Special Dividends

January has been a very busy month for me as one of my long-term IT contracts switches into maintenance phase and I look for new opportunities. Hence I have not had a chance to blog about many interesting developments such as the negative article about Medifast (MED) in Barron’s magazine, the class action lawsuit against wireless/WiMax equipment provider Alvarion (ALVR) and rumors about the acquisition of mortgage lender Countrywide Financial (CFC) by Bank of America (BAC). The news has not been bleak for all the companies in the InsideArbitrage model portfolio with Suntech Power (STP) posting gains of over 46% in less than six months and our May 2007 put option in the mortgage REIT New Century Financial (NEW) almost doubling in value. I will discuss all these developments and more in the next edition of InsideArbitrage, which will be sent out to subscribers in the next couple of days.

This blog entry is about special dividends and is based on a question a subscriber asked me about the $10 special divided that Health Management Associates (HMA) declared a couple of weeks ago to ward off a private equity takeover. This subscriber felt that this $10 special dividend represented a good short-term profit opportunity and was wondering why the stock had not appreciated after the announcement.

HMA has actually declined more than 8% since the announcement of a special dividend because the company has taken on additional debt in order to finance the dividend, has decided to suspend its regular dividend indefinitely and in the process got its debt rating cut to junk status by Standard & Poor’s. Essentially what HMA is doing is similar to you taking a big loan of $100,000 from your bank and then considering it as cash in your pocket to spend freely. Hence HMA’s balance sheet is not as strong as it used to be and the stock is worth less.

Just like any other special dividend, as soon as the $10 dividend is paid out, the price of the stock will drop by $10 per share since market makers will adjust the price down by the amount of the dividend. As you can see from the following charts, this is exactly what happened after TD Ameritrade (AMTD) paid out its $6 per share special dividend and Marcus (MCS) paid its $7 per share special dividend in 2006. If you are not familiar with Marcus, you might find my earlier blog entry titled Bring Out The Popcorn For Marcus interesting.

Another issue with special dividends is taxation. Special dividends are sometimes considered an “adjustment to the cost basis” and sometimes are taxed at the same rate as regular dividends, currently at a rate of 15%. Most folks holding stocks that pay these dividends in a taxable account may not be happy with this sudden tax burden. The FAQs about the Marcus dividend and the TD Ameritrade dividend should provide additional insight into how special dividends are paid out and taxed.

As an interesting side note, I should mention that according to the academic study Special dividends and the evolution of dividend signaling, 61.7% of NYSE firms paid special dividends in the 1940s, while only 4.9% of NYSE firms paid special dividends in the first half of the 1990s. According to this study, while the stock market generally reacts favorably towards companies declaring special dividends, this positive reaction only averages about 1%. Hence it is hard to make a case for investing in companies primarily because they have declared a special dividend.