More companies will cut their dividends in coming months. Don't be a victim!
With savings rates at such low levels, the attraction of dividends has never been higher. There are plenty of companies on the stock market with apparent dividend yields many times higher than even the very best savings accounts. But are these yields too good to be true?
For some companies they certainly are. In the last few weeks a number of high profile companies have announced significant cuts to their dividends. Many of these are not small, unknown companies, but the big, blue-chip beasts of the stock market. Rumours in the stock market are that there are more dividend cuts to come.
So how do investors avoid falling into the trap of buying apparently high yielding companies which then cut their dividends?
What are dividends?
It may seem a strange question to be asking but one which is crucial to an understanding of the current situation. Every company is initially set up with capital from its original shareholders. The capital is then used by the business to generate profits. Directors can either keep these profits in the business, and add them to the capital base of the company, or pay some or all of them out to shareholders as dividends. It's largely down to their discretion and the needs of the business.
So why do companies end up cutting their dividends?
Debt is a dividend killer
Most businesses are funded by a mixture of capital (money provided initially by shareholders and the profits they add to it) and bank debt. One impact of the credit crunch is that banks have become much less amenable to providing high levels of borrowing. If companies are going to get less of their funding from banks then they are going to have to increase the amount of funding from capital. One obvious way to do this is to stop paying it out as dividends.
It's a lesson not lost on BT (LSE: BT-A) shareholders. With borrowings rising to £10.4 billion in its last accounts, its annual dividend cost of £1.2 billion became just too much for it. As a result BT slashed its final dividend by nearly 90%.
The Hidden Debt in Pensions
A couple of years ago I wrote an article called "Are you investing in a company or a pension fund?"
It looks like the investors in Dairy Crest (LSE: DCG) have just found out. They probably don't like the answer.
Although Dairy Crest had a net pension fund surplus of £31.6 million at the end of last year, pension fund liabilities amounted to a whopping £653 million. That's was significantly more than Dairy Crest's net assets of £388 million. With pension fund investments hit this year by stock market falls, the fund swung into a deficit of £63.3 million. As a result Dairy Crest appears to have had little choice but to 'rebase' its dividends downwards by 25 per cent.
For companies with final salary pension schemes, it's not just the level of underfunding which is important to consider, but the absolute level of pension fund liabilities to which they are exposed.
Profit downturns
As outlined earlier, dividend payments are largely discretionary. However whilst companies can cut their dividends, they can't just cut their interest payments. Inevitably therefore companies with high levels of debt are more vulnerable to dividend cuts when they experience a stumble or downturn in trading.
Marks & Spencer (LSE: MKS) recently announced a 29 per cent fall in underlying operating profits. However due to the impact of rising interest charges this was magnified into a 36 per cent fall in underlying earnings per share to 28.0p. With no sign of improvement in retail markets, and debts of £2.5 billion Marks & Spencer's annual dividend payment of 22.5p finally became unsustainable. It has been rebased down by a third.
British Airways (LSE: BAY) similarly found that its exposure to higher oil prices and a deterioration in its core markets pushed it into a loss of 32.6p a share. With net borrowings escalating to £2.4 billion, British Airways was unable to afford any dividend at all.
Growing companies also need money
However it's not just struggling businesses which are vulnerable to dividend cuts.
Growing companies need more and more funding. They need it for extra working capital and for the additional investment in infrastructure they must have to support their larger operations. When bank debt was plentiful it was easy to borrow that funding. That's recently become much harder. Consequently growing companies are facing having to find more of the funding from their own resources and that means paying out less of their profit as dividends.
Although growing waste management company Shanks Group (LSE: SKS) recently announced a 16 per cent increase in operating profits, debt was also up to £424 million. The results were accompanied with details of a rights issue and cancellation of the final dividend.
Dividends are paid in cash. It doesn't matter how much profit a company makes, if it doesn't have the available cash, it can't pay the dividends.
More from Steve Scott:
Thankfully Steve holds no shares in the aforementioned companies.
