When a dividend-paying company suddenly announces that they are decreasing (or eliminating) their dividend, most people think the worst – investors used to steady cash flows will panic, the company will be faced with tough times financially and the stock will plummet.
While that can (and does) happen when a dividend gets cut, the results aren’t always as bad as people think.
A recent study showed that from 1965-2001 35% of dividend cuts led to operating improvements, increased profitability and the resumption of dividends within 5 years.
Management of Cash Flows
While most people view decreasing (or eliminating) a dividend as a sign of dire finances, it could simply be a way for a company to better manage its cash flows.
Cash dividends are funds paid from the company to the shareholders. While that is normally a good thing for investors, in changing market conditions it can be a bad thing. If the price of oil declines and an energy company bases its revenues on oil prices – this means lower revenues. Lower revenues generally mean lower cash flows. Some companies may choose to cut their dividend in order to improve cash flows in the future – with the intention of reinstating the dividend once market conditions improve.
In this way a dividend cut could simply be taken as a way of managing cash flows based on current market conditions. Many investors would agree that a dividend cut would be more favorable than the company taking on more debt to fund their dividend.
A study from 2005 showed that over 2/3 of investors see earnings stability as an important factor when deciding whether to invest.
Companies may cut their dividend as a way to achieve stable earnings in volatile industries like oil & gas. Long term investors can be rewarded by not panicking when a dividend cut is announced and staying invested for the long term.
Related: Surviving a Market Meltdown
Market conditions will go up and down, but the goal of virtually every company is the same: to reward investors with stable earnings over long periods of time. A dividend cut might be one way some companies choose to do that.
Another way a dividend cut may not necessarily be a bad thing is if the company uses the extra cash on large, long term capital projects.
No investor would argue that a company is better off to sacrifice long term profitability by maximizing short term payouts (through the form of a dividend).
If a company is facing deteriorating market conditions but still plans to spend capital on projects created to generate revenues for the next 10-20 years, it would make sense to preserve cash in the short term and focus on where the money is best spent.
While some investors would argue the money should go to investors no matter what the situation, most would agree that a long term view is best when looking at where company cash is best spent.
- Teck Resources. With the global financial crisis in full force their management was forced to make tough spending choices. In 2008 they scrapped their dividend and the share price tanked, going from $45 to $3 within months. Within two years the dividend was reinstated and the share price had recovered, reaching $60 in 2010.
- Husky Energy. In 2008 they cut the dividend from $0.50 to $0.30 and although the share price decreased slightly, it remained relatively steady at $30 for years after the dividend was slashed.
Conclusion: dividend cuts are never easy – for management or investors. Many investors panic at the thought of a dividend cut, but in the long run they aren’t always a bad thing. They can increase cash flows for long term capital spending, increase financial flexibility to pay off debt and smooth out earnings in the long run.
They also avoid what no investor would want – using debt to finance a dividend.