Dear Linda:
Good question - where do the profits go? I can't pretend to any special
knowledge here, never having worked for a pharmaceutical.
Let's examine the alternatives under the scenario " In 2002, Company X, a
pharmaceutical, earns record profits because it has developed and brought
product V to market."
A. The board of directors declares an extraordinary dividend to the
stockholders - directors and top management are usually major stockholders
though their holdings typically amount to only a few percent. All earnings
greater than the average over the last ten years are paid out to the
stockholders - most of whom are members of the investing public.
-X could have reinvested this money in research and development
thus improving the company's product pipeline (products that will be
available in the future), more efficient fixed assets, improved management
structure or hiring of employees at every level, but instead go for the
quick killing. Board members, management and large stockholders receive
millions - average holders receive thousands instead of hundreds.
-X's earnings prospects for the future are diminished. It could
have reinvested most of its profit with the expectation of greater earnings.
Investors and analysts expect that - the current stock price reflects
expected future earnings - since these are down, X's stock price goes down.
-Y and Z invest in the areas that X failed to invest additionally
in. Y and Z's competitive position is bettered; X's worsened. People that
hold X's debt see it go down in value - creditors are more reluctant to
extend credit to X.
X's stockholders have received an extraordinary dividend - however, their
basic holdings (typically fifteen to thirty times the company's normal
earnings per share) have declined. X's prospects for raising future capital
are diminished - X would get less if X tried to sell stock; potential and
actual creditors look at X more critically, want to lend less and charge a
higher rate of interest. As X has not invested its extraordinary profits,
it can only reinvest ordinary profits plus a smaller amount now available in
the capital markets. This further decreases X's earnings prospects.
This is a situation I don't remember hearing about - I don't believe it ever
occurs because the board of directors and top management are composed of
people with experience and know what would happen.
B. The board of directors votes to give top management, many of whom sit on
the board, incredible bonuses. Because a new drug brought to market can
yield many hundreds of millions, and much of the cost has already been
incurred in research and development, hundreds of millions are still left
for these bonuses.
-X's stock price goes down as in A above, but probably even more
sharply. Stockholders in the public have just figured out X is not being
run for their benefit, but management's. What are shares in X worth if any
earnings above average will just be paid to management and the board? Very
sharp questions are raised at the next annual meeting, which probably has an
agenda item which includes electing a new board of directors. New board
would summarily fire top management. Stockholders sue former board members,
charging breach of fiduciary duty.
-X's debt decreases in value - rate X has to pay for new debt
goes up - new credit is harder to obtain
This scenario or something like it is possible - though just barely. The
individuals on the board and in management that arrived at the huge bonus
decision probably won't sit on any more boards or work at high levels again.
They will have their huge bonuses but won't be welcome at the country club.
Their stock holdings and retirement funds will have declined in value.
Good-bye golden parachutes. I have rarely if ever heard about this
situation, though from time to time bonuses which are subjectively and
objectively large do happen.
C. The board of directors approves of management's plan to reinvest most of
the extraordinary profits in hopes of streamlining operations thus cutting
costs or successfully discovering and marketing another V. The financial
markets react favorably; stock price goes up because earnings prospects are
increased. Creditors are more willing to extend more credit. The rate X
has to pay for debt goes down.
This often happens - pharmaceutical stock prices routinely jump when the FDA
has approved their drug - or even when a trial phase has been successfully
completed. Directors and managers holdings increase in value. Increased
bonuses are voted to top managers and employees - X can afford more
compensation because it can streamline operations or pay less interest on
new debt because rates go down.
Most likely by far is C - tradeoff is much higher current return in A and B,
but C offers the potential for large payoff in stock prices AND large (but
not huge) bonuses. If management continues to be successful, the increased
future earnings may persist for many years. The payoff in the corporate
world is highest for those successful over a long period.
Michael in Tampa
Father is PWP
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