The wreckage in crude oil prices has left many in awe of the range of probable outcomes for the commodity even over a multi-month period, let alone a multi-year period. The precipitous decline has forced high-yielding equities such as Linn Energy (LINE) and Seadrill (SDRL) to slash their income payouts and begin the long road to recovery, as it has pushed the backs of others, including Legacy Reserves (LGCY), against the wall. Investor confidence, once lost, however may never be regained, and management teams know this. A dividend cut will always be the last resort, but crude oil hasn’t been the only commodity falling out of favor. Copper and iron ore have also seen much better days, too.
January 26 brought news that global iron ore producer Cliffs Natural (CLF) would suspend its dividend, a move that had been telegraphed by the firm’s very poor Dividend Cushion ratio. For those just getting familiar with this fundamental-based dividend coverage ratio, the Dividend Cushion ratio, which is proprietary to Valuentum, is forward-looking and derived from future financial forecasts of free cash flow (cash flow from operations less capital spending), a company’s net balance sheet (cash less debt), and future expected cash dividends paid. It can be found in each firm’s dividend report.
The higher the Dividend Cushion ratio above 1, the healthier the dividend. It means that the firm can cover expected growth in the dividends with future expected free cash flow and net cash on the balance sheet. On the other hand, the lower the Dividend Cushion ratio below 0, the riskier the dividend, all else equal. Cliffs Natural’s Dividend Cushion ratio was -5.2 (negative 5.2) before the cut, so the suspension was all but guaranteed, in our view, with timing the only true variable. This is yet another example of the importance of forward-looking cash-flow based analysis, which is second to none both in equity valuation and dividend growth analysis.
The list of ‘Dividend Yields to Avoid’ can always be found in the left column of the website under the ‘Stock Screens’ section, and you’ll see that Cliffs made that list. Because a company’s balance sheet and cash-flow profile do not change much on a daily basis, we update the list on a monthly basis and include it in the monthly Dividend Growth Newsletter. Other firms that are at risk of a dividend cut include the aforementioned Legacy Reserves, Peabody Energy (BTU), Tidewater (TDW), Roundy’s (RNDY), Windstream (WIN), Frontier (FTR), and Centurylink (CTL) among others. These are relative high-yielding equities so many income investors may hold these firms without knowing the significant risk related to the long-term sustainability of their dividend payment. Much of the uncertainty in these cases rests on the massive debt obligations on the balance sheet that take priority over any dividend payment to shareholders.
Our best dividend growth ideas are always included in the Dividend Growth portfolio, and we use a combination of high yield, strong Dividend Cushion, and valuation to assess whether a company is worthy of inclusion. At the moment, there are 17 holdings in the Dividend Growth portfolio, which is updated in each edition of the monthly Dividend Growth Newsletter that we email to members on the first of each month.
The start of the week of January 26 also brought a number of disappointments. (1) Brookdale Senior Living (BKD) lowered its 2015 CFFO guidance to $2.60-$2.75 per share from $2.95-$3.10, and shares are taking a hit. Hard drive giant (2) Seagate’s (STX) sales outlook for the calendar first quarter came in a bit lower than expectations, and peers such as Western Digital (WDC) and Hutchinson (HTCH) are facing selling pressure on the news. Toy maker (3) Mattel (MAT) announced the resignation of its CEO as it lowered its fourth-quarter guidance. Shares of Mattel have been punished significantly the past many months, and we continue to point to long-time Dividend Growth portfolio holding Hasbro (HAS) as the clear winner in that rivalry. Industrial distributor (4) Grainger (GWW) also announced lower expected sales growth in 2015 (now 3%-7%, was 5%-9%), and homebuilder (5) NVR (NVR) issued weaker than expected fourth-quarter performance, though D.R. Horton’s (DHI) more optimistic tone about January sales has mitigated some of the concerns across the industry.
All in all, not a great start to the week. As your sifting through the wreckage in commodity-linked industries, please don’t forget to pay attention to the Dividend Cushion ratio when evaluating dividend health.