The Dividend Cushion ratio continues to build an impressive track record of warning investors of impending dividend cuts, but it’s not perfect. Let’s examine a few recent cases.
By Kris Rosemann and Brian Nelson, CFA
The Dividend Cushion ratio has proven to be an extremely useful tool for income investors to help safeguard their portfolios from dividend cuts, but it does have its limitations. Sometimes, external forces that cannot be captured in the calculation of the Dividend Cushion can impact the sustainability of the dividend payment. Some of these external factors can be as complex as a transformational acquisition, to as straightforward as an unexpected guidance reduction, to as simple as a capital allocation policy change. The board sets the size of the future dividend payment, and to put it bluntly, the board can do whatever it wants–regardless of the financial statements, provided it has the capital to do so.
Let’s briefly walk through the calculation of the Dividend Cushion ratio. The Dividend Cushion ratio combines our forecasts of a company’s traditional free cash flow generation (cash flow from operations less all capital spending) over the next five years with the company’s last fiscal year net cash or net debt position. That sum is then divided by our projections of the company’s cumulative cash dividend payments over the next five years–all housed in our discounted cash flow model. The projections are driven by analyst expectations, supported by management guidance and/or the underlying trajectory of the business in the near term (and cross checked against consensus numbers). In the out-years of the model (Years 3-5), assumptions are driven by a convergence to mid-cycle expectations on the basis of a normalized analytical approach or to capture ongoing secular long-term growth, in most cases.
Though a significant number of factors are reflected in a company’s Dividend Cushion ratio via such financial assumptions, there are a number of situations that are difficult to anticipate as they often land outside the predictive nature of financial statement analysis. A recent example of this was the dividend cut we witnessed at Diebold (DBD). Diebold’s decision to cut its dividend was part of the company’s capital allocation strategy laid out in its acquisition announcement of Wincor Nixdorf. Free cash flow had weakened in recent years, and the increased leverage the firm brought on to finance the deal ended up coming at the expense of the dividend. The company financed the cash portion of the deal with funds available and the sale of senior notes. A management team’s unpredictable appetite for deal making can sometimes throw a wrench into our work, and while Quality Systems (QSII) was another instance, these situations are more the exception than the rule.
Another example came in July 2013 when Jakks Pacific (JAKK) suspended its dividend. The dividend cut came as a surprise to the market, and shares were pummeled. This sell-off was a result of a major “miss” in the firm’s reported results and a rather large downward guidance revision. In this particular example, the issue was not a problem in the Dividend Cushion ratio process, but rather in the material change in the trajectory of Jakks Pacific’s future business that management simply mis-estimated. The preferences of children had continued to move away from its more traditional leisure products and toward mobile device gaming. When management makes huge changes to its forward guidance with little warning, the Dividend Cushion ratio can be caught off guard. In Jakks’ case, management’s initial guidance was way off the mark, and this is something that’s difficult to anticipate and falls outside the construct of the Dividend Cushion. This, unfortunately, happens.
CECO Environment (CECE), an air quality and fluid handling company, is a similar example, one in which we were effectively blindsided by immediate and rapidly-changing fundamentals. CECO always had a net debt position, but we thought its capital-light operation and free cash flow generating potential would easily support the cash dividend (traditional free cash flow had been a multiple of cash dividends paid). In November 2017, however, CECO Environment reported third-quarter 2017 results that revealed operating performance had turned noticeably worse relative to our future forecasts of free cash flow. Cash flow from operations fell off a cliff during the first nine months of 2017, to a burn of $1 million (-$1 million) from $52.9 million (+$52.9 million). With good reason, the weakness prompted management to pursue an aggressive market share strategy, implement a restructuring program, and suspend the dividend. With CECO Environment, operating performance simply changed on a dime, from excellent to very, very poor. The massive sell-off in shares November 2017 spoke to the abrupt change in the fundamental, cash-flow makeup of the company.
Another instance occurred with National Oilwell Varco (NOV) in April 2016. This particular example, however, probably best falls into the category of: “the board can do what it wants.” Although National Oilwell Varco’s dividend cut had been directly related to expectations for continued pressure in the oil and gas markets, management cut its dividend significantly while it still had a solid Dividend Cushion ratio (and it still had a good one after the cut). In many ways, it should probably not have cut the dividend in the first place. That said, we can’t really fault the company for wanting to preserve cash in the then-difficult business environment, especially as year-over-year revenue trends looked extremely ominous at the time. Most companies cut their quarterly payout when the business is typically nearing a credit crunch, liquidity shortfall, or financial distress, but in case of National Oilwell Varco, things weren’t that bad, and we think management overreacted. The ratio can’t predict overcautious behavior by the board, a large unquantifiable dynamic.
Another example was Meridian Bioscience (VIVO). In January 2017, the company cut its dividend after a rather large downward reduction in its own forward-looking assumptions, which it changed relatively suddenly. Similar to the case of Jakks and CECO Environment above, for example, Meridian had just issued its guidance for 2017 in November, but just a few months later, the company abruptly cut its forecast for the entire fiscal year after only one quarter into the year. Clearly, we and the market were caught off guard, and management’s unfounded optimism in November 2016 unfortunately found its way into the Dividend Cushion ratio. Making matters worse is that the earnings revision came at an inopportune time during our update process, as the next update to Meridian’s dividend report was about to reflect the company’s net balance sheet swing from a net cash position of ~$50 million at the end of 2015 to a net debt position of ~$10 million at the end of 2016 as a result of debt-financed M&A activity (a ~$60 million swing).
The Dividend Cushion ratio construct remains predictive but sometimes nuances can catch us off guard, as in the examples in this article. Whether it be companies pursuing aggressive debt-funded acquisitions, mis-estimation by management in providing guidance, or abrupt and rapid changes in the cash-flow-generating makeup of the company, we’re not necessarily happy about any of these instances where the Dividend Cushion ratio may have come up short. Still, we wanted to put them all on the table so that you can make the best use of the Dividend Cushion ratio. Knowing areas of weakness makes the process even stronger, and that’s what we’re hoping to achieve with this piece. Importantly, please always refer to the qualitative language found throughout the dividend reports for more in-depth and nuanced opinions of the quality of dividends in our coverage universe. We continue to work to improve our processes and add as much analysis regarding the strength or weakness of a company’s dividend as possible within our research suite.
Article updated December 2017 to reflect CECO Environment example.