Retirees know that a dividend cut could be disastrous to their income portfolio, as future income is not only reduced but it is also very likely that capital is permanently impaired. The Dividend Cushion ratio, an integrated leverage and liquidity metric, is designed to provide the income investor with a trusted and independent opinion of the safety and future growth potential of a firm’s dividend. It not only has shown to predict dividend cuts, but the ‘cushion’ behind the Dividend Cushion reveals just how much capacity a firm has to continue growing its dividend into the future.
Technically speaking, the Dividend Cushion ratio considers the firm’s net cash on its balance sheet (cash less debt) and adds that to its forecasted future free cash flows (cash from operations less capital expenditures) and divides that sum by the firm’s future expected cash dividend payments over a discrete five-year period. At its core, it tells retirees whether the prized stock in their income portfolio has enough cash to pay out its dividends in the future, while considering its debt load. If a firm has a Dividend Cushion ratio above 1, it can cover its dividend, in our view, but if it falls below 1, trouble may be on the horizon.
A question comes up frequently about why we use a 5-year discrete forecast period in the Dividend Cushion calculation. In short, we think it is a great way to rank dividend risk across companies, combining in one metric insight with respect to both leverage and liquidity analysis.
As for how to interpret the Dividend Cushion ratio, itself, it is a measure of financial risk to the dividend, much like a credit rating is a measure of the default risk of the entity, for example. Said differently, a poor Dividend Cushion ratio of below 1 or even negative doesn’t imply the company will cut the dividend tomorrow, no more than a junk credit rating implies a company will default tomorrow.
That said, the Dividend Cushion ratio does punish companies for outsize debt loads because in times of adverse conditions, entities often need to shore up cash (and those with limited financial flexibility have fewer options), and that means the dividend becomes increasingly more risky. Lofty net debt positions and extremely capital-intensive business models often spells disaster.
We think investors should look at a variety of different metrics in assessing the sustainability of the dividend. Because the Dividend Cushion ratio is systematically applied across our coverage, it can be used to compare entities on an apples-to-apples basis. Dividend payers with significant free cash flow generation and substantial net cash on the balance sheet often register the highest Dividend Cushion ratios, as they should. These companies have substantial financial flexibility to keep raising the dividend.
Adding to the list found at, “Dividend Cushion Ratio Predicts Two More Cuts,” released July 2015, the Dividend Cushion ratio has yet again warned investors of risk in the payout of several companies in advance of their cut. Though one company was a much larger company, the Dividend Cushion revealed its efficaciousness in both scenarios. It’s very important to note that the Dividend Cushion ratio warned about the risk of a dividend cut in advance and that the metric is a real-time, forward-looking metric that readers can use now to assess the risk of a dividend cut in their income portfolios.
One extremely high-profile case, Kinder Morgan (KMI), cut its dividend by 75% December 8, as its overleveraged, commodity-price dependent, capital-intensive business model felt the weight of more cautious equity and debt markets. Though management stated internal measures of “distributable cash flow” would be sufficient to cover 6%-10% dividend growth in 2016 on December 4 (just 4 days before it cut its payout), the firm’s significantly negative Dividend Cushion ratio spoke to considerable risk.
Kinder Morgan may be the first of many notable midstream companies to slash its dividend, as cash flows continue to weaken across the highly-leveraged sector. This slide deck highlights the scenario surrounding Kinder Morgan and potential for more cuts in the space. We continue to point to Plains All American (PAA) as next in line of the major MLPs to cut its distribution, and we fear the Energy Transfer “empire” in Energy Transfer Equity (ETE) and Energy Transfer Partners (ETP) will succumb to a much more cautious credit market.
On a fully-consolidated basis, including all subsidiaries, Energy Transfer Equity is more than 7x leveraged, as measured by net debt to annualized EBITDA. We outline the calculation in the following piece, “Alert: Energy Transfer Equity Is More than 7x Leveraged!”
The Dividend Cushion ratio also effectively warned investors of the coming cut in Alleghany Technologies’ (ATI) dividend. The firm cut its dividend by 56% December 10 due to challenging market conditions in its ‘Flat Rolled Products’ segment and ‘Grain-Oriented Electrical Steel’ products. Alleghany’s Dividend Cushion ratio was -2.2 at the time of the cut.
We continue to reiterate our view that forward-looking, cash flow-based dividend analysis is a great way to determine the future safety and capital-market dependence of a company’s payout. Please do keep monitoring the Dividend Cushion ratios of companies in your portfolio, especially if you’re dependent on them for income.