With buybacks and dividends under fire, Goldman proposes a new way for companies to return capital

Published Tue, Apr 21 202011:03 AM EDT

Jesse Pound @/in/jesse-pound @jesserpound

( This story is for CNBC Pro subscribers only ). Economic and political forces are threatening the typical programs of dividends and buybacks used by companies, so Goldman Sachs suggested in a new note that maybe now is the time to try a new approach. The economic slowdown caused by the coronavirus pandemic has led to major companies cutting and suspending their dividends, with Goldman projecting a 25% decline for S & P 500 dividends this year, and the CARES Act restricts some companies from dividends and buybacks. "An event like this allows for deeper reflection of past capital management strategies, brings to light the benefits of a more variable cash outlay tied to performance, and encourages an open mind to adjustments that can make businesses more durable in the future," the note said. The bank said public companies should consider using a "variable dividend," and laid out two different scenarios for how it would work. In the first, dividends are set as a percentage of free cash flow, and the amount used buybacks changes based on the remaining free cash flow and the change in share price over the past year. In the second, there is a small flat dividend, and then additional dividends and buybacks are variable. Both approaches lead to less capital returned to shareholders over time but result in companies with less debt and fewer buybacks when stocks are at the top of the market, the note said. "This results in a better capitalized balance sheet ... that can be opportunistically invested or drawn on during a more challenging operating environment," the note said. Companies are often reluctant to cut dividends for fear that their shareholders are income investors who will dump the stock. However, Goldman argues that the variable dividend system would not be much different for shareholders in the long run. "First, for well positioned companies, a variable dividend could still be one that realizes dividend growth in most (if not all) years; so no different from current," the note said. "Second, at a higher level, we would argue that this social contract has been fractured for some time as this current pandemic has sprung a third instance of economic pressure and round of dividend cuts in the last 20 years." Goldman looked at energy giant Exxon as an example of how variable dividends could have improved a company. The company has not generated enough free cash flow to cover its growing dividends for more than 5 years, Goldman calculated, leading Exxon to issue more debt. "We believe the adoption of a variable dividend policy by XOM would allow for cash to be returned to shareholders while balancing the immediate needs of the business in a more sustainable manner," the note said. On the other hand, insurance company Progressive has used a variable dividend since 2007, and has consistently been valued at a higher price-to-earnings multiple than peer companies, the note said.

Brendan McDermid | Reuters

(This story is for CNBC Pro subscribers only).

Economic and political forces are threatening the typical programs of dividends and buybacks used by companies, so Goldman Sachs suggested in a new note that maybe now is the time to try a new approach.

The economic slowdown caused by the coronavirus pandemic has led to major companies cutting and suspending their dividends, with Goldman projecting a 25% decline for S&P 500 dividends this year, and the CARES Act restricts some companies from dividends and buybacks.