Our Dividend Methodology Is Rocking!
publication date: Feb 17, 2014
author/source: Brian Nelson, CFA
· The Valuentum Dividend Cushion is a helpful tool to predict future dividend cuts and assess the growth potential of a company’s dividend.
o Since development, the Valuentum Dividend Cushion has predicted the dividend cuts of the following firms in real-time (i.e. Valuentum members were well aware of the significant risk to these firms’ dividends before they slashed them): SuperValu (SVU), Roundy’s (RNDY), Dover Downs (DDE), Strayer (STRA), Exelon (EXC), Cliffs Natural (CLF), Pitney Bowes (PBI), and CenturyLink (CTL), among others (ACI, WTW, JCP, etc).
o The Valuentum Dividend Cushion is designed to provide the income investor with a trusted opinion of the safety and future growth potential of a firm’s dividend. It not only predicts dividend cuts, but the ‘cushion’ behind the Valuentum Dividend Cushion reveals just how much capacity a firm has to continue growing its dividend in the future.
o The foundation behind the measure—assessing cash flows relative to dividend payments in the context of a firm’s balance sheet—remains as relevant as ever. The metric cannot be found anywhere else but at Valuentum—other research firms do not have future forecasts of free cash flow like we do.
o The Valuentum Dividend Cushion score is found within each firm’s Dividend Report. We update our Dividend Reports on firms regularly, and we encourage members to check the Dividend Cushion scores on their income investments at least quarterly (in accordance with our update cycle).
Predicting Dividend Cuts
What do these companies have in common? The Valuentum Dividend Cushion, our dividend growth methodology, highlighted them as having significant dividend risk in advance of their respective dividend cuts.
Valuentum members are well-aware of the significant statistical backtesting we’ve performed to develop the Valuentum Dividend Cushion (click here), a ratio that compares a firm’s future free cash flow generation to its future expected dividends after considering its capital structure.
Thus far, the Valuentum Dividend Cushion's track record has been near perfect—and we don’t say that lightly. The measure has highlighted dividend cuts in real time, in advance, and for all to see. Absent "misleading" management teams in the case of JAKKS Pacific (JAKK) and deliberate moves to not support the distribution in the case of Boardwalk Pipeline (BWP)--two very unusual cases--the Valuentum Dividend Cushion hasn’t missed identifying the risk related to a dividend cut within our 1,000+ company coverage universe yet, and it even picked up the risk associated with steady-eddy utility firm, Exelon.
Income investors know that a dividend cut could be disastrous to their portfolio, as future income is not only reduced, but it is also very likely that capital is permanently impaired. The Valuentum Dividend Cushion 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 predicts dividend cuts, but the ‘cushion’ behind the Valuentum Dividend Cushion reveals just how much capacity a firm has to continue growing its dividend into the future.
Technically speaking, the Valuentum Dividend Cushion score 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. At its core, it tells investors whether the firm has enough cash to pay out its dividends in the future, while considering its debt load. If a firm has a Valuentum Dividend Cushion above 1, it can cover its dividend, but if it falls below 1, trouble may be on the horizon.
The Valuentum Dividend Cushion score is found within each firm’s Dividend Report. We update our Dividend Reports on firms regularly, and we encourage members to check the Dividend Cushion scores on their income investments at least quarterly (in accordance with our update cycle).
Is the Valuentum Dividend Cushion Still Relevant?
When we were developing the Valuentum Dividend Cushion, we scoured our stock universe for firms that cut their dividends in the past to uncover the major drivers behind the dividend cut. Back then, this is what we found out: The major reasons why firms cut their dividend had to do with preserving cash in the midst of a secular or cyclical downturn in demand for their products/services or when faced with excessive leverage (how much debt they held on their respective balance sheets). Fundamental weakness often exacerbates financial (balance sheet) weakness, hurting cash available for dividends. The Valuentum Dividend Cushion highlighted significant risk related to the dividend in the following examples.
Let’s now walk through the examples above on an individual basis so that members can get familiar with the qualities and Valuentum Dividend Cushion scores of companies at risk of a dividend cut. Having an understanding of some common characteristics of those that have cut their dividend in the past may help you avoid a potential disappointment in your own portfolio in the future. The more you know, the more equipped you are to make the best decision.
Example #1: SuperValu (SVU): “A case of too much debt”
From our analyst note, dated July 12, 2012: “As we predicted several months ago, grocer SuperValu (SVU) announced on Wednesday that it will suspend its dividend in an effort to better allocate capital and start to reduce its enormous debt load. The company also reported that it plans to replace its current senior credit facility with one that will be backed by the company’s assets, thus allowing for increased flexibility and less stringent financial covenants. We applaud both moves as efforts to deleverage the firm’s balance sheet and ensure the firm’s long-term survival. The Valuentum Dividend Cushion predicted the dividend cut months ago (click here to read our warning about the imminent cut in an article we published in late March).”
Example #2: Roundy’s (RNDY): “Another case of too much debt”
From Roundy’s third-quarter 2012 press release, dated November 8, 2012: “Recognizing that the economy and competitive environment are likely to remain challenging into fiscal 2013, we are reducing our quarterly dividend to strengthen our balance sheet and increase our financial flexibility. We believe that it is in the best long-term interest of our shareholders as it will enable us to continue to invest in the business and expand our growth banner, Mariano’s, in the Chicago market, as well as provide cash flow to pay down debt.
Example #3: Dover Downs (DDE): “Facing declining demand”
From Dover Downs’ fourth-quarter 2012 press release, dated January 24, 2013: “Gaming revenue fell 21.4%...as a result of increased competition in the region…Gaming expansion in Maryland and Pennsylvania continues to depress gaming revenues in Delaware…Given the competitive environment and recent financial results, the Company’s Board of Directors has suspended the quarterly dividend.”
Example #4: Strayer (STRA): “Another case of declining demand”
From Strayer’s third-quarter 2012 press release, dated November 9, 2012: “Revenues for the three months ended September 30, 2012 decreased 9% to $124.3 million… Income from operations was $7.8 million compared to $24.4 million for the same period in 2011, a decrease of 68%... Net income was $4.1 million compared to $13.9 million for the same period in 2011, a decrease of 71%...The Company announced today that its Board of Directors declared a regular, quarterly cash dividend of $1.00 per share to be paid on December 10, 2012 to shareholders of record as of November 26, 2012. The Company also announced that it does not currently intend to pay a regular quarterly dividend in 2013.”
Image Sources: Strayer
Example #5: Exelon (EXC): “Concern over balance sheet, leverage”
From our analyst note, released February 8, 2013: “In its fourth-quarter earnings presentation slide deck, Exelon (EXC) announced that it would slash its quarterly dividend payout to $0.31 per share (was $0.525 per share) beginning in the second quarter of 2013 (see image below). Valuentum members were well aware of the risks of the dividend cut long before it became apparent to the market. Our July 2012 dividend report on Exelon revealed a 0.3 Dividend Cushion score, and our October 2012 dividend report revealed a -0.1 Dividend Cushion score. Any Dividend Cushion score below 1 indicates that there is significant risk with respect to the long-term sustainability of a company's dividend.”
Image Source: Exelon
Example #6: Cliffs Natural (CLF): “Declining demand and weak free cash flow”
From our analyst note, released February 13, 2013: "After we predicted a dividend cut in November 2012, Cliffs Natural Resources (click ticker for report: CLF) finally cut its dividend after posting poor results for 2012. The firm slashed its quarterly payout 76% to $0.15 per share.
Results for Cliffs were actually a bit better than consensus estimates on both the revenue and earnings side. Total revenue declined 4% year-over-year to $1.5 billion, while earnings dipped 59% year-over-year to $0.62 per share (after adjusting for a $1 billion goodwill impairment). Free cash flow for the year was incredibly weak, falling to a negative $613 million, explaining why the dividend needed to be cut. If we only took into account the payout ratio, Cliffs’ adjusted earnings per share of $3.45 for 2012 would seem to give the dividend ample cushion (its prior annual dividend payout was $2.50 per share, an adjusted payout ratio of 72.5%). However, Cliffs is a perfect example of the significant and potential tragic pitfalls of using the payout ratio as a measure of dividend safety and why the Valuentum Dividend Cushion is one of the most important metrics for income investors to use to safeguard their portfolios from dividend-growth blow-ups."
Example #7: Pitney Bowes (PBI): “Another case of leverage”
From Pitney Bowes’ press release, dated April 30, 2013: “In connection with the ongoing management of the Company’s capital structure, The Board of Directors of Pitney Bowes Inc. (NYSE: PBI) approved a reduced second quarter dividend of 18.75 cents per share for the Company’s common stock. The quarterly cash dividend is payable June 12, 2013, to stockholders of record on May 10, 2013. This action will provide the Company the added financial flexibility to invest in its business and enhance its capital structure, while continuing to provide a very competitive return to shareholders.”
Example #8: CenturyLink (CTL): “Yet another case of too much debt.”
From CenturyLink’s press release (link no longer valid), dated February 13, 2013: “In connection with the new repurchase program, the board also indicated its intention to revise the company's quarterly dividend rate to $0.54 from $0.725 per share. The board expects to approve this new rate at its next regularly-scheduled meeting on February 26, 2013, with the change effective with the March 2013 quarterly dividend payment. CenturyLink also expects to utilize a portion of its free cash flow generated in 2013 and 2014 to repay debt and maintain leverage at less than 3.0 times EBITDA (earnings before interest, taxes, depreciation and amortization).”
The Valuentum Dividend Cushion Is a Valuable Dividend Investing Tool
Income investors have a lot to analyze, but nothing comes close to the effectiveness and simplicity of the Valuentum Dividend Cushion. Though "misleading" management guidance and deliberate moves (by management or a partner) to not support the dividend fall outside the realm of the Valuentum Dividend Cushion's effectiveness, the foundation behind the measure—assessing cash flows relative to dividend payments in the context of a firm’s balance sheet—remains as relevant as ever. The up-to-date metric cannot be found anywhere else—other research firms simply do not have future forecasts of free cash flow like we do. To stay on top of firms at risk of a dividend cut, please be sure to subscribe to Valuentum’s website and Dividend Growth Newsletter.