FLATBUSH SHIPYARD INC

At the February 5, 1959, meeting of the board directors, Mr. Donald Padgett, president of
Flatbush Shipyards informed the directors that the company had just received a $97 million
contract from the U.S Navy for the design and construction of three missile-armed warships.
This contract swelled the company’s backlog of firm orders to $190 million and assured capacity
operations for about two and one-half years. In view of this backlog, Mr. Padgett expressed
confidence that stockholders earnings would be somewhere between $14 and $15 a share in 1959
and would probably exceed $16 a share in both 1960 and 1961. He thought these earnings level
would be an important factor in the decision on a quarterly dividend payment rate, the first topic
scheduled for discussion at the board meeting.

Mr. Padgett opened the dividend discussion by pointing out the company’s historic policy
of paying out approximately 50% of current earnings in cash dividends each year. This policy
suggested that dividend payments of $7 a share or more should be made in 1959. Mr. Padgett
consequently recommended that the board approve an increase in the quarterly dividend rate
from the current level of $1.2 to $1.6 a share. Additional dividend distributions, if any, would be
declared as year and extras at the November, 1959, board meeting. Mr. Padgett believed that a
further increase in the regular quarterly dividend rate-perhaps to $1.8 or $2 a share—might be
possible in 1960 and that it might be possible to consider a stock split at that point.

Mr. Curtis Davis, a New York investment banker and newly elected outside director,
immediately spoke against the proposal for a sharp increase in quarterly dividend payments. Mr.
Davis had become increasingly concerned about the volatily of the market price for Flatbush
common stock. Erratic price movements and high stock turnover (sometimes the shares traded in
one month’s time equaled about 20% of total outstanding shares) suggegsted to him that the
stock was the subject of considerable speculation. He believed these speculative influences hurt
the stock’s reputation, preventing it from being traded at a value approaching its true worth. As a
result, the large majority of stockholders who held the stock as an investment, not a speculation,
suffered undue hardship. He thought that Flatbush Shipyards’ erratic dividend payments,
attributed to the current policy of paying out 50% of earning per share, stimulated much of the
speculation in the stock. He therefore argued for a complete reevaluation of the company’s
dividend policy objectives.

Mr. Davis thereupon proposed a radically new dividend policy. The basic objective of
this new policy would be to pay a stable quarterlu cash dividend payment rate insofar as possible
in both good years and bad. He suggested that the current $1.2 dividend payment would make a
good base rate. In good earnings years, Mr. Davis proposed doing two things in lieu of
increasing the cash dividend rate. He would first allocate the funds above the annual $4.8
dividend payment (that is, the additional amount that would have been paid out if the 50%
dividend payout policy had been continued) into a funded dividend reserve. The company would
then be in a position to draw against the dividend reserve during poor earnings years, as
necessary, to support the $4.8 dividend payment level. He further suggested the payment of a
small stock dividend in good years to compensate stockholders, in part, for their lower cash
dividend payments.

This proposal stimulated considerable discussion among the board members, but because
of its radical nature (Mr. Davis was unable to cite a single instance of a cyclical company
following this type of policy) the board of directors decided to defer a decision on the proposal
until the May, 1959, board meeting. As an interim measure, the directors declared a $1.2
quarterly dividend for the March payment date. Finally, the board charged Mr. Joseph Medwick,
treasurer of Flatbush Shipyards, with the responsibility of preparing a report evaluating Mr.
Davi’s proposal.

Postwar operations of Flatbush Shipyards

During the postwar period, approximately two thirds of Flatbush Shipyards revenues
came from the constructions of small and medium-sized naval vessels. These vessels typically
required 12 months or more to complete from the day the keel was laid. The company also
operated a dry dock for the U.S Navy on a contract basis, and 20% of its revenues developed
from the related repairs and conversions of warships in the U.S fleet. Remaining sales grew out
of miscellaneous job orders, handled by the company’s machine shops, whenever excess
capacity existed. These job orders typically did not bring in more than $10 million in sales
volume during years when naval construction had fallen of sharply.

Flatbush was heavily dependent on decision in Washington for orders to keep its
shipbuilding activities humming. As the Defense Department and Congress had radical changes
in their ideas about what constituted an adequate, modern fleet for defense purposes, Flatbush’s
sales volume proved quite unstable throughout most of the postwar period. Sales, for example
had fallen from a war peak of $52.6 million in 1944 to a level of $12.7 million in 1947. Profits
had followed an even more radical cyclical course. Indeed, were it not for the fact that the
company could accumulate large backlogs of firm orders in years when Congress and the
Defense Department were in a spending mood, these sales and profit fluctuations would have
been even more cyclical. In 1954, for example, Fatbush received only $11 million of orders for
new ships, yet sales levels were supported by an existing backlog. Exhibit 1 summarizes various
sales and profit information over the period 1944-1958.

In view of the cyclical nature of its business, the Flatbush management had striven for a
conservative financial position. There was no long-term debt outstanding at the end of 1958, hor
had there been since WW II. Cyclical upswings in working capital requirements had largerly
been financed by means of advances and progress payments, with only occasional needs to
borrorw from commercial banks on a short-term basis arising. Management had also adopted the
conservative practice of retaining 50% of earnings. These funds along with depreciation
resources more than covered the company’s expansion and modernization requirements.
Stockholders had occasionally criticized the dividend policy as being too conservative since
management had over the years permitted an accumulation of substantial cash funds, (Exhibit 2
contains recent balance sheets).

The company’s immediate business outlook was extremly encouraging. Sales volume for
19959 was estimated at $72 million, up more than 33% from the level of the previous year.
Moreover, a firm backlog of orders of $190 million seemed to assure sales of $84 million in both
1960 and 1961. These sales were expected to produce record earnings, averaging about $3.8
million annually over the three year period. Capital expenditure and working capital fund
requirements were not expected to cause any financial strain during this period. Funds to be
generated through future depreciation charges and excess cash balances already on hand more
than covered all anticipated funds requirements.

Mr. Padgett had recently been barraged with a large number of stockholder complaints.
These letters all were harshly critical of the board’s decision to cut the quarterly dividend from
$1.3 to $1.2 a share in the fall of 1958, particularly since the company held sizable cash funds at
the time. Mr. Padgett had courteously replied that the company’s current earnings levels and
business outlook had not at the time warranted holding the dividend at the previous level.
However, a large inflow of new orders (totaling more than $162 million) shortly after the
dividend had been cut made his explanation more difficult to convey. By December Mr. Padgett
had reached the conclusion it would be most desirable to increase the dividend again as soon as
possible. Shortly thereafter it became apparent 1959 would be an excellent year for the company,
with earnings per share exceeding $14. Mr. Padgett thereuppon decided that a substantial
dividend increase would be both possible and highly desirable. Consequently, at the next
meeting of the board of directors in February, 1959, Mr. Padgett made the proposal, descrived
earlier, to increase the quarterly dividend rate from $1.2 to $1.6 a share.

Mr. Davi’s dividend proposal

Mr davis, an outside director, immediately objected. As a preface to his suggestion of a

new dividend policy, Mr. Davis criticizied severely the erratic nature of previous dividend
payments. Because the dividends were not dependable, the market did not, in his opinion,
evaluate them at their true worth. He estimated that on the average the market price of the stock
during the postwar period was so low it could typically be purchased to offer an immediate
dividend yield of 9.0%. this dividend yield seemed exceedingly high. To illustrate this point, he
noted that one investment service reported that the average dividend yield on the current market
prices for all stocks traded on the New York Stock Exchange was 4.1% in mid-January, 1959,
and so called ―income stocks of medium quality‖ were priced to yield 4.8%.
 Mr. Davis also believed the market for Flatbush stock was dominated by speculators out
for a ―quick buck‖. He cited the extremely high turnover of Flatbush stock and the volatile price
movements as evidence of this condition. (market price data are shown in exhibit 3&4) This
condition disturbed him for three reasons. No self-respecting investorm particularly the mutual,
trust, and pension funds, would touch Flatbush stock while the market was speculatively
dominated. This adverse reputation, in turn, narrowed the stock’s marketability and depressed its
price. Second, whenever the successful speculators unloaded, ―little guys from Main Street‖ got
stuck with shares. These people tended to become discontented stockholders whenever the
Flatbush stock fell precipitously in value and were not, as a result, desirable types of
stockholders for a company to have ―on its back‖ when business was depressed. Finally, Mr.
Davis believed that the speculative atmosphere surrounding the stock beclouded its desirable
attributes. Few investment analysts, for example, recognized either the modest stability or rapid
growth characteristics that earnings and dividends had displayed over the postwar period. As a
result, the stockk seemed badly undervalued at its current price.

Mr. Davis believed the company’s erratic dividend record was largely to blame for the
speculative interest in the stock. Dividend cutbacks and temporary increases created a basis for
wider price movements than normal and invited speculators to ―move in‖. Moreover, these
dividend changes tended to confirm the market’s opinion that Flatbush stock was highly cyclical.
Management had through its dividend payments created an undesirable image of the company on
Wall Street. This adverse image in his mind severely hurt the interest of present stockholders.

Mr. Davis then argued that the company should place a high priority on recreating a
favorable corporate image on Wall Street by restructuring Flatbush’s dividend policies. The
foremost objective in his mind was to create the impression of stability. He believed that if the
company were to pay s stable dividend over a period of years, the stock might eventually sell to
yield approximately 5%. Given a dividend payment of $4.8 a share each year, this suffested a
market price of $96. Mr. Davis observed that Flatbush stock had not sold at a price as high as
$96 except for a brief speculative flurry in late 1956. Equally important, such a move would tend
to stabilize the company’s market price and thereby attract a more desirable group of
stockholders.

Mr. Davis suggested the first move in this direction would be to freeze cash dividend
payments at the current rate of $1.2 a quarter. As a part of this scheme, Mr. Davis wanted to set
aside any additional funds available for distribution to stockholders in a funded dividend reserve.
This reserve would then be drawn against whenever earnings fell off to a level that might tend to
jeopardize the $4.8 annual dividend. Mr. Davis envisioned setting aside $2 million of current
excess cash funds and $0.6 million a year for each of the next three years in this funded dividend
reserve. By the end of 1961, funds totaling $3.8 million for approximately three years dividend at
a rate of $4.8 a share would have been set aside in the dividend reserve. This sum appeared to be
an adequate reserve for foreseeable dividend contingencies and would tend to safeguard the $4.8
dividend rate well into the future. Mr. Davis further believed that the market would express an
immediate and favorable reaction to this change and anticipated that the market price of the stock
would rise to $96 a share or higher soon after the plan was made public. Mr. Davis did not
believe that any other dividend action the board was likely to take at the moment would have as
favorable or as lasting an effect on the market.

Mr. Davis was also interested in creating a growth image for Flatbush stock. He
underscored his idea that the image should be one of secular not cyclical growth and, therefore,
must be predicated on a stable but growing dividend. The most desirable method of
accomplishing this objective in his mind was to pay a small stock dividend of 3 to 5% whenever
earnings levels justified the distribution. This procedure would tend to assure a fairly constant
growth in stockholders capital values and dividend income throughout periods of cyclical
prosperity. These growth characteristics would tend to further enhance the value of the stock on
the market without detracting from the stability image. Although admittedly guessing, he
envisioned that investors might be willing to buy a stock such as he was describing for a cash
dividend yield as low as 4%. If true, this could signal a rise in the value of Flatbush stock to $120
a share. The stock dividend proposal also had the advantage of offering stockholders something
tangible in periods when earnings might justify larger dividends than $4.8 a share.

Objections by other directors

A number of directors immediately raised objections to Mr. Davis proposed dividend

policy. It was first pointed out that a number of Mr. Davis conclusions about the relative
advantages of his proposal were highly speculative. Since no board member knew of any
company that had adopted a dividend policy of this radical nature, Mr. Davis hypothesis could
not be tested in advance. Several board members appeared unwilling to run the risks associated
with the pioneering a new type of dividend policy.

A second set of criticism was directed at the idea of a funded dividend reserve. A number
of stockholders had already expressed their disfavor when management had accumulated cash
balances at the expense of paying larger immediate dividends. Since a funded dividend reserve
accomplished the same objective under a different guise, stockholders might still voice
objections. Several directors thought this issue was particularly important because Mr. Davis
proposals failed to consider recent stockholder demands for returning dividends to the previous
$1.3 per share quarterly rate.

Along the same line, one director noted that Flatbush’s ―cost of capital‖ approximated
18% :

This director consequently did not feel justified in retaining earnings merely to invest the funds
gained in government bonds that would yield no better than 4% at the very best. Moreover,
recent price fluctuations in the bond market had convinced him that even government bonds
were not a completely safe investment for a reserve of this nature. He argued, in conclusion, that
stockholders would benefit more from direct distributions of available earnings-funds they could
invest as they chose-than they would if she company became in part ―a closed end investment
trust specializing in government securities.‖

Another director criticized the plan because it sounded to him like a ―Guaranteed Annual
Dividend‖ – a further step in ―assuring security from cradle to grave‖ and a plan ―leading the
country along the disastrous road to socialism‖. Moreover, he believed Flatbush was a cyclical
company as ―any fool could see when he stopped to consider what would happen to the
shipbuilding industry if the cold war ever eased.‖ Any attempt to dress Flatbush up in ―clothes
that didn’t fit‖ would in his mind only be doing stockholders a disservice over the long run.

After further discussion, Mr. Davis proposal was tabled to allow each director to give the
matter further consideration. As an interim step, the board voted a $1.2 dividend for payment on
March 31, 1959. The board agreed, however, that a firm dividend policy would have to be set at
the May board meeting in order to avoid embarrassment. As soon as the $1.2 dividend was
announced, the market price of Flatbush stock (then $78) began declining and within a week’s
time had reached a level of $69 a share.

The treasurer’s analysis

The Flatbush treasurer, Mr. Medwick, who had been charged with preparing a report for
the board evaluating Mr. Davis proposal, was at a loss to know where to begin his analysis. He
was reluctant to discuss the proposal with security analysts and other investor advisors for fear of
starting an unfounded rumor. He could find little help in the statistical data on corporate
shareholders (summarized in exhibit 5) available in the corporations files. He could locate no
company that had tried out a similar plan, and any further attempt to analyze data on other
companies seemed speculative. A brief investigation of market data, however, did convinve him
that Flatbush;s historic yields were not significantly out of line when compared with other
cyclical companies. On the other hand, he noted that several stocks known for stable income
tended to have current yields of about 5%, while growth stocks – even in cases of less widely
known companies – often had current yields below 4%.

In a final effort to gain information for his analysis, Mr. Medwick decided to telephone a
small random sample of local Flatbush stockholders in order to solicit their opinions directly.
After these telephone calls, his most significant conclusion was that the alternatives were
difficult to explain in terms readily understood by the stockholders. There were, neverthelelss,
several interesting remarks-recorded in part below-made by these stockholders.

― i bought your stock for its high income. You’ve cut the dividend twice since I bought it
in early 1956. I’m a widow and can frankly use more money. I prefer to see you increase the
dividend again.‖
 ―Flatbush-I bought it as a hot tip. Some tip! All i want you to do is to get the price up
again so I can get out.‖

―The income really doesn’t do me any good-taxes, you know. I’m holding the stock for
my retirement in 15 years. You figure out what will be best for me then.‖

―I’m mostly interested in appreciation over the next few years. I’m for the plan that will
be best for me.‖

Forty additional calls yielded many variations on these themes but little in the way of
helpful information. Mr. Medwick was most disturbed by the fact that he was unable to detect
any trend that might enable him to classify Flatbush stockholders as having a definable set of
mutual interest. On this note, he began preparing his report for the board.