Image Source: Kryzysztof
“If mangement teams want to give bogus forward earnings guidance as in the case of Jakks Pacific or balk in light of ominous industry conditions as in the case of Marriott or National Oilwell Varco, or simply abandon the dividend altogether with no warning despite a flawless balance sheet and strong free cash flow generation as in the case of Quality Systems, the objective and financially-based Dividend Cushion ratio may come up short in predicting such irrational human behavior. The board can do what it wants with the dividend, and every board is different.” — Brian Nelson, CFA
By Kris Rosemann
The Dividend Cushion ratio does not have a perfect record in catching dividend cuts, though it has been very, very good. There have been a number instances in recent years of the ratio failing to warn of a coming cut in a firm’s payout, and we feel the need to apologize to our members for our shortcomings in these areas.
One such instance came in July 2013 when Jakks Pacific (JAKK) was forced to cut jobs and suspend its dividend as the preferences of children moved away from its more traditional leisure products and towards mobile device gaming. The decision came as a surprise to the market, and shares were pummeled. This sell-off, however, was more a result of the major miss in the firm’s reported results and rather large downward guidance revision.
In this case, the issue was not a problem in the Dividend Cushion ratio process, but rather in a material change in the trajectory of Jakks Pacific’s future business. Management was able to foresee the coming pressures on its business much easier than we were able to, an inevitability when considering the fact that it is focused on one firm and we concisely cover well over 1,000 with a high degree of relative precision. When management makes huge changes to its forward guidance with little warning, the Dividend Cushion ratio can be caught off guard.
Our objective processes are not perfect, but this is why including a qualitative overlay in the dividend risk management process is incredibly important. The dynamics of Jakks Pacific’s business changed drastically due to continuing changes in the play patterns of children, and this is ultimately what impacted its dividend prospects, and our prior forecasts were left virtually meaningless as management made an adjustment based on its qualitative assessment of its operating environment. We were blindsided by management’s decision to cut the guidance. Others may think that the executive team could have done a better job of predicting its own business trends, instead of leading the Street’s forecasts astray.
The recent developments around National Oilwell Varco (NOV) and its dividend have been directly related to the volatility and expectations for continued pressure in the oil and gas markets that it serves. Though we have a bone to pick with management in that it cut its dividend significantly while it still had a solid Dividend Cushion ratio (and it still has a good one after the cut), we cannot fault the firm for wanting to preserve cash in such a difficult business environment, especially as year-over-year revenue trends look ominous through 2016 thus far. When most companies cut their quarterly payout, the business is typically nearing a credit crunch, liquidity shortfall, or financial distress, which is what the Dividend Cushion ratio is designed to warn of, among other financial concerns such as free cash flow shortfalls or burdensome debt loads. The ratio, however, does not (and cannot) predict overreactions by management that make preemptive moves as in the case of National Oilwell Varco.
In 2015, National Oilwell Varco did swing to a net debt position from a previous net cash position in 2014, but free cash flow remained positive. The biggest issue that we can point to under the firm’s control is the excessive ramp up in share repurchases, which totaled more than $2.2 billion in 2015 compared to less than $800 million in 2014 and nothing in 2013. We fail to see how this was a prudent use of cash, especially in light of the company cutting its dividend. This brings up another potential shortcoming of the Dividend Cushion ratio. The ratio does not take into account the impact of share repurchases a given firm may be planning to undertake. The reasoning for this nuance is that the dividend is traditionally viewed as sacred territory, so cutting back share buybacks often happens before the dividend is cut, making buybacks much more discretionary in nature. Companies may not execute their plans for buybacks as intended, and penalizing firms with more transparent share repurchase programs than others lacking such clarity would create an apples-to-oranges type of dynamic. Transparency in most cases should be rewarded.
We are continually working to improve our processes at Valuentum, and as we continue to roll out the second page to our dividend reports, we are working tirelessly to address such qualitative issues via our ‘Key Strengths’ and ‘Potential Weaknesses’ sections. If you haven’t seen one of our new dividend reports, please take a look at Wal-Mart’s (WMT) report .
Another company was able to sneak a cut past the Dividend Cushion ratio in early 2016. Quality Systems (QSII) recently ceased paying a dividend in order to facilitate its transaction with HealthFusion and increase its acquisitive options. The company is now focused on a total shareholder return strategy that includes accumulating dry powder to eventually put to work instead of returning capital to shareholders via dividends. From our point of view, there was little warning or suggestion that this type of move was coming, making the qualitative analysis around the firm’s Dividend Cushion ratio, which was strong, somewhat moot. It would have been nearly impossible for the Dividend Cushion ratio to catch the cut in Quality Systems’ dividend, which was not mentioned in its recent press release outlining its strategy review, due to the fact that there was little, if any, deterioration in the company’s financial health. In fact, the firm has no debt on its balance sheet as of the end of 2015, and it remained free cash flow positive through the first nine months of fiscal 2016!
Again, we feel we must apologize for each of the aforementioned situations that went undetected by the Dividend Cushion ratio. The simple truth is that every system has flaws, and while we continue to work towards improving our processes, these are the kinds of events that keep us up at night. We truly do strive to be the champion of the investor, and these types of scenarios simply cannot become commonplace, particularly as more and more investors are dependent on dividends for income through their golden years. We hope you will continue to bear with us and trust that you have found great value in the many strong dividend-paying ideas we have uncovered through the past few years. On a positive note, the Dividend Growth Newsletter portfolio continues to outperform its annualized return goal, and we have yet to have a single company cut its dividend while in the portfolio.
However, we’re not satisfied with constantly driving the green; our short game might need a little work. We’re as hungry as a young Tiger Woods, chasing Jack Nicklaus’ record number of major tournament victories.