Many times, when a respective stock falls significantly in value, the dividend-oriented investor decides to double down on the original investment. In our opinion, this turns out to make sense many times especially if the fundamentals of the company have not changed all that much. Doubling down on dividend aristocrats fits the equation here nicely for two reasons.
Firstly, a proven dividend growth stock (25+ years of dividend increases) will invariably have a track record of elevated earnings and cash flows which support the dividend. A "shock" to the financial system or something internally based should be able to be weathered due to the financial strength and fundamentals of the aristocrat.
Secondly, aristocrats because of the way they are set up need to be very risk averse with how they manage their capital. The reason being is that they know they have a sizable expense (sometimes a rising expense if the share count is not coming down) to their shareholders every year. Because of this, cash flows need to be protected, which is why acquisitions and capex projects have to be costed comprehensively before getting the go-ahead.
Most times though the aristocrats come with lofty valuations, which means their dividend yields are not that high. On the opposite side of the spectrum, you have a company like Guess (NYSE:GES) which up to the first quarter this year paid out an annual dividend of $0.45, which equates to a present yield of 4.7% (well above average). Management stated back in March that it was postponing its decision with respect to the payment of the quarterly dividend in the first quarter. Value investors have to consider here that the dividend may not return in the foreseeable future, so they must price this into their potential investments. Shares at present are trading well under $10 a share, which means that they are down approximately 60% from their year-to-date highs of $23.50.
Shares are currently trading at just over 7 times earnings. Therefore, let's dig into Guess and see how we would approach a potential investment here from a potential dividend suspension or cut standpoint.
First off, the dividend was cut in the middle of last year by exactly 50%. Quarterly dividend dropped from $0.226 to $0.1125. The cut dropped the quarterly payout from about $19 million to $8 million. At the time, investors believed that the dividend cut put a bottom in the share price as shares briefly traded below $14 a share last August before launching higher.
Recent developments though put that idea to bed as the yield as mentioned has spiked well above 4%. From a dividend growth standpoint, even before the cut last year, there had not been any growth in the payout since 2015. However, considering the company's valuation, growth is not our primary concern but rather the sustainability of the payout. Any more cuts or suspensions (which is why management needs to be prudent) would most likely be bearish for the share price (at least in the short-term) irrespective of the cheap valuation on offer at present.
The reason being is that the company's operating margins dropped from over 16% back in 2011 to under 3% a mere six years later. Since 2017, the company has managed to increase operating margins back up close to 6%, but still nowhere near their former glory. This means that the firm does not have a strong economic moat and management alluded to same in the recent annual report.
Suffice it to say, the firm needs momentum. If foot traffic for example was to slow up significantly over the next few quarters, this could spike inventory levels as well as adversely affect growth initiatives. Some industries (like manufacturing niches) are able to withstand downturns better as all they do is dial-down operations to match demand. Guess though with its real estate in North America as well as in international markets has sizable fixed costs which must be paid for irrespective of market conditions. Add in the forex risk of its international markets against the US dollar and we quickly see that the income statement can quickly become impaired if demand does not return.
Guess earned $172 million in EBIT and $96 million in its latest fiscal year which ended in February. Although, these numbers are the best income numbers since 2014, they have come at a cost. The quick ratio is now under 1 and interest expense continues to rise. Suffice it to say, even if Guess resumes the payment of the dividend shortly, growth looks like it will be stagnant for some time yet.
Therefore, to sum up, from a value investor's perspective and company standpoint, the best course of action at present is to not pay the dividend to protect the firm's liquidity position. The firm has already drawn down funds from its credit facility. More liquidity may be needed if the recovery does not take place faster than expected. This can come from the dividend cut.
This decision may have repercussions in the short-term, but it is all about the risk/reward set-up for us. Guess at present is still profitable, has a strong balance sheet, and generates strong cash flow. The second-quarter bottom-line number is expected to be announced this week. It is expected to come in around -$0.88. A worse print than this and a confirmation of a dividend freeze may give us the long set-up we will be looking for.
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Elevation Code's blueprint is simple. To relentlessly be on the hunt for attractive setups through value plays, swing plays or volatility plays. Trading a wide range of strategies gives us massive diversification, which is key. We started with $100k. The portfolio will not stop until it reaches $1 million. If you do not achieve a 20% return in 12 months, you get your money back - guaranteed
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