Income investors don't like it when the Board of Directors concludes that it is necessary to cut a dividend payment to shareholders. However, this view is misguided when you talk about cyclical companies that have their earnings dip below the dividend payments during low points in the business cycle. If a dividend isn't maintained when there are no profits available to support it, the shareholders will come to suffer over the long term as the business must trash its balance sheet by taking on debt or raising new capital and diluting the existing shareholder base.
Unfortunately for Williams (NYSE:WMB) shareholders, the Board of Directors has elected to both raise capital and tarnish the balance sheet in order to maintain the dividend. Consider this: In 2011, Williams paid out a dividend of $0.78 per share while earning $1.55 in net profits and generating cash flows of $4.30 per share.
By 2016, the dividend climbed to $2.56 per share even while cash flows are only expected to be in the $2.70 per share range and earnings are expected to be around $0.50 per share. The distinction between cash flow and earnings is worth making, as Williams incurs a lot of depreciation charges associated with transporting natural gas. This means that cash flow is a better metric than earnings for measuring dividend paying capacity because current earnings incorporate amortization from past upfront capital expenditures (this is a GAAP measure rather than a cash flow measure.)
To get that dividend up from $0.78 per share in 2011 to an annualized rate of $2.56 in 2016 required the imposition of significant harm upon long-term shareholders. Williams only had 590 million shares outstanding back in 2011. And, as the stock price has fallen from the $50s and $60s to the $20s and $30s over the past five years, Williams chose to issue 160 million shares of stock at low prices. Not only did shareholders have their ownership position diluted by 30%, but they didn't even raise an adequate amount of capital in exchange for the diminishment of their ownership interest.
Perhaps worse, Williams shareholders also had to deal with an exploding debt position that was necessary to keep up the dividends. Back in 2011, Williams only had $8.3 billion in debt on its balance sheet. It was in solid position, generating $2.5 billion in cash flows that could support its reasonable debt burden.
But while diluting its shareholders over the past five years, Williams also ratcheted up the debt. It's now got over $24 billion in long-term debt, triple the debt amount that existed just five years ago. Meanwhile, the cash flows in the $2 billion range. But the dividend is right there too--depending on how much share dilution happens this year, the dividend payment ought to require a payment of $1.9 billion.
There is "no slack" left for Williams to maintain the dividend in the event of any adverse developments for the core operating business. Five years ago, Williams had some wiggle room to borrow and dilute shareholders in the event that there was a hit to cash flows. Not anymore. When your cash flows are only at $2 billion, and you have 12x your cash flows in debt, and all of your cash flows are going towards the dividend, you have run out of lifelines to maintain the dividend. The next hiccup, even a relatively small one, will demand a dividend cut.
Up until Friday night, it looked like Williams shareholders were going to catch a break. There was a planned acquisition by Energy Transfer Equity that would have given each Williams shareholder $8.00 in cash and 1.527 shares of Energy Transfer Equity as part of a merger into a combined "Energy Transfer Corporation" entity. That would have been nice, as it would have given Williams shareholders a meaningful cash payment and an ownership stake in a stronger combined entity (although, to be sure, Energy Transfer Equity would have brought along enormous debt too).
But Judge Glasscock of the Delaware Chancery Court ruled that Latham & Watkins' inability to provide a tax opinion can give Energy Transfer Equity an out to avoid the merger. The allegations of Energy Transfer Equity desiring this outcome seem to be fair; who wouldn't have second thoughts about picking up a company burdened by $24 billion in debt relative to $2 billion in cash flows?
Some Williams investors may be looking at the 7% fall in response to Judge Glasscock's ruling and think that is the worst of it. But it's not. In some regards, the story of the Williams acquisitions is a red herring. The real issue is that Williams chose to maintain its dividend at the expense of the long-term interest of shareholders. The tripling of the debt burden and the 30% dilution of the stock while cash flows came down from $2.5 billion to $2.0 billion over the past five years is the real story. I would expect Williams to cut its annual dividend down near $1 per share, as a payout of $700+ million from a $2 billion cash flow would give Williams the flexibility to combat its ballooning debt and even open an eye to the future with new capital projects.
Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.