Dividend Distress

In light of the investing environment today, two pertinent factors should be examined carefully by income investors. First, is the yield offered higher than the average in the industry? Second, what is the dividend cover? In answering these two questions, the investor should try and form a conclusion as to whether the dividend policy of the company is sustainable.

According to Bloomberg, in 2015 there were 394 dividend cuts, which was only surpassed in 2009 with 527 cuts.

divcuts

To add to the concern, Buttonwood in the Economist points out to the general fall in dividend cover,

The best measure for working out whether dividends are at risk is to look at the cover; this compares earnings per share with dividends per share (see chart below). The higher the cover the better; companies have more scope to maintain the dividend if profits falter. (A ratio of 2 used to be regarded as comfortable.) As you can see, the current cover ratio is the lowest this century. That clearly implies that investors expect dividend cuts. The miners are expected to cut (although, surprisingly, BP and Shell maintained their payouts despite a plunging oil price).

So don’t be fooled by that 4.2% dividend yield. That refers to the past; it is not what investors will get over the next 12 months.

divcoverecon

Looking at the fall in oil prices, one would have expected a major adjustment in dividend policies, at least for the medium term. However, this is not what is happening, at least not for the large producers. From Forbes, the dividend offered by the six oil super-majors are as follows:

  • BP has a dividend yield of 7.8%
  • Eni SpA has a dividend yield of 6.3%
  • Total SA has a dividend yield of 6.0%
  • Chevron has a dividend yield of 5.0%
  • ExxonMobil has a dividend yield of 3.7%
  • Royal Dutch Shell has a dividend yield of 7.7%

The behaviour of oil companies with regards to dividends is a good example of dividend smoothing. Even now, academia is still trying to explain the phenomenon. From Dividend Smoothing: An Agency Explanation and New Evidence, by Anzhela Knyazeva and Diana Knyazeva, U.S. SEC,

This paper provides an agency interpretation of dividend smoothing and offers evidence that variation in corporate governance and managerial incentive conflicts explains differences in intertemporal properties of dividends. We argue that smooth dividends are an alternative to traditional corporate governance mechanisms. Empirically, we document a greater degree of dividend smoothing, fewer dividend cuts, and a trend towards regular incremental dividend increases at firms with weak traditional monitoring mechanisms. The effect of governance on dividend changes is largest for firms with high free cash flow.

The banking sector, according to the FT, as well aim to be rock-solid dividend payers. In this case, offering stable albeit lower dividends,

The likes of Lloyds (1.19 per cent yield) and Barclays (3.57 per cent yield) have passed the bank stress tests and are exposed to the UK where the macro picture is looking relatively positive. As Mr Gunn puts it: “The banks are seeking to become dividend-paying machines.”

Alternatively, when dividend smoothing is not an option, research has shown that cutting dividend is the preferred choice instead of better management of earnings. Presumably, this would be even easier if others in the same industry are also doing it. From Dividend Stickiness, Debt Covenants, and Earnings Management by Jaewoo Kim, Kyeong Hun Lee and Erik Lie,

Consistent with the notion that dividends are very sticky, Daniel, Denis, and Naveen (2008) report evidence that firms manage earnings upward when pre-managed earnings are expected to fall short of dividend payments. However, we find that this evidence is not robust when controlling for firms’ tendency to manage earnings upward to avoid reporting earnings declines. We further report that the decision to cut dividends depends on whether reported earnings fall short of past dividends, but not on earnings management that eliminates a shortfall in pre-managed earnings relative to dividend payments. Overall, our evidence suggests that firms that face dividend constraints are more likely to cut dividends than to manage earnings to avoid dividend cuts.

In addition, when there is a need to cut, the handling of the event by the company may have some signalling element and offer a clue as to the the health of the company. According to the paper, ‘Preparing’ the Equity Market for Adverse Corporate Events: A Theoretical Analysis of Firms Cutting Dividends, by Thomas J. Chemmanur and Xuan Tian,

In equilibrium, firms in temporary financial difficulties but good long-term growth prospects are more likely to prepare the market in advance of dividend cuts, while those with permanently declining earnings are less likely to prepare the market.

So be aware of what the surprise cuts might indicate.

In addition to how a company manages its dividend policy, one should question the company that would rather take out debt in order to continue its dividend policy, (a topic I have brought up in a previous post). The dividend policy should reflect expectation of future cash flow and supporting it through debt may be an exhibition of imprudence. Having said that, the capital structure of the company needs to be looked at before making a judgement of the appropriateness of debt supported dividend payments.

To continue, checking dividend cover is not the only way of getting the feel for future dividends. Another way is to look at the dividend futures index. According to Bloomberg Gadfly in Beware Banks Yielding Dividends,

There are more red flags elsewhere. While banks are expected to report increased earnings, at least according to consensus estimates, dividend futures are much less bullish. The Eurostoxx dividend futures index has dropped since mid-August — not just because the decline in the oil price will cut into that industry’s dividends but also because of concerns about the banks, according to Edmund Shing, a derivatives strategist at BNP Paribas.

6monthdivfut
Six months Eurostoxx dividend futures index

Amidst all of the red flags pointing to more dividend cuts in the future, it bears to ask, what does it mean for the company when it cuts dividend? Looking at the chart below from the Telegraph, the answer is obvious. Except for the very few, their share prices get punished.

sharesdivcut

 

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