Education: Growth & Income Investing

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The Risk of a Dividend Cut

The longer a company has been paying dividends, the more likely it will continue to do so going forward. Investors have come to expect this cash flow and if terminated, the company runs the risk of upsetting or even losing its investor base.

Sound familiar? If it does, I am tickled pink. You most likely read my article discussing the power of dividends, and you are better for having done so. In any case, companies have been known to cut their dividends at times. For those depending on this stream of income, this spells bad news. Are there any warnings signs that investors should be on the lookout for? Well, read on…

There Are No Guarantees

The “problem” with dividend-paying stocks is that investors grow so accustomed to this stream of cash flow that they eventually believe it is guaranteed. It is important that an investor does not get caught up in this mindset.

One need not look further than General Motors Corporation, the world’s largest auto company. On Feb 7, 2006, the company announced that it would cut its dividend in half, the first such reduction in 14 years. Its last reduction came when the company was in the middle of a deep financial crisis that resulted in the ouster of its management team.

The dividend cut will save GM about $565 million annually. This was just one of its restructuring moves aimed at reviving profits—moves in the best long-term interests of its shareholders. Shareholders of GM stock witnessed a decline in value by 52% in 2005. Was the writing on the wall? Did its stockholders see this coming? They should have.

Hunting for Clues

1. A company can distribute a portion of its profits to its shareholders in the form of a dividend. If a company has no earnings, this makes it very difficult to do so (rocket science, huh?).

Taking a look at GM’s net income, or bottom line, from 2003 to 2005, one will quickly notice a sharp drop-off in the company’s profits. They went from $3.8 billion in 2003 to $2.8 billion in 2004. Then 2005 produced a negative $10.6 billion figure!

When an investor notices a company’s profits plummeting in a similar fashion to GM’s, a red flag should go up.

2. One should also focus their attention on a firm’s cash flow statement in order to determine the risk of future dividend cuts. After all, dividends are paid from a company’s cash flows, right?

To be precise, it is recommended that free cash flow be calculated. This amounts to whatever a company has left after it has paid all of its expenses. Free cash flow is calculated as operating cash flow minus capital expenditures. Both figures can be found on a company’s cash flow statement. If a downward trend is noticed, a dividend cut may be in the company’s not too distant future.

GM’s free cash flow nose-dived from 2004 to 2005.

3. Debt is defined as the amount owed to a person or organization for funds borrowed. You should concern yourself with a company’s long-term debt. Long-term debt consists of loans and obligations with a maturity of longer than one year, and is usually accompanied by interest payments. This figure can be found on a company’s balance sheet.

The key words here are interest payments. When a company must choose between making interest payments and issuing dividends, guess which one they are going to choose. If an upward trend is detected when looking at a company’s long-term debt, and the firm is currently strapped for cash, yep, you guessed it, red flag time.

GM’s long-term debt in 2004 was $300.3 billion. In 2005, long-term debt finished the year at $285.8 billion. Total liabilities were up in 2005.

4. Track a company’s Zacks Rank. The Zacks Rank is a proprietary quantitative model that uses trends in earnings estimate revisions and EPS surprises to arrive at a very simple, understandable recommendation. When a company’s Zacks Rank begins to fall, something is fundamentally wrong with it. (Learn more about the Zacks Rank). Can a dividend cut be next? Perhaps so.

Tough Times Call for Tough Measures

Dividend cutbacks are often necessary during tough times. While companies typically cut or reduce dividends in order to conserve cash or pay off debt, those highly dependent on them are sure to suffer. Being aware of the warning signs mentioned above should help you prepare accordingly.