With Q.E. and interest rates at record lows investors have demanded strong dividend payments and share buy-backs for a number of years now. Unfortunately in order to satiate the demands of investors many companies have resorted to increasing debt as their free cash flows have proven inadequate. I believe that the current capital management strategy of many S&P 500 (NYSEARCA:SPY) constituents is unsustainable. Buy-backs across the board will have to be cut significantly especially if interest rates are set to rise.
To prove this I have analyzed the changes in the financial data of all S&P 500 constituents between the years 2005, 2010 and 2015. I have condensed various financial data points into three sets of charts. These sets of charts provides the median and average data for:
- Total debt vs. cash equivalents.
- Net debt vs. revenue.
- Free cash flow vs dividends paid and buy-backs.
Companies have a strong preference for maintaining dividends and for 2015 repurchased stock exceeded the amount spent on dividends. Investors will therefore need to ask themselves whether or not they are comfortable holding stocks that have the potential of their buy-backs being cut dramatically.
Note: my analysis focuses on median figures rather than the average figures. For the sake of this analysis I believe that the median is a better representation of central tendency as it is less prone to being impacted by outliers. Despite this I have still included the average figures in a separate chart for the sake of balance.
1) Total Debt & Cash Equivalents
Source: Bloomberg, Company filings
If you look at the chart on the left you will see that median total debt has exploded compared to median cash & marketable securities. In 2005 and 2010 the ratio of cash to debt was between 0.30 to 0.36. In 2015 this has dropped by over a third to 0.22 as debt rose significantly and cash remained flat. Of course an increase in debt relative to cash is not necessarily a bad sign if debt is being used to invest in the future growth of the company. However we will soon see this is not the case and that this increase in debt has come about as a means of funding buy-backs and paying dividends.
As a side note, on the right you will see that the average shows the exact opposite has occurred where cash relative to debt has been increasing over time. Again I want to remind readers that the average can be skewed by a handful of constituents and is not an accurate representation of the overall central tendency of all S&P 500 constituents. For example, the net cash position of AAPL alone has a disproportionate impact on this figure as their net debt position rose from -$8bn to -$141bn between 2005 and 2015.
2) Net Debt & Revenue
Source: Bloomberg, Company filings
As previously stated an increase of debt relative to cash is not necessarily a bad thing if it is fueling growth. However on the left we can see that an increase in median net debt (debt minus cash) has not translated into a proportionate increase in revenue. Net debt has increased 345% from $0.74bn to $3.30bn yet revenue has only risen 60% from $5.67bn to $9.11bn over the same period. This is also reflected in the revenue / net debt ratio having fallen almost two-thirds from 7.6 in 2005 to 2.7 for 2015. Furthermore in 2005-2010 an additional $0.58bn of debt resulted in $1.65bn of additional revenue gains, which is a ratio of 2.85. For 2010-2015 however an additional $1.99bn in debt only resulted in $1.79bn of additional revenue which is a ratio of 0.90. No matter which way you slice these figures they are bad.
I see only a couple of plausible explanations for this dramatic drop off. It may have become increasingly more difficult for companies over the past 5 years to produce an additional dollar of revenue for every additional dollar of net debt they have taken on. The alternate explanation to this is that a significant portion of net debt has been diverted from revenue generating opportunities into facilitating dividend payments and buy-backs instead. I believe the latter is much more likely and you will see why below.
3) Free cash-flow, dividends paid and buy-backs
Source: Bloomberg, Company filings
The ratio on the left estimates what percentage of free cash flows have been used to finance dividends and buy-backs from the S&P 500 as a whole. In 2010 this figure was -0.36, in other words 36% of free cash flows were used to finance dividends and buy-backs. For 2015 this ratio hit a shocking -0.96 or 96%. In other words approximately 250 companies in the S&P 500 have been paying more than 96% of free cash flows out in dividends and buy-backs.
This estimate is also validated by performing this ratio on each company individually and then calculating the median: the exact number of companies that are paying out more than 100% of free cash flows is 192, this is almost 40% of the S&P 500. It is also interesting to note that in 2010 buy-backs only constituted 11% of free cash flows compared to 2015 which sits at 55%, a 400% increase in only 5 years. Finally you will see that dividends remain in a very comfortable position relative to free cash flows which is why I believe across the board dividends are very safe.
Putting it all together: what it means
We have been able to ascertain a few facts about S&P 500 constituents when it comes to the median data:
- Total debt is rising much faster than cash & cash equivalents.
- No matter which way you slice it the amount of additional revenue generated for every dollar of additional net debt has fallen dramatically.
- There were 192 S&P 500 constituents in 2015 that paid more on dividends and buy-backs than they received in free cash flows.
- Debt is being used by many S&P 500 companies to help finance dividends and buy-backs.
There are a number of implications that we are able to take away with us from this analysis:
- Many companies may struggle to continue increasing their top line as their balance sheets have already been strained to buy-back stock.
- It is clear that most companies in the S&P 500 are able to comfortably service dividends if they choose to cut their buy-backs.
- Companies may choose to cut their buy-back program in the face of rising interest rates or in order to strengthen their balance sheet. These companies may experience a significant increase in downside volatility as the buying support that they had once provided their stock is no longer there.
What investors can do about it
What I encourage every investor to do is to check that the dividends and buy-backs of each of their holdings are sustainable by looking at them relative to the free cash flows that the company generates. If you notice that your holdings are diverting debt to buy-backs ask yourself the following questions;
- Am I comfortable with the prospect of increased downside volatility in the share price if the company decides to cut its buy-back in the future?
- Has the company stretched its balance sheet too much as a result of buy-backs over the past 10 years?
- Will the company be able to adequately balance their growth objectives with its current buy-back and dividend policy?
- Do I expect a growth in top line revenue growth and free cash flows to maintain or even increase the current level of buy-backs and dividends?
If you are uncomfortable with the answers to these questions then I believe it is prudent of you to think one step ahead of the pack and begin cutting those positions.
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.