Do DRIPs drain share values?

Advisors hold split opinions on dividend reinvestment plans (DRIPs)—but not from the perspective of whether they benefit clients. Rather, some advisors view DRIPs as a financial crutch for companies, and they dislike the equity dilution that can result.

The level of dissatisfaction is sometimes tied to the DRIP’s details, with certain plans offering reinvestment of the forgone cash into shares at a discount to market price, typically of 2% to 5%.

But issuing equity at a discount is common, and many firms see DRIPs as a source of financing.

Fortis Inc.’s management disclosed recently that it has a 35% to 40% dividend reinvestment rate. The company raises $300 million per year through its DRIP—a success partly due to the 2% discount offered to plan participants.

Fortis is in the midst of a five-year, $17.3-billion capital investment plan to expand its customer rate base at a compound rate of about 6% annually. Utility and pipeline companies targeting substantial growth need to raise funds while building the projects aimed at producing future cash flow increases.

Fortis plans to raise roughly 30% of the required capital through debt issuances and asset sales. The remainder will come from cash generated from operations after net dividends, which takes into consideration the cash saved when investors participate in the DRIP.

If Fortis didn’t offer a DRIP, it would probably need to raise $1.5 billion by issuing new equity to the market, with underwriters taking 3% to 4% of the money—more than the 2% discount given to current shareholders through the DRIP.

In contrast, some companies turn off their DRIPs while pursuing major expansions. Enbridge Inc. is involved in a three-year, $23-billion capital program through 2020 but doesn’t expect to raise new equity. It forecasts self-funding and expanding through debt after 2020. As a result, the company suspended its DRIP in November.

But not every company has that option. Enbridge just completed a massive corporate reorganization of its sponsored entities and the sale of non-core assets. In the end, the company was in an advantaged position—and in the minority of firms looking to expand substantially over the near term without needing equity.

In addition to Fortis, other S&P/TSX 60 names like TransCanada, Emera and Inter Pipeline look to leverage their DRIPs as a flexible source of funds.

Another financing option for companies is to use at-the-market (ATM) equity issuances, where the traditional underwriters take on the role of sales agent. This cuts the fee to around 2% (which, depending on the DRIP discount, may offer an advantage) but presents a concern regarding management timing the equity issuance.

Stopping the DRIP as a regular source of equity financing in favour of sporadic equity issues is reminiscent of when companies execute large one-time share buybacks instead of making regular repurchases. It ignores the generally accepted concept of dollar-cost averaging.

Shaw Communications is another company with a high DRIP participation (in the 30% range), partly because of a 2% discount and also likely due to participation of founding family members. This wrinkle offers a different reason to make advisors skeptical of DRIPs, since the family would likely use the reinvestment plan without a discount and the company would still benefit from the cash savings. Yet, these situations are rare.

In most cases companies must issue equity to expand. While DRIPs are dilutive to shareholders, the plans are attractive to some investors because the new shares aren’t subject to brokerage fees, they allow for fractional share investments and they offer the best compounding over time.

To create substantial participation among shareholders, a discount is normally needed. If the cut is better than or on par with that of a bought deal or ATM equity offering, regular equity issuance through a DRIP is one of the better options for companies and shouldn’t be regarded as a lazy addiction of management.