 2015, 2017, and 2019, respectively. Three billion dollars will go toward the special dividend, while the additional $500 million will be used for general business expenses.

This is an unusual move. With a blended average interest rate of about 1.2%, Costco has essentially undertaken to pay an additional $40 million or so in interest annually in order to shovel cash to shareholders now. While that's not much of an added expense for a reliable revenue generator like Costco, It's not typically the kind of behavior I like to see from a company focused on the long term.

However, Galanti did reassure investors that the special dividend would not impact the company's long-range strategy of share buybacks or capital expenditures, and Costco remains on track to accelerate new store openings from the mid-teens to as many as 30 per year by 2014. When asked on the call why the company chose to finance the dividend with debt instead of cash, Galanti noted that Costco prefers to keep a strong balance sheet, and pointed to the company's access to credit at incredibly favorable terms.

That makes me think that the special dividend should really be seen as a one-of-a-kind deal, an opportunity brought on by the specter of higher dividend taxes in the near future married with the availability of very cheap credit. Costco basically thought that it could provide a service to shareholders by exploiting its access to low-interest capital, and making that capital available to investors before the higher tax rates take effect.

This may indicate that Costco, long chastised by Wall Street for putting members and employees before investors, may be focusing more on shareholders under new CEO Craig Jelinek, who took the reins from founder Jim Sinegal earlier this year. However, given the unique circumstance of the move, and the fact that shareholders have hardly been poorly treated over the last two decades, it's not clear that the special dividend or the ratings cut is any sort of buy or sell signal. In short, the $7 per share special dividend is a nice holiday present to investors, but ultimately doesn't really affect the investing thesis for Costco one way or another.

The article What Costco's Special Dividend Means for Shareholders originally appeared on Fool.com.

Fool contributor Daniel Ferry owns shares of Costco Wholesale. The Motley Fool owns shares of Costco Wholesale and Dillard's. Motley Fool newsletter services recommend Costco Wholesale. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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