Even though UK dividend payouts hit a record high in the first quarter of 2012, the risk of dividend cuts remains very real. Indeed, so far this year we’ve seen cuts from a few notable names like Home Retail (HOME) and Kesa Electricals (KESA), and a suspended dividend from Thomas Cook (TCG). And with investors turning to higher-yielding shares in this low interest rate environment, it’s important for investors to take notice of five signs that may reveal a dividend in danger of being cut.
A Declining Dividend Cover Trend
Companies that aren’t generating enough free cash and profit to cover their dividend are more likely to have an at-risk payout. Intuitively it makes sense: a firm that covers each £1of dividends with 90p in free cash will have trouble maintaining that payout.
The trouble is that looking at just one year of data can be misleading as the company could have had an unusually good or bad year. Instead, review a company’s dividend cover ratio over a number of years in order to ascertain a possible trend.
Consider that Home Retail’s earnings cover steadily declined from 2.5 times in 2008 to 1.55 in 2010, just before it began running into bigger trouble. This past year, Home Retail’s cover fell below one times and the dividend was subsequently dropped. Hindsight is perfect, of course, and Home Retail might have been able to turn things around, but the rapidly declining cover was a sign that the payout was becoming riskier and the high yield less sustainable.
Diminishing Competitive Advantages
Rapid technological innovations and a more integrated global economy have led to an increasingly competitive global marketplace. A company that’s currently dominant in a particular line of business must continuously seek ways to strengthen and maintain its advantages or competition will surely find a way to erode its profitability.
For a point of reference, firms with sustainable competitive advantages tend to consistently produce double digit operating margins and returns on equity. In fact, recent Morningstar research suggests that the ten-year average operating margin and return on equity for companies with “narrow” economic moats was 14.6% and 14.4%, respectively. For “wide” moat firms, those figures are each above 20%.
By paying attention to trends in a company’s profit margins and return on equity we might be able to identify trends in its competitive positioning. A firm that’s seen its profitability metrics diminish relative to its historical levels and its peer group may also have more difficulty sustaining its dividend, especially if any of the other factors mentioned here are present.
Weakening Balance Sheet
Equity owners are below creditors in the pecking order, so it’s important to make sure that bondholders are being taken care of before we can even think about dividends. In fact, creditors often attach covenants to their loans to ensure that the company will pay them back in full, and these covenants regularly have provisions to restrict dividend payments to equity owners if those agreements are breached.
In more cases than not, when companies announce a dividend cut they cite the need to shore up cash to improve the balance sheet, so it’s important to pay attention to trends in key ratios like net debt-to-EBITDA, net gearing, and interest coverage when assessing the health of a company’s dividend. Firms whose net debt-to-EBITDA ratios are trending above two times and interest coverage ratios declining toward three times should be approached with caution.
Slowing or Stalled Dividend Growth Rate
A rising dividend is seen by some as a signal that the company is confident in its future prospects. That’s because by “committing” to a higher payout level, management is implicitly saying that the company should be able to grow and generate enough free cash to comfortably pay that higher amount going forward.
Following that logic, a company that has either markedly slowed its dividend growth rate or even held the payout steady year-over-year might be signalling trouble ahead. Prior to its dividend cut in 2010, for instance, HMV Group’s (HMV) annual dividend growth had been held flat year-over-year since 2007 after it had grown 18% annualised between 2003 and 2006.
Eventually every company’s dividend growth rate will slow as the business matures, but ideally the decline will be gradual and steady; if it is an abrupt slowdown, it could be a sign of trouble to come.
An Ultra-high Dividend Yield
A share’s price and dividend yield have an inverse relationship -- when one goes down, the other goes up. More often than not, then, a share with an ultra-high yield is a result of a very depressed share price and not representative of a company’s generous payout policy. A good rule-of-thumb is to treat any dividend yield more than twice the FTSE 100 average with a bit of scepticism -- today, that would mean any share with a trailing dividend yield above 7.5%. Considering that long-term equity returns have been near 8%, if all investors agreed that a company's 8% dividend yield was sustainable they would pile into that share and as a result send the yield down closer to the market average.
Granted, some sectors -- such as utilities and telecoms -- tend to have higher yields than others, so it is worth comparing a company’s yield to others in its peer group. Be especially cautious of a share whose yield is significantly higher than its closest peers as that company’s board may be more inclined to cut the dividend if it runs into trouble. Before Pfizer cut its payout in 2009, for example, its yield was well above that of its major peers and during the dividend cut announcement Pfizer’s board stressed that, despite the cut, its yield continued to be competitive in the industry. In other words, because Pfizer’s yield was so much higher than other pharmaceutical companies’ at the time, it was easier for the board to justify a cut and remain attractive to investors in the sector.
Bottom Line
High dividend yields are especially attractive to income-seeking investors today given the low interest rates on fixed income and savings accounts, but it’s critical to remember that, unlike the interest generated from bonds, a company does not have a contractual obligation to pay you a dividend. The board can consider reducing the dividend if times get tough and the sooner you can recognize negative changes in the underlying business, the better. Hopefully these five warning signs will help you separate a healthy dividend payout from one that’s in danger of being cut.
This article was part of Morningstar.co.uk's "Seeking Income Week" series from July 2012.
