On October 26, Hi-Crush (HCLP) and Legacy Reserves (LGCY) became the latest two companies that the Dividend Cushion ratio warned about regarding a distribution cut, both serial “cutters.” Just a reminder, a raw, unadjusted Dividend Cushion ratio below 1 indicates significantly higher risk of the sustainability of the payout. The Dividend Cushion ratio, however, does so much more than warn investors of the risk of potential dividend cuts.
Perhaps it is our own fault, as we have noted on several occasions the efficacy of the Dividend Cushion ratio in warning investors of a dividend cut in advance, that readers are focused on the metric primarily as a warning system instead of a generator of ideas that have fantastic dividend growth prospects. Its track certainly speaks of its effectiveness as a warning system, but the Dividend Cushion ratio also unveils companies that may raise their dividends in a big way.
Recently, market research firm Markit highlighted financial services giants Visa (V) and MasterCard (MA) as the top two dividend growers for the fourth quarter of this year. In many ways, we’re seeing the same things. For example, both Visa and MasterCard have fantastic, net-cash-rich balance sheets, and both have strong free-cash-flow generating capacity, a combination that helps drive their outstanding Dividend Cushion ratios. As of the most recent report update, the Dividend Cushion ratios of Visa and MasterCard are 7.6 and 5, respectively. Contrast these two ratios with the 0.8 and -1.4, the latest from Hi-Crush and Legacy Reserves, respectively, two companies that have slashed their payouts.
Not only do Visa’s and MasterCard’s Dividend Cushion ratios speak of these entities being able to grow the dividend significantly in the future (their ratios are significantly greater than 1), but it’s important to note that the Dividend Cushion calculation already embeds strong growth in their payout, implying that these companies can raise their dividend at a pace far greater than even our existing robust expectations. For example, Mastercard’s Dividend Cushion of 5 includes the expectation that the firm will increase its annual payout 50% before the end of 2016 and at a double-digit pace each year after that. MasterCard’s Dividend Cushion ratio implies that it can handle a dividend growth trajectory far greater than that of which we have even modeled, a promising proposition for long-term-oriented dividend growth investors.
The pace of growth in Visa’s and Mastercard’s annual dividends has been phenomenal in recent years, something investors should continue to expect from companies with such lofty Dividend Cushion ratios. The dichotomy between firms with lofty Dividend Cushion ratios raising their dividends in a big way and firms with very poor Dividend Cushion ratios cutting their dividends (eventually) remains valid. The Dividend Cushion ratio is not a one-dimensional tool, and while no estimate of the future should be viewed with precision, our forecasts for the pace of dividend growth within each firm’s dividend report help to inform what income investors can expect in terms of the magnitude of growth over time.