When dividends must be cut
When Provident Financial scrapped its dividend in August following a major profit warning – due to problems stemming from its debtcollection workforce – its shares plunged. They have not recovered. But a dividend cut may sometimes be a necessary part of the purge that puts an ailing business back on the road to success. Additionally, a dividend cut that sparks over-selling can present a buying opportunity.
Many companies currently maintain payouts that appear unsustainable based on “dividend cover” – a measure of a company’s ability to sustain distributions out of profits. Dividend cover of less than one indicates profits do not cover the dividend, and anything under 1.5 is typically viewed as a concern.
According to screening service Stockopedia, of the 15 stocks in the FTSE 100 index that have a dividend yield of more than 5pc, 10 have a dividend cover score of less than one.
Facing up to reality
Mining stocks are one recent example where dividend cuts became part of a life-saving necessity following the 2014-2015 commodity price collapse.
Juliet Schooling Latter, of investment shop Chelsea Financial Services, said: “Look at Anglo American. After suspending its dividend and announcing investment in a huge restructuring in 2015, the stock turned around. It is now over 200pc higher and paying a dividend again.”
She explained that while a recovery in commodity prices played a part in Anglo American and other miners’ recovery, it was not the only factor.
“By paying down debt, instead of paying big dividends,they were able to repair their balance sheets. Lenders were less worried they’d go bankrupt, so they were able to refinance their debts more cheaply,” she said.
Standard Chartered, the bank, attracted significant investor ire after scrapping its dividend in 2015. According to Chris Kinder, manager of Columbia Threadneedle’s UK fund, the dividend was stopped in 2015 after “rapid growth evaporated in 2014”. A major restructure, including 15,000 job cuts, was undertaken, during which time the shares carried on falling. The share price has since recovered some of the losses.
“They appear to be prioritising the long term, rather than focusing on the share price boost from reinstating the dividend,” said Mr Kinder.
One other business that has made a success of a dividend cut recently has been Rolls-royce, according to Mr Kinder. “In February 2016, it cut its dividend for the first time in 25 years. The share price rose over 30pc in days as investors took encouragement from the absence of a profit warning, after five in two years.”
Now, a significant restructure has taken place, and the CEO is waiting patiently to increase the dividend. “Problems remain, but the stock is 70pc higher than its February 2016 low,” said Mr Kinder.
Shareholders’ thirst for income is part of the problem
Fears of displeasing investors can sometimes lead to firms paying unsustainable dividends by taking on debt, selling assets, or reducing investment in future business.
“The biggest risk is from a company becoming wedded to its dividend and doing anything to sustain it,” said Elizabeth Davis, one of the managers of Rathbones’ £1.4bn Income fund.
She pointed to construction firm Carillion, whose shares fell by more than 70pc in July after it scrapped its dividend. This was prompted by a dismal, unexpected profit warning, in which it announced it was having to set aside £845m due to problem contracts. On Friday, the firm fell sharply again, after revealing a £1.2bn loss during the first half of the year.
“It was paying a substantial dividend, but we saw debt rising, margins falling and, when operational issues surfaced, it didn’t have the cash reserves needed to ride out the storm.”
Ms Davis flagged Next as an example of “management continuing to return cash to shareholders when we would rather they didn’t”. She explained that their dividend decisions are made on “what is obvious and measurable”, but that increasing investment in IT instead could “future-proof ” the business against the likes of Amazon.
With interest rates so low, companies can borrow cheaply in order to pay dividends.
“Companies in the UK and US have taken on ever more debt to cover dividends. This can’t continue forever, and some companies may struggle to refinance and be forced to cut dividends,” said Ms Schooling Latter.
‘The biggest risk is a company doing anything to sustain its dividend payment’
A model poses for Next, the retailer. Analysts worry it is paying out too much