One important lesson we learned from the 2008-2009 financial crisis was that it didn't matter how long a company had increased its dividend, tough economic times could push it to cut its dividend. In most cases the companies' investors were not surprised because they saw the early warning signs that indicated a dividend cut was imminent. Here are three signs that a company is heading toward a dividend cut:
I. Change In Business Conditions
An abrupt or permanent shift in a company's business model as a result of business conditions could lead to a dividend cut. During the financial crisis, virtually all businesses experienced an adverse change in business conditions. However, the pertinent question is to what degree? Consider these two examples:
Gannett Co. (NYSE:GCI) publishes about 100 daily U.S. newspapers, more than 500 non-daily publications in the U.S., and more than 200 U.K. titles, and operates 23 TV stations in the U.S. With the mass adoption of the internet, traditional news outlets such as newspapers are experiencing a slow death. After several years of declining earnings, GCI cut its quarterly dividend in March 2009 from $0.40 per share to $0.04 per share. In March 2012, the company was paying $0.20 per share, half of what it was paying 3 years ago prior to the cut.
Pfizer (NYSE:PFE) is the world's largest pharmaceutical company. However, in February 2009 it wasn't "too big to fail." At that time the company cut its quarterly dividend from $0.32 per share to $0.16 per share. After years of unsuccessful attempts to get approval of a "blockbuster" drug, the cash rich company sought a merger partner with a good drug pipeline. In anticipation of it proposed combination with Wyeth, PFE cut its dividend. Since then, its dividend has increased to $0.22 per share.
II. Dividend Yield Above Historic and Industry Norms
A dividend yield that is higher than average and/or higher than others in the industry are indications, not all is well with the company. The market is adjusting to compensate for the higher risk of holding the company. When dividend yields start creeping up, it is time to start evaluating if the company can continue to pay its dividend.
Consider Bank of America Corp. (NYSE:BAC). Between 2000 and 2007 the company's dividend yield hovered in the 3%-4% range. In 2008, the dividend yield ranged from around 5% to the teens prior to its dividend cut. The same situation occurred with General Electric (NYSE:GE) over the same period. GE's dividend yields from 2000-2007 normally were in the range of 1.5%-3.5%. However, in 2008 the dividend yield more than doubled as investors lost confidence in the company. Eventually, BAC and GE cut their dividends.
III. Diminishing Cash Available to Pay Dividends
Ultimately, the ability of a company to pay its dividend is determined by its cash position- both cash on its balance sheet and its ability to generate cash flow. All the companies above had one thing in common - a deterioration of cash flow available for paying dividends.
GCI's free cash flow peaked in 2004 at $1.3 billion. Since then it has declined in 5 of the last 7 years and was at $742 million in 2008. Though GE's free cash flow was increasing, the company was taking on significant debt. GE's debt increased from $201 billion in 2000 to $524 billion in 2008 and it could no longer afford its dividend.
A Look Ahead
Unfortunately, there will be more dividend cuts in the future. It is just part of the business landscape and the ever-changing economic tide.
CenturyLink, Inc. (CTL) has aggressively grown over the last several years with the acquisitions of Embarq, Qwest and Savvis. This growth has financially challenged the company; so much so, that it has left its quarterly dividend flat at $0.725 since March 2010. Free cash flow could grow to level that would allow the company to sustain its dividend, but it is a risk I was not willing to take at the level I was invested. In 2011 I significantly reduced my holding in CTL to a level I am now comfortable with.
Pitney Bowes Inc. (PBI) is the world's largest maker of mailing systems, also provides production and document management equipment and facilities management services. Like GCI, the industry in which PBI operates has probably seen its best days. The decline in the mailing services industry is forcing PBI to reinvent itself. Unlike CTL, PBI's financial are in decent shape, with my main concern with the level of debt. I wouldn't consider PBI as an appropriate investment in my Dividend Growth Portfolio, but I have given consideration to adding it to my high-yield portfolio to milk the cash cow while seeing if the company can successfully to transform itself.
The above three items will help you determine which companies are at risk of cutting their dividends. Cash is king, so pay special attention to free cash flows and debt levels. Buy and hold is not buy and forget - never take your eyes off your investments.
Full Disclosure: Long CTL in my Dividend Growth Portfolio. See a list of all my dividend growth holdings here.