We had our first encounter ever with a dividend freeze within our portfolio. I know, It’s not so bad though, imagine they would have cut their dividend… We never actually thought about what we would do if and when such a thing would happen. Although it’s very common and could basically happen anytime with any stock, it can also catch you by surprise.
We buy shares of companies that pay AND grow their dividends. Because of this, we can make use of the beautiful magic of compounding. Over (a long) time, the growth will accelerate our cash flow from dividends and our yield on cost will steadily increase.
I decided to check up on the why of the company in this particular case, and research how dividend cuts affected companies in the past. Hopefully, it will give us some insight into how to make decisions based on a cut and if it’s all that bad at all?
The background story
We invested a bit of money in shares of a company called TKH. A Dutch mid-cap tire manufacturer based in the Netherlands. Or better yet, a machine manufacturer for tire manufacturers. They also do some other stuff with Innovative Telecom and Building & Industrial Solutions. [http://www.tkhgroup.com/nl] They pay out a yearly dividend of 1.10 euro per share, have a 2.9% dividend yield and a 49.2% payout ratio. So far, so good.
A few weeks ago, they announced their first quarterly results of 2017. After which the stock prices immediately went up with 5% in only 1 day. Their dividend remained the same for this year. No increase, no nothing, not even a minor 0.1 percent. Just the same amount it was last year.
If you are a dividend growth investor and have a company in your portfolio which doesn’t grow their dividend…. Well, that’s not something that fit’s the bill.
Continuous growth of dividends is a fundamental part of this strategy and to preserve income power in the long term. Especially companies that grow their dividends at a faster rate than inflation are interesting to own.
We track our dividend income monthly (link to dividend page), and it’s awesome to see how much of an impact dividend increases can have on growing your passive income stream. Except when there is none, what should you do?
One option is to sell the shares. But to ONLY think about the dividend growth or their lack of it, might set you on the wrong path. So I decided to look a bit further in this particular case. Most of the times when investor research companies, they look for reasons to buy. So, I started digging for ‘the bad things’, or reasons why we should SELL our shares instead. First off, why the dividend freeze in the first place?
Figure out the why
The announcement of the company was that they decided to hold off a dividend increase for now. In their quarterly report, it was clear that the company results were pretty decent. And after some years of struggle and uncertainty, this was a big relief to many investors. Although their fourth quarter results were very good, it didn’t help in the overall results of 2016. The turnover over that year was still not on the levels that were expected. And their struggle in keeping the sales afloat is still present.
They suffer from a lower order intake in 2016, mainly derived from China. But is increasing in recent months. They also have been investing in R&D in order to sustain future growth in horizontal markets.
Additional, their dividend policy says the following:
A healthy balance sheet is of great significance with respect to the continuity of our company. Considerations when it comes to determining the dividend to be paid out include how much profit the company must retain in order to realize medium-term plans, bearing in mind a solvability of at least 35%. On the basis of the growth objectives for the coming years, a payout between 40% and 70% will be the objective.
So, it looks like a new dividend increase would have hurt their solvability, or it would exceed the payout ratio range that is preferred? Maybe even both. The good thing is that the turnover looked positive in the last quarter, and the expectations are higher for the quarters still to come. They keep on pumping cash into the company to further develop their current products and create new business opportunities.
One thing is sure. If they would have increased the dividend, there would be less capital to realize medium-term plans. They choose to invest in the company itself over growing the investors return. Which could be a very wise decision to make. But may also lead to the expectation of a higher capital appreciation. We’ll have to see if they can live up to that.
Looking for other bad signs
When checking out for other signs that might scare off an investor. Two things really stand out in the story of TKH, and those are the political developments in China and the lower oil price. Both are a reason why they struggle to attract investments within certain markets. These are also the reason why they decided to increase their investment in Research & Development and conduct a more aggressive growth plan. The expectation is that in 2017, the negative sentiment will be turned around and from 2018 the growth will also be materialized. It will take some time to see those results actually happen. And of course, if markets keep on stagnating and macroeconomic elements will influence their business, anything can still happen. At least they are preparing to keep on innovating and adjust to market circumstances.
The reluctance for investment in the oil and gas industry will probably maintain for a few years. And in some marketing (optical fiber) scarcity will decrease, and therefore their margin will be put under pressure.
Their revenue has been growing every single year. Although it’s been growing less rapidly. Their 10-year average growth rate in revenue has been 9.6%, their year on year growth was 2.07%. This has also set pressure on their earnings per share (current: -3.29). Although not yet really alarming, their investments should better pay off.
Reevaluate our reasons
TKH is a Dutch company so it would mean diversification on a regional basis. Besides, it’s a mid cap company and isn’t trading on the AEX, but on the AMX. We expected that in this particular sector a mid-cap company with a solid moat could have an advantage over competitors and therefore a possible higher growth rate in terms of revenue. On the long term that is. It’s obvious that they can’t sustain the growth rate anymore which we were expecting. The good thing about this is that the reasons behind this are mostly macroeconomic and therefore not conflicting their management or fundamental business.
Effects of dividend cuts in the market
The biggest worry of a dividend investor is a firm dividend cut. The year 2009 was a record year for companies to cut their dividend, 41 within the S&P 500 decided to do so, but in total there were 527 companies that slashed at their precious dividends. Interestingly enough, 2015 poised again to be a year with a high number of dividends cuts. Investors saw their dividend income being swindled by a total of 394 cuts that year alone.
There is a bit of a stigma on cutting a dividend. With all the challengers, competitors and champions in the investing markets, when companies decide to cut it, all hell brakes loose. Every company that builds up a solid relation with its investors by returning a positive cash flow, will always try to keep their dividend growing as long as possible. Because otherwise, the investor might walk away. Within Europe, and especially the Netherlands, there is far less focus on quarterly dividends than in the US of A. But, it’s still important to many investors to get a steady income stream derived from their shares. This is also one of the reasons why we have a high allocation in the US, besides EU stocks.
The most well-known effect of a dividend cut is its effect on the share price. In 9 out of 10 times, the share price will firmly decline. Investors will lose trust in the company, cutting dividends is seen as a weakening financial position for the company. Because if a company no longer has the financial aids to keep it’s dividend afloat… It will have trouble with growing revenue and profit altogether. What’s the first thing you think when a company announces a dividend cut? Bet it is something negative related to the performance of the company.
In 2016 there were a few big names in the investment world that cut their dividends. Two of them were Kinder Morgan and BHP Billiton. In February of 2016 Kinder Morgen decided to cuts it’s dividend with -75% from 0.51 to 0.125 dollar. Ouch. Whereas the dividend of BHP was still 0.62 cents and they reduced it first to 0.16% (a cut of -74%) and later on even to 0.14%.
The dividend of Kinder Morgan is still at the same price point, there hasn’t been any movement. However, BHP decided to increase their dividend again. Their current dividend payout is now 0.40 dollar, which means that they have increased it by +85%. They’re not at the same point as it was before, but you wouldn’t have lost too much either.
Kinder Morgan, as a pipeline company, had troubles to maintain a growing revenue because of the low oil prices and the pressure of a massive debt they would have to pay off. The oil prices haven’t really recovered fully yet, so as long as that lingers Kinder Morgan will be facing the same difficulties.
BHP Billiton operates in a volatile market. The world leading mining company faced a terrible reduction in net profit, partially because of oversupply but mainly because of one-time impairment charges. Which is why they cut their dividend as well. But because demand is constantly moving, and the write-offs of that year were a one time only, it was easier to get back on track again for BHP, and therefore to increase their dividend in 2017.
Looking back it’s very important to check why a company freezes or even cut, their dividend. Is it for a good reason and possibly future growth, or is the company lacking in performance overall? It could be a wise decision of the management to choose the companies growth over your cash flows growth. To choose for innovation and product development over investor satisfaction. Because when you invest for the long run, the company you choose to invest in better have the potential to always be a step ahead and still be there, steady and strong, over 20 years from now.