Fellow SA contributor Josh Arnold recently wrote an interesting article regarding dividend policy at consumer products giant Procter & Gamble (PG). His main point concerned the fact that both net income and free cash flow at PG have been trending lower the past couple of years, while the dividend has been increasing. Even for the accounting novice, it is obvious that such a disconnect cannot remain in place in perpetuity. This article will take up the premise of how reflective the dividend should be of a company's near-term operations and if there is a point where perceived shareholder friendly behavior becomes an affront to responsible management of a company.
An Increasing Shareholder Focus On Dividends
Procter and Gamble is considered by many to be the "granddaddy of them all" when it comes to dividend growth companies. It has paid shareholders every year since 1891 and has raised its dividend each of the last 57 years. For better or worse, there is an inherent expectation in the investment community that come hell or high water and as sure as the sun will rise, PG will raise its dividend. Procter's annual increase announcement comes like clockwork each April and is paid in the middle of May.
Most companies that pay a dividend don't have the history or the added pressure that comes along with having such a pristine growth record. However, I would argue that given the low interest rate environment and the clear focus that investors are putting on yields and income growth, that dividend payers are becoming more highly scrutinized on how much is distributed to common shareholders and at what increased annual rate.
This scrutiny has led to a preoccupation with the payout ratio, which measures the percentage of corporate net income that is paid out to shareholders, and is typically measured as illustrated below. As Arnold mentions in his article, however, when it comes to the dividend, from an accounting perspective, free cash flow and not net income may be the more appropriate baseline metric upon which to conduct analysis.
Companies with lower payout ratios may be viewed as possessing more "room" to move the dividend higher, regardless of current fundamentals. And while a somewhat arbitrary figure, there generally seems to be "concern" about dividend health when the payout ratio reaches the 50-60% area when based upon net income. The perception is that not enough cash is being conserved from ongoing operations to fund expansion and guard against problems that might arise at the company.
Arguably though, through the corporate lifecycle, less operational cash might be required to grow the company during mature years as compared to youthful years. Still, if the company maintains a lower payout ratio, it has infinitely more financial flexibility as compared to a peer with a higher ratio. If a recession hits or a company runs into a bit of dry spell, robust dividend growth can be maintained much more easily and with less controversy when the payout is on the low side.
Intel: The Anti-PG Dividend Growth Company
While you wouldn't necessarily see much in common between Intel (INTC) and P&G, I think they are both, from an operational perspective, at a similar crossroads in today's market. They are both mature companies with near-term top- and bottom-line financial headwinds, have similar yields and payout ratios, and are highly regarded by dividend investors. Yet there is a profound difference in the way Intel has been paying its dividend compared to PG.
Intel's 20-year dividend history has been demonstrably more erratic. There have been several occasions when the company has gone longer than a year without an increase - once for 13 straight quarters (7/00-9/03) and a year (2008) when it increased the payout twice. It has also been inconsistent in the month in which it announces increases. Two times, in both 2004 & 2005, Intel doubled its dividend.
The latest disruption in Intel's payment was this past July, with many expecting at least a nominal increase but not getting it. Management hesitancy to boost the dividend shouldn't have been a total shock given the above history in my opinion. It is interesting, however, that Intel's management is holding back in the face of operating weakness versus P&G which has provided annual increases despite its difficult operating environment. Given Intel's history, I suppose it's possible that a better than expected fourth quarter will lead to a dividend hike the first quarter of next year.
Regardless, investors looking for a more "reliable" dividend growth stock should have probably never steered towards Intel, given its past unpredictable propensities.
Should Reliability Trump Practicality?
Having shown that P&G exemplifies more of a consistent, reliable dividend growth company whereas Intel embodies more of a practical, deliberate one, the question becomes whether one philosophy should be considered more "responsible" or effective than the other?
It would be foolish to assume that PG and INTC management are not attune to the consequences of their dividend decisions. While PG continues to keep its dividend streak in tact and consistently reward shareholders, its payout ratio continues to increase, without a definitively visible rebound in sales. And though Intel has been conserving cash and keeping a cushion by not increasing the dividend, it is likely alienating a certain contingent that expects their investment to reliably return cash, no matter the operating environment.
An optimist could view the P&G situation as though management is expecting a reversion to growth in the upcoming years, thus is confident with executing dividend increases that undermine near-term cash flow. That same optimist might consider Intel "chicken" for not raising the dividend back in July. Pessimists would view Intel as being prudent, while perhaps viewing P&G as reckless.
There does seem wisdom in both schools of thought, but in the current market environment, I think I'd prefer to see a company err on the side of caution rather than having to see it backtrack on aggressive decisions it made during previous years. But despite the fact I see Intel as being a bit more pragmatic with its dividend policy right now, I don't think P&G, given its current situation, is being reckless - perhaps bold, but certainly not reckless.
In Management We Trust?
In the end, when one makes an equity-income investment, there is a bevy of blind trust that is put in management's ability to balance cash benefit with corporate prudence. I don't know whether management develops a "ceiling" of payout that it will provide to shareholders before putting the brakes on or not, but in this day and age, I would think consideration of such limitation as being quite responsible. Though I like the idea of an increasing dividend payment as much as the next investor, it's certainly not healthy for a company to be offering more to shareholders than it realistically should, no matter what reputation it wants to hold on to.
Additional disclosure: Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.