By David Sterman
This month marks the five-year anniversary of an era many would rather forget.
The S&P 500 fell nearly 10% in June 2008, and investors began to brace for an eventual market crash later in the year. That was also a time when companies sealed the hatches and girded for tough days ahead, in many instances eliminating dividends that had been in place for many years.
Though many companies eventually restored those dividends, some companies are only now contemplating such a move. By following a few simple markers, you can make some well-informed predictions about which companies could soon issue a fresh dividend.
Before digging into these markers, let's take a quick look at the 15 largest companies in the S&P 500 that do not currently pay a dividend.
Right away, we can eliminate certain types of companies from contention, simply because they have had many decades to pursue a dividend policy, and never have done so. Warren Buffett's Berkshire Hathaway (NYSE: BRK) is a perfect example. His company is such an active acquirer of businesses that retaining cash flow is a key ingredient of success.
This, of course, may change when Buffett relinquishes control. After all, Berkshire has now generated more than $10 billion in free cash flow in each of the past four years, after never having generated more than $7.2 billion in free cash flow in any prior year in its history. The company's gross cash balance reached $47 billion at the end of 2012, and the topic of a dividend is surely raised at the company's board meetings.
For that matter, it's unwise to expect an imminent dividend from the other two $100 billion companies on the list, Amazon.com (NASDAQ: AMZN) and Google (NASDAQ: GOOG). These companies are aggressively investing in future growth initiatives in their bid to conquer the technology landscape.
Neither company is showing signs of maturity just yet -- but it's hard to ignore Google's ever-rising free cash flow, which hit $13.3 billion in 2012, or its $48 billion gross cash balance at year end. If Google used all of its free cash flow for a dividend, then the payout would be $40 a share, good for a 4.6% yield.
Earlier, I noted key markers to look for. Free cash flow and current cash are two of them, along with capital spending. A great industry example is Big Pharma, which includes major drug stocks such as Merck (NYSE: MRK), Pfizer (NYSE: PFE) and others.
These firms long ago realized that that free cash flow handily exceeded their capital spending needs (mainly research and development), and to attract investor interest, a dividend made sense. (A caveat: These companies are growth constrained and often can't afford dividend hikes. Merck's dividend, for example, has barely budged since 2004).
Yet you'll notice a pair of large biotechs on the table above, Gilead Sciences (NASDAQ: GILD) and Celgene (NASDAQ: CELG). With each passing year, these companies are starting to resemble the Big Pharma stocks with their rising free cash flow that now exceeds capital spending. Why don't they pay dividends? Short answer: They will.
In fact, biotech pioneer Amgen (NASDAQ: AMGN) has already kicked off the trend, with its first-ever dividend in 2011 (for 56 cents a share) and a payout that now approaches $2 a share.
Not paying a dividend made sense for Celgene in 2004 through 2008, when the company generated an average annual free cash flow of $125 million. That figure hit $800 million in 2009 and $1.6 billion by 2011, and is on track to exceed $2 billion this year. Gross cash now exceeds $4 billion, even after Celgene has acquired a variety of smaller biotechs over the past five years.
The fact that Gilead Sciences has never had a dividend is even more perplexing. Free cash flow has averaged $2.5 billion a year over the past five years, and as I noted this week, a soon-to-be-approved new drug may take that cash flow even higher.
In the past few years, Gilead has taken advantage of a weak stock price to buy back more than 300 million shares. Yet with shares now breaking out to new heights, buybacks make less sense. Of these two, Gilead looks to be a first mover in terms of a dividend initiation, though Celgene and Biogen Idec (NASDAQ: BIIB) may not be far behind.
The No-Brainer Pick
Yet there is one company on the table above for which a dividend -- and a good one at that -- appears to be in the offing. It's a company that once paid out annual dividends in excess of $10 a share, was decimated by the 2008 financial crisis, and is now a lot healthier than many realize.
I'm talking about American International Group (NYSE: AIG), the once-reviled insurer that needed a massive government bailout but has since exited many risky lines of business. AIG now focuses on a pair of insurance lines (life and property/casualty) that generate steady predictable cash flow. In 2012, free cash flow exceeded $3.5 billion, and analysts see that figure hitting $5 billion by next year. With 1.7 billion shares outstanding, a $2-a-share dividend would be quite feasible, and as interest rates rise (boosting AIG's returns on its gross cash holdings), this dividend could climb higher from there.
Frankly, with shares trading well below tangible book value of $65 a share, a stock buyback makes even more sense. CEO Robert Benmosche discussed both of these options in a recent interview with CNBC.
Risks to Consider: Dividend growth has been a key investment theme in recent years -- yet as we saw in 2008, a weak economy can lead to dividend cuts, so don't be alarmed if your dividend-paying stock does so. History says that dividends will be back at full strength after the economic weakness passes.
Don't just focus on companies that don't yet have dividends. Some companies that have only recently begun to offer a payout also have the potential for robust dividend growth. My favorite example is Ford (NYSE: F), which in my view could triple its current 40-cent-a-share dividend over the next few years without making a dent in the balance sheet.
If you are looking for potential dividend initiators, focus on companies with a history of solid and rising free cash flow, manageable (and preferably falling) levels of debt, and minimal needs for cash in terms of capital spending or acquisitions.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.