Don't Chase Special Dividends

NEW YORK (TheStreet) -- For some reason, traders gravitate toward special dividends, and there have been a rash of them lately.

Take Costco (COST), for example, which was up 6% to $101.88 Wednesday, within a few dollars of its all-time high, on word that management was returning $3 billion of cash to shareholders in a one-time dividend.

One time -- that's the problem. Costco's dividend of $7 a share can be funded primarily with cash on hand; cash that shareholders already had a right to. Rather, management has decided to sell new debt to cover the payout. The one-time dividend is equal to 6.4 years' worth of the retailer's regular quarterly payout of $0.275, a 1.1% yield. To me, that sounds odd for a growth company that's only been paying a dividend for eight years.

Just as I don't like to see regular dividends that can't be covered with earnings, special dividends should be covered without the need for external financing. No value was created through this one-time payout, but the stock gained $2.6 billion of market value in one day on news of the dividend and a November same-store sales report that merely matched expectations.

The reason we are seeing more of these one-time payouts is a likely increase in tax rates on dividends as we approach the fiscal cliff. Whatever the reason, paying taxes on profits is a good problem to have.

Ultimately, investors want growth, and they will pay a premium for it. Even with dividends, I'd rather see a 2% or 3% yield that grows every two or three years, and can be comfortably covered with earnings, than an 8% yield that may or may not be paid out.

The bottom line: Special dividends aren't bad, but they do little to help investors. A steadily growing dividend rewards long-time investors for sticking around, especially in this low-interest-rate environment. Share buybacks cut the amount of shares outstanding, which helps boost earnings per share for a profitable company, but a special dividend is just a return of capital. At best, it's an admission that management isn't smart enough to invest the money in ways that grow the business better. At worst, it's a case of management lining its pockets, especially if they need to raise more debt to fund the payout.

Here are three recent special-dividend announcements that I believe have been of little service to the average investor and should give readers pause before committing new funds.

Dillard's (DDS): The special dividend of $5 a share is equal to 25 years' worth of the regular quarterly dividend of $0.05 a share, a 0.2% yield. The retailer does not have enough cash to cover the one-time payout. The Dillard family and Dillard's Retirement Trust own about a third of the total shares outstanding and will earn $78 million from the payout.

Las Vegas Sands (LVS): The special dividend of $2.75 a share is just under three years' worth of the regular quarterly dividend of $0.25, a 2.1% yield, which the casino operator only started paying earlier this year. The company has enough cash on hand to cover the one-time payout, but has 2.5 times more debt than cash on its balance sheet. What I find even more intriguing is that Founder, Chairman, CEO and Treasurer Sheldon Adelson owns more than 51% of the total shares outstanding. It must have been easy to convince the board to declare a special dividend, as Adelson will receive a $1.17 billion payment.

Westlake Chemical (WLK): The special dividend of $3.75 a share is equal to five years' worth of the regular quarterly dividend of $0.1875, a 1% yield. The company has enough net cash on hand to cover the one-time payout. Note that the Chao family, which controls about 69% of outstanding shares, will receive $172.5 million in the payout.

David Peltier is a research associate at TheStreet. In keeping with company editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Peltier appreciates your feedback; click here to send him an email.