Gainesboro Machine

Tools Corporation

In mid-September 2005, Ashley Swenson, chief financial officer (CFO) of Gainesboro

Machine Tools Corporation, paced the floor of her Minnesota office. She needed to

submit a recommendation to Gainesboro's board of directors regarding the company's

dividend policy, which had been the subject of an ongoing debate among the firm's

senior managers. Compounding her problem was the uncertainty surrounding the

recent impact of Hurricane Katrina, which had caused untold destruction across the

southeastern United States. In the weeks after the storm, the stock market had spiraled

downward and, along with it, Gainesboro's stock, which had fallen 18%, to $22.15. In

response to the market shock, a spate of companies had announced plans to buy back

stock. While some were motivated by a desire to signal confidence in their companies

as well as in the U.S. financial markets, still others had opportunistic reasons. Now,

Ashley Swenson's dividend-decision problem was compounded by the dilemma of

whether to use company funds to pay shareholder dividends or to buy back stock.

Background on the Dividend Question

After years of traditionally strong earnings and predictable dividend growth, Gainesboro

had faltered in the past five years. In response, management implemented two extensive

restructuring programs, both of which were accompanied by net losses. For three years

in a row since 2000, dividends had exceeded earnings. Then, in 2003, dividends were

decreased to a level below earnings. Despite extraordinary losses in 2004, the board of

directors declared a small dividend. For the first two quarters of 2005, the board declared

no dividend. But in a special letter to shareholders, the board committed itself to

resuming payment of the dividend as soon as possibleideally, sometime in 2005.

In a related matter, senior management considered embarking on a campaign

of corporate-image advertising, together with changing the name of the corporation to

"Gainesboro Advanced Systems International, Inc." Management believed that the name

change would help improve the investment community's perception of the company.

Overall, management's view was that Gainesboro was a resurgent company that

demonstrated great potential for growth and profitability. The restructurings had

revitalized the company's operating divisions. In addition, the newly developed

machine tools designed on state-of-the-art computers showed signs of being well

received in the market, and promised to render the competitors' products obsolete.

Many within the company viewed 2005 as the dawning of a new era, which, in spite

of the company's recent performance, would turn Gainesboro into a growth stock. The

company had no Moody's or Standard & Poor's rating because it had no bonds outstanding,

but Value Line rated it an "A" company.1

Out of this combination of a troubled past and a bright future arose Swenson's

dilemma. Did the market view Gainesboro as a company on the wane, a blue-chip

stock, or a potential growth stock? How, if at all, could Gainesboro affect that perception?

Would a change of name help to positively frame investors' views of the

firm? Did the company's investors expect capital growth or steady dividends? Would

a stock buyback instead of a dividend affect investors' perceptions of Gainesboro in

any way? And, if those questions could be answered, what were the implications for

Gainesboro's future dividend policy?

The Company

Gainesboro Corporation was founded in 1923 in Concord, New Hampshire, by two

mechanical engineers, James Gaines and David Scarboro. The two men had gone to

school together and were disenchanted with their prospects as mechanics at a farmequipment

manufacturer.

In its early years, Gainesboro had designed and manufactured a number of

machinery parts, including metal presses, dies, and molds. In the 1940s, the company's

large manufacturing plant produced armored-vehicle and tank parts and miscellaneous

equipment for the war effort, including riveters and welders. After the war, the company

concentrated on the production of industrial presses and molds, for plastics as well

as metals. By 1975, the company had developed a reputation as an innovative producer

of industrial machinery and machine tools.

In the early 1980s, Gainesboro entered the new field of computer-aided design and

computer-aided manufacturing (CAD/CAM). Working with a small software company,

it developed a line of presses that could manufacture metal parts by responding to computer

commands. Gainesboro merged the software company into its operations and,

over the next several years, perfected the CAM equipment. At the same time, it developed

a superior line of CAD software and equipment that would allow an engineer to

394 Part Five Management of the Firm's Equity: Dividends and Repurchases

1Value Line's financial-strength ratings, from A to C, were a measure of a company's ability to withstand

adverse business conditions and were based on leverage, liquidity, business risk, company size, and stockprice

variability, as well as analysts' judgments.

design a part to exacting specifications on a computer. The design could then be entered

into the company's CAM equipment, and the parts could be manufactured without the

use of blueprints or human interference. By the end of 2004, CAD/CAM equipment

and software were responsible for about 45% of sales; presses, dies, and molds made

up 40% of sales; and miscellaneous machine tools were 15% of sales.

Most press and mold companies were small local or regional firms with limited

clientele. For that reason, Gainesboro stood out as a true industry leader. Within

the CAD/CAM industry, however, a number of larger firms, including Autodesk, Inc.,

Cadence Design, and Synopsys, Inc., competed for dominance of the growing market.

Throughout the 1990s, Gainesboro helped set the standard for CAD/CAM,

but the aggressive entry of large foreign firms into CAD/CAM and the rise of the U.S.

dollar dampened sales. In the late 1990s and early 2000s, technological advances and

aggressive venture capitalism fueled the entry of highly specialized, state-of-the-art

CAD/CAM firms. Gainesboro fell behind some of its competition in the development

of user-friendly software and the integration of design and manufacturing. As a result,

revenues slipped from a high of $911 million, in 1998, to $757 million, in 2004.

To combat the decline in revenues and to improve weak profit margins, Gainesboro

took a two-pronged approach. First, it devoted a greater share of its research-anddevelopment

budget to CAD/CAM in an effort to reestablish its leadership in the field.

Second, the company underwent two massive restructurings. In 2002, it sold two

unprofitable lines of business with revenues of $51 million, sold two plants, eliminated

five leased facilities, and reduced personnel. Restructuring costs totaled $65 million.

Then, in 2004, the company began a second round of restructuring by altering its

manufacturing strategy, refocusing its sales and marketing approach, and adopting

administrative procedures that allowed for a further reduction in staff and facilities.

The total cost of the operational restructuring in 2004 was $89 million.

The company's recent consolidated income statements and balance sheets are

provided in Exhibits 1 and 2. Although the two restructurings produced losses totaling

$202 million in 2002 and 2004, by 2005 the restructurings and the increased

emphasis on CAD/CAM research appeared to have launched a turnaround. Not only

was the company leaner, but also the research led to the development of a system that

Gainesboro's management believed would redefine the industry. Known as the Artificial

Workforce, the system was an array of advanced control hardware, software, and

applications that could distribute information throughout a plant.

Essentially, the Artificial Workforce allowed an engineer to design a part on CAD

software and input the data into CAM equipment that could control the mixing of

chemicals or the molding of parts from any number of different materials on different

machines. The system could also assemble and can, box, or shrink-wrap the finished

product. The Artificial Workforce ran on complex circuitry and highly advanced

software that allowed the machines to communicate with each other electronically.

Thus, a product could be designed, manufactured, and packaged solely by computer

no matter how intricate it was.

Gainesboro had developed applications of the product for the chemicals industry

and for the oil- and gas-refining industries in 2004 and, by the next year, it had created

applications for the trucking, automobile-parts, and airline industries.

Case 29 Gainesboro Machine Tools Corporation 395

By October 2004, when the first Artificial Workforce was shipped, Gainesboro

had orders totaling $75 million. By year end, the backlog was $100 million. The future

for the product looked bright. Several securities analysts were optimistic about the

product's impact on the company. The following comments paraphrase their thoughts:

The Artificial Workforce products have compelling advantages over competing entries,

which will enable Gainesboro to increase its share of a market that, ignoring periodic

growth spurts, will expand at a real annual rate of about 5% over the next several years.

The company is producing the Artificial Workforce in a new automated facility,

which, when in full swing, will help restore margins to levels not seen in years.

The important question now is how quickly Gainesboro will be able to ship in volume.

Manufacturing mishaps and missing components delayed production growth through

May 2005, putting it about six months beyond the original target date. And start-up costs,

which were a significant factor in last year's deficits, have continued to penalize earnings.

Our estimates assume that production will proceed smoothly from now on and that it will

approach the optimum level by year's end.

Gainesboro's management expected domestic revenues from the Artificial Workforce

series to total $90 million in 2005 and $150 million in 2006. Thereafter, growth in sales

would depend on the development of more system applications and the creation of system

improvements and add-on features. International sales through Gainesboro's existing

offices in Frankfurt, Germany; London, England; Milan, Italy; and Paris, France; and

new offices in Hong Kong, China; Seoul, Korea; Manila, Philippines; and Tokyo, Japan,

were expected to provide additional revenues of $150 million by as early as 2007. Currently,

international sales accounted for approximately 15% of total corporate revenues.

Two factors that could affect sales were of some concern to Gainesboro. First,

although the company had successfully patented several of the processes used by the

Artificial Workforce system, management had received hints through industry observers

that two strong competitors were developing comparable products and would probably

introduce them within the next 12 months. Second, sales of molds, presses, machine

tools, and CAD/CAM equipment and software were highly cyclical, and current predictions

about the strength of the U.S. economy were not encouraging. As shown in

Exhibit 3, real GDP (gross domestic product) growth was expected to hover at a steady

but unimpressive 3.0% over the next few years. Industrial production, which had

improved significantly since 2001, would likely indicate a trend slightly downward next

year and the year after that. Despite the macroeconomic environment, Gainesboro's

management remained optimistic about the company's prospects because of the successful

introduction of the Artificial Workforce series.

Corporate Goals

A number of corporate objectives had grown out of the restructurings and recent technological

advances. First and foremost, management wanted and expected the firm to

grow at an average annual compound rate of 15%. A great deal of corporate planning

had been devoted to that goal over the past three years and, indeed, second-quarter

396 Part Five Management of the Firm's Equity: Dividends and Repurchases

financial data suggested that Gainesboro would achieve revenues of about $870 million

in 2005, as shown in Exhibit 1. If Gainesboro achieved a 15% compound rate of

growth through 2011, the company could reach $2.0 billion in sales and $160 million

in net income.

In order to achieve that growth goal, Gainesboro management proposed a strategy

relying on three key points. First, the mix of production would shift substantially.

CAD/CAM and peripheral products on the cutting edge of industrial technology would

account for three-quarters of sales, while the company's traditional presses and molds

would account for the remainder. Second, the company would expand aggressively in

the international arena, whence it hoped to obtain half of its sales and profits by 2011.

This expansion would be achieved through opening new field sales offices around the

world. Third, the company would expand through joint ventures and acquisitions of

small software companies, which would provide half of the new products through

2011; in-house research would provide the other half.

The company had had an aversion to debt since its inception. Management believed

that small amounts of debt, primarily to meet working-capital needs, had their place,

but that anything beyond a 40% debt-to-equity ratio was, in the oft-quoted words of

Gainesboro cofounder David Scarboro, "unthinkable, indicative of sloppy management,

and flirting with trouble." Senior management was aware that equity was typically

more costly than debt, but took great satisfaction in the company's "doing it on its

own." Gainesboro's highest debt-to-capital ratio in the past 25 years (22%) had

occurred in 2004, and was still the subject of conversations among senior managers.

Although eleven members of the Gaines and the Scarboro families owned 13%

of the company's stock and three were on the board of directors, management placed

the interests of the outside shareholders first. (Shareholder data are provided in

Exhibit 4.) Stephen Gaines, board chair and grandson of the cofounder, sought to

maximize growth in the market value of the company's stock over time.

At 61, Gaines was actively involved in all aspects of the company's growth. He

dealt fluently with a range of technical details of Gainesboro's products, and was especially

interested in finding ways to improve the company's domestic market share.

His retirement was no more than four years away, and he wanted to leave a legacy

of corporate financial strength and technological achievement. The Artificial Workforce,

a project that he had taken under his wing four years earlier, was finally beginning

to bear fruit. Gaines now wanted to ensure that the firm would also soon be able

to pay a dividend to its shareholders.

Gaines took particular pride in selecting and developing promising young managers.

Ashley Swenson had a bachelor's degree in electrical engineering and had been a systems

analyst for Motorola before attending graduate school. She had been hired in 1995,

fresh out of a well-known MBA program. By 2004, she had risen to the position of CFO.

Dividend Policy

Gainesboro's dividend and stock-price histories are presented in Exhibit 5. Before

1999, both earnings and dividends per share had grown at a relatively steady pace, but

Gainesboro's troubles in the early 2000s had taken their toll on earnings. Consequently,

Case 29 Gainesboro Machine Tools Corporation 397

dividends were pared back in 2003 to $0.25 a sharethe lowest dividend since 1990.

In 2004, the board of directors declared a payout of $0.25 a share, despite reporting

the largest per-share earnings loss in the firm's history and despite, in effect, having to

borrow to pay that dividend. In the first two quarters of 2005, the directors did not

declare a dividend. In a special letter to shareholders, however, the directors declared

their intention to continue the annual payout later in 2005.

In August 2005, Swenson contemplated her choices from among the three possible

dividend policies to decide which one she should recommend:

Zero-dividend payout: This option could be justified in light of the firm's strategic

emphasis on advanced technologies and CAD/CAM, and reflected the huge cash

requirements of such a move. The proponents of this policy argued that it would

signal that the firm now belonged in a class of high-growth and high-technology

firms. Some securities analysts wondered whether the market still considered

Gainesboro a traditional electrical-equipment manufacturer or a more technologically

advanced CAD/CAM company. The latter category would imply that the

market expected strong capital appreciation, but perhaps little in the way of dividends.

Others cited Gainesboro's recent performance problems. One questioned

the "wisdom of ignoring the financial statements in favor of acting like a blue

chip." Was a high dividend in the long-term interests of the company and its

stockholders, or would the strategy backfire and make investors skittish?

Swenson recalled a recently published study that found that firms were displaying

a lower propensity to pay dividends. The study found that the percentage

of firms paying cash dividends had dropped from 66.5%, in 1978, to 20.8%, in

1999.2 In that light, perhaps the market would react favorably, if Gainesboro

adopted a zero dividend-payout policy.

40% dividend payout or a dividend of around $0.20 a share: This option would

restore the firm to an implied annual dividend payment of $0.80 a share, the

highest since 2001. Proponents of this policy argued that such an announcement

was justified by expected increases in orders and sales. Gainesboro's investment

banker suggested that the market might reward a strong dividend that would

bring the firm's payout back in line with the 36% average within the electricalindustrial-

equipment industry and with the 26% average in the machine-tool

industry. Still others believed that it was important to send a strong signal to

shareholders, and that a large dividend (on the order of a 40% payout) would suggest

that the company had conquered its problems and that its directors were confident

of its future earnings. Supporters of this view argued that borrowing to pay

dividends was consistent with the behavior of most firms. Finally, some older

managers opined that a growth rate in the range of 10% to 20% should accompany

a dividend payout of between 30% and 50%.

Residual-dividend payout: A few members of the finance department argued that

Gainesboro should pay dividends only after it had funded all the projects that

Part Five Management of the Firm's Equity: Dividends and Repurchases

offered positive net present values (NPV). Their view was that investors paid managers

to deploy their funds at returns better than they could otherwise achieve, and

that, by definition, such investments would yield positive NPVs. By deploying

funds into those projects and returning otherwise unused funds to investors in the

form of dividends, the firm would build trust with investors and be rewarded

through higher valuation multiples.

Another argument in support of that view was that the particular dividend

policy was "irrelevant" in a growing firm: any dividend paid today would be

offset by dilution at some future date by the issuance of shares needed to make

up for the dividend. This argument reflected the theory of dividends in a perfect

market advanced by two finance professors, Merton Miller and Franco Modigliani.3

To Ashley Swenson, the main disadvantage of this policy was that dividend payments

would be unpredictable. In some years, dividends could even be cut to zero,

possibly imposing negative pressure on the firm's share price. Swenson was all

too aware of Gainesboro's own share-price collapse following its dividend cut.

She recalled a study by another finance professor, John Lintner,4 which found that

firms' dividend payments tended to be "sticky" upwardthat is, dividends would

rise over time and rarely fall, and that mature, slower-growth firms paid higher

dividends, while high-growth firms paid lower dividends.

In response to the internal debate, Swenson's staff pulled together Exhibits 6

and 7, which present comparative information on companies in three industries

CAD/CAM, machine tools, and electrical-industrial equipmentand a sample of

high- and low-payout companies. To test the feasibility of a 40% dividend-payout rate,

Swenson developed the projected sources-and-uses of cash statement provided in

Exhibit 8. She took the boldest approach by assuming that the company would grow

at a 15% compound rate, that margins would improve over the next few years to historical

levels, and that the firm would pay a dividend of 40% of earnings every year.

In particular, the forecast assumed that the firm's net margin would hover between

4% and 6% over the next six years, and then increase to 8% in 2011. The firm's operating

executives believed that this increase in profitability was consistent with

economies of scale to be achieved upon the attainment of higher operating output

through the Artificial Workforce series.

Image Advertising and Name Change

As part of a general review of the firm's standing in the financial markets, Gainesboro's

director of Investor Relations, Cathy Williams, had concluded that investors misperceived

the firm's prospects and that the firm's current name was more consistent with

its historical product mix and markets than with those projected for the future.

Williams commissioned surveys of readers of financial magazines, which revealed a

relatively low awareness of Gainesboro and its business. Surveys of stockbrokers

revealed a higher awareness of the firm, but a low or mediocre outlook on Gainesboro's

likely returns to shareholders and its growth prospects. Williams retained a consulting

firm that recommended a program of corporate-image advertising targeted toward

guiding the opinions of institutional and individual investors. The objective was to

enhance the firm's visibility and image. Through focus groups, the image consultants

identified a new name that appeared to suggest the firm's promising new strategy:

Gainesboro Advanced Systems International, Inc. Williams estimated that the imageadvertising

campaign and name change would cost approximately $10 million.

Stephen Gaines was mildly skeptical. He said, "Do you mean to raise our stock

price by 'marketing' our shares? This is a novel approach. Can you sell claims on a

company the way Procter & Gamble markets soap?" The consultants could give no

empirical evidence that stock prices responded positively to corporate-image campaigns

or name changes, though they did offer some favorable anecdotes.

Conclusion

Swenson was in a difficult position. Board members and management disagreed on

the very nature of Gainesboro's future. Some managers saw the company as entering

a new stage of rapid growth and thought that a large (or, in the minds of some, any)

dividend would be inappropriate. Others thought that it was important to make a

strong public gesture showing that management believed that Gainesboro had turned

the corner and was about to return to the levels of growth and profitability seen in the

1980s and '90s. This action could only be accomplished through a dividend. Then

there was the confounding question about the stock buyback. Should Gainesboro use

its funds to repurchase stocks instead of paying out a dividend? As Swenson wrestled

with the different points of view, she wondered whether Gainesboro's management

might be representative of the company's shareholders. Did the majority of public

shareholders own stock for the same reason, or were their reasons just as diverse as

those of management?