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I prefer to research before buying and to monitor while holding. I have a background in tax/finance/accounting with a career focus in the real estate industry. My username has a personal meaning and has nothing to do with the metal.
  • Should Dividends Wag The Dog? 0 comments
    Apr 11, 2014 1:34 AM | about stocks: PG, CL, WMT, INTC, PETS, CATO, CTL, TAXI

    (click to enlarge)

    It is often said that one should not let the tail wag the dog, so should dividends wag the company?

    Say a firm sells a product for $100, has $30 of inventory cost, $20 of operating expenses, pays $20 of tax (40% rate) and the business requires on-going capital expenditures of $10/year. This means that the company's cash flow yield from each sale is $100-30-20-20-10 = $20, or 20%. The company also pays $15 of dividends to shareholders (and retains a $5 contingency reserve).

    With a cursory glance, the $15 of dividends generated from every $100 sale may appear rather "juicy".

    But let's think about this one step further: where did that $15 of dividends come from and is there a hidden cost of such high "excess" cash flow?

    From a theoretical standpoint, the company could afford to cut their prices by 15% (or raise costs by the same amount) and still have a positive cash flow yield (because their tax expense would be lower at 14 instead of 20; thus, 85-30-20-14-10 = 11), while also being able to pay dividends of $6 (and retain a $5 contingency reserve).

    So would a 15% price cut (or sales discount) be worth a potential 60% "cut" in the dividend ((15-6)/15 = 60%)?

    One reason this might be worthwhile is if competition is eating into market share. Lower prices, should theoretically generate more demand, right? Stated another way, if sales are stagnant, could the company's dividend be too generous at present?

    Continuing from the example, if every 15% discounted sale at $85 adds $6 to the potential dividend pool, then if the company can generate 2.5 additional sales from a 15% price cut, it would still have $15 ($6*2.5) of dividends to distribute, and the temporary dividend "cut" may not even materialize (and note there would likely be "leverage" on fixed operating expenses, further adding to the bottom line and reducing the number of additional sales necessary to break-even).

    It should go without saying that revenue growth, cash flow growth and EPS growth all tend to lead to higher share price valuations as well, so perhaps this a good strategy.

    There are plenty of iterations and break-even scenarios that we could come up with. But there is a larger point I'm trying to convey here: A low market share (or low revenue growth) may be the price for a high dividend.

    ---------------

    Here is a tool you can use to help screen if a company's dividends are coming at the price of low revenue growth (or market share): consider dividends paid + share buybacks as a percentage of gross profit (I'll call this the payout sales ratio = "PSR").

    If the PSR is much higher than peers, this may be a red flag indicating poor management efficiency and effectiveness. It could also signal that the board of directors are either not doing their job, or just want to milk the company for cash at the expense of the market share and stock valuation. It may also signify management's strategy to borrow long at low rates and buyback stock to lower their cost of capital - so just use the PSR as an initial screen and take a look a the 10K.

    A PSR that is much lower than peers could signal high operating costs or one-time expenses, or it could signal that management is building up cash for an acquisition or debt pay-off. Needless to say, it warrants further analysis if the PSR is way out of line from peers.

    Moreover, a high PSR doesn't necessarily mean the company is a bad investment as a high PSR may be an opportunity for significant share price appreciation if management or the board were to implement a low price/discount optimization strategy similar to what I described above. Alternatively, a low or average PSR doesn't necessarily mean the company is an alpha generating investment (although it is probably a safe investment) if the firm is already optimized for performance... and the market has fully valued the shares.

    -----------------

    Here are a couple of examples from 2013 financials taken from Yahoo Finance. First, some arguably healthy and well known dividend payers (all amounts are approximate):

    PG - Gross Profit = $41.7B, Dividends + buybacks = $9B, PSR = 21.6%

    CL - Gross Profit = $10.2B, Dividends + buybacks = $2.6B, PSR = 25%

    WMT - Gross Profit = $118B, Dividends + buybacks = $13.5B, PSR = 11.5%

    INTC - Gross Profit = $31.5B, Dividends + buybacks = $5.3B, PSR = 16.9%

    Next, here are four less well known names:

    PETS - Gross Profit = $77.1M, Dividends + buybacks = $35.7M, DSR = 46.3%

    CATO - Gross Profit = $348M, Dividends + buybacks = $11.8M, DSR = 3.4%

    CTL - Gross Profit = $10.6B, Dividends + buybacks = $2.8B, DSR = 26%

    TAXI - Gross Profit = $49.8M, Dividends + buybacks = $19.5M, DSR = 39%

    And, in the example I gave above, the PSR would be 21% (15 /(100 -30)) before the discount strategy, and would be 11% (6/ (85 -30)) after the discount strategy.

    -----------------

    Please note that these results are illustrative only and should serve as a spring board for further due diligence on your part. Also, this methodology doesn't necessarily work for every company or entity type (e.g. REITs, MLPs, etc.), and should be expected to vary considerably from industry to industry.

    As always, I take no responsibility for your investment decisions and you must perform your own due diligence. This data and any analysis are for informational purposes only and are intended to promote financial literacy.

    Best of luck to everyone,

    Palladium31

    Disclosure: I am long WMT.

    Additional disclosure: I am effectively long PETS via cash secured puts with a strike price below the current market price. I wrote this post myself and am not receiving any compensation from any of the companies mentioned in this article.

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