If you’ve ever listened to the earnings call for a company that’s reporting less than stellar results you’ve probably heard an analyst ask a variation of this question – “Is the dividend in danger of being cut?”. The CEO or CFO always responds with a variation of what the CEO of Royal Dutch Shell (RDS) said on a recent earnings call – that they are “pulling out all the stops” to protect the dividend.
“Pulling out all the stops” usually involves cutting costs, cancelling new projects, and taking on debt to continue paying the dividend.
Taking on debt to pay a dividend is a terrible idea.
Companies take on debt for a variety of reasons. A good use of debt is to fund investments in the core business that will result in higher profits in the future. Sometimes the debt is to make an acquisition. This could be good or bad, as acquisitions are only successful about half the time. Occasionally the debt is used to buy back shares (whether that’s a wise move or not depends on valuation). And, unfortunately, sometimes the debt is to enable the company to continue paying dividends.
Dividends should come from profits
Don’t get me wrong – I love dividends. I love getting checks from the companies I’ve invested in and I track my dividends every month. I enjoy watching that dividend stream grow quarter by quarter and year over year.
My own retirement will largely be funded by dividends. I’ll use those dividends to buy groceries, put gas in my car, and pay my bills. However, as a shareholder/partial owner of the company, I’m concerned about the long-term health of the company. I’m not willing to sacrifice the health of the company for this quarter’s dividend. Unfortunately, I seem to be in the minority with this line of thinking.
A dividend is the owners’ share of the profits. Note the key word there – profits. If there are no profits the company shouldn’t be paying a dividend. Think about it this way – let’s say you own a restaurant. The restaurant is doing well and, as the owner, the profits are your income. Your restaurant made $40,000 last year and will make $50,000 this year. Next year a new restaurant moves in across the street and takes some of your customers. Profits drop to $10,000 for the year. Would you go to a bank to borrow $40,000 so you could pay yourself the same $50,000 you made last year? Of course not. You might want this money, you might even NEED this money, but if the business isn’t posting a profit there’s no money to be had.
Let’s take a look at a publicly traded company doing exactly this.
In 2015 Q4 Chevron paid a $1.07/share dividend while losing $.31/share. Chevron had to borrow to fund the dividend, but covered the $.31/share loss out of cash reserves. In 2016 Q1 Chevron again paid $1.07/share while losing $.39/share. Money was borrowed to pay the dividend. In 2016 Q2 Chevron paid the same dividend of $1.07/share while posting a quarterly loss of $.79/share. Again – money was borrowed to pay the dividend.
As a result, Chevron’s debt has ballooned from $35.8B in 2015 Q4 to $38.5B in 2016 Q1 and now sits at $42.3B in 2016 Q2. The debt has increased by $6.5B in the last 3 quarters. And guess how much Chevron has paid in total dividends over the last 3 quarters? $6B.
The dividends are being funded entirely by debt.
Why is this a bad idea?
Money spent on dividends is money not spent on capital improvements or other investments in future profits. By definition, borrowing money to pay a dividend is pulling profits from the future and paying them out today. The borrowed money must eventually be repaid, with interest.
Let’s go back to Chevron. Of the roughly $6.2B in bonds due in 2017, just a bit more than $2B of the bonds have a floating interest rate. Of the remaining $4.2B, virtually all have a fixed interest rate of around 1.5%. That’s pretty low. No problem there. Their cost of borrowing is dirt cheap and below the rate of inflation.
In 2018 there’s another $7.4B of bonds maturing, and again the vast majority of it is at a fixed rate of under 2%. Looks like there’s nothing to worry about, right?
Well, the reality is that Chevron can’t repay these bonds when they come due in 2017 and 2018. Chevron is losing billions of dollars a year. They can’t pay the $6.2B due in 2017 or the $7.4B due in 2018. Chevron will need to take out new bonds to pay the existing bonds as they become due, while at the same time issuing even MORE bonds (taking on debt) to pay dividends for 2017 and 2018.
What happens if/when interest rates rise in the next 2 years? Chevron will be rolling their existing bonds over into new bonds at higher rates PLUS issuing new bonds at the higher rate. Now their interest payments each year are even higher, which makes it even harder to turn a profit to start paying down the existing debt.
A recent example of this scenario unfolding was Kinder Morgan (KMI). I bought KMI a few years ago because it had stable earnings and I thought it was largely insulated from oil prices. I didn’t take into account the large debt load the company had. KMI took on this debt to pay for new projects (which did add quality revenue to the company). However, Kinder Morgan took on too much debt – their debt ballooned from 14B in 2011 to 42B in 2015 (3x in 3 years).
Eventually the credit ratings threatened to cut KMI’s credit rating to below BBB (the threshold for “investment grade” debt), which would not only cause their cost of borrowing to rise, but make their bonds untouchable by many institutions. As a result, KMI did the prudent thing – they cut their dividend so they could start repaying their debt. Investors panicked and stock price got hammered. KMI is now starting the long process of repaying this debt.
Chevron is nowhere near a debt crisis. Debt is only 31% of equity. Chevron has a AA- credit rating. But if oil prices stay low for a few years (or decades) Chevron will be in a lot of trouble. If interest rates start rising over the next few years they’ll start feeling the pain, and more and more future profits will need to be redirected to paying off the debt created today.
The more debt Chevron takes on the more they rely on higher oil prices in the future. By paying dividends and taking on unnecessary debt today Chevron is dramatically reducing how long they can survive at these oil prices. They are borrowing away their margin of safety.
A better way
I’d prefer a dividend policy that is less concerned with a consistent dividend and more concerned with a sustainable dividend. A company should have a targeted payout ratio – say, 50% of profits. The dividend would vary each year based on profitability. In years where there was no profit there would be no dividend.
The key benefit of this dividend policy is that a company doesn’t overextend itself. When the company is profitable shareholders are rewarded. When times are tough and profits are low then the dividends are low. And if the company is losing money then no dividend is paid. The company isn’t hurting its long-term profitability by taking on unnecessary debt.
Companies, like investors, make their money during downturns. Fortunes are made in the market by buying assets when they are available at bargain prices. In my investing career this has happened to stocks in the tech crash of 2000-2002, real estate from 2009-2011, and stocks (especially financial stocks) during 2009-2011. I was able to profit from these times by aggressive investing in stocks during the tech bust and in real estate during the financial crisis.
But what if you’re a retiree who needs consistent income? No problem – just buy stock in companies with more consistent earnings. Buying an oil company, or an auto maker, or a shipping firm, and expecting consistent income is ridiculous. These industries are, by definition, cyclical. Somebody who needs consistent income should be buying Johnson & Johnson, Coke, Medtronic, Altria, and other companies with steady and predictable profits.
What if you wanted to maintain consistent income AND buy cyclical companies? That can be done by pairing 2 countercyclical companies. Here’s what I mean – when the price of oil drops the oil companies get hit hard, but airlines (for whom the cost of fuel is far and away their largest expense) do well. So you could buy $10,000 of Exxon and $10,000 of JetBlue and receive a more stable income over time than either firm alone would provide.
The market is overvalued today, so this isn’t a good time to be putting new money to work in the market. It’s a TERRIBLE time for corporations to be assuming piles of new debt so they can continue to pay dividends they can’t afford.
If you decide you are going to buy at these prices, make sure your investment’s dividends are funded from profits, not debt.