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The Case for Cutting The Dividend

Alex Morris

Alex Morris

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“Do you know the only thing that gives me pleasure? It's to see my dividends coming in.” John D Rockefeller had it spot on; nothing beats that feeling every three months when you log on to your brokerage account and your cash balance has magically increased. Unfortunately, much like with stock buybacks (which are more often than not made at highs rather than lows), management has a tendency to make questionable dividend decisions when the economy heads south. Once they start paying money to shareholders consistently, investors don’t take too kindly to dividend cuts (as reflected in the stock price upon the announcement). And as nice as constant quarterly dividends are, for some businesses (read: cyclical and/or growth) this is an illogical strategy (unfortunately, not all businesses have the resilience of a Coca-Cola or a PepsiCo). When times turn sour, money needs to be either held on the balance sheet to meet future needs (the case for a dividend can be made for a business with a fortress balance sheet like JNJ or MSFT), or reinvested to grab market share while weaker competitors are struggling to stay in business.

A great example is Dicks Sporting Goods (DKS). In October 2009, a competitor in the northwest United States named Joe’s (formerly G.I. Joe’s) went under. Dick’s was quick on the draw, and immediately laid out plans to speed expansion in the region. The plans called for 18 stores in Washington (1 at the time), six stores in Idaho (1 at the time), five in Montana (0 at the time), and an astounding 94 total stores in California (15 at the time). The funny thing is that in this same year, they lost nearly $40 million; they were struggling just like competitors were. But short term setbacks are not an issue as long as the finances are setup in preparation for what lies ahead. For Dick’s, the future is still full of profitable growth opportunities, which means a dividend, no matter how modest, does not make sense for long term investors (the group management is supposed to represent); this money is better spent by reinvesting in future growth. By holding off on a dividend, management was able to continue expanding at an opportune time while most competitors were either hoarding cash or struggling to stay afloat. In 2010, they are back to solid profitability; the balance sheet looks good as well, with the cash position alone covering total debt. This is an example of effective capital management and driving long term shareholder value.

Now let’s look at the other side of the coin. Callaway Golf was plugging along nicely in 2006; for the year they pulled in more than $23 million in net income, and the stock was trading for the majority of the year in a range between $13-15/share. At the time, the company derived 44% of their sales outside the United States (up from 42% in 2004), and had a clear path for growth considering the struggles that were being seen by the decline in U.S. players. On top of that, the company had spent roughly $30 million on R&D each of the past five years, which is a necessary expenditure in a highly competitive industry. Based on these assumptions, the company had two reasonable routes to take looking ahead (5-10 years out): either reinvest in the international business with excess funds, or set the money aside for a rainy day. Instead, the company decided to pay $0.28/share in dividends for the year, at a cost of $19.212 million. Fair enough; management had paid the dividend in the years prior, and will almost always avoid cutting the dividend unless their hand is forced.

Fast forward to 2009; after a strong year in 2008 ($66.18 million in net income), the company hit a rough patch. The global recession was in full swing and the consumer was nowhere to be found, especially for new golf equipment. Naturally, management can’t be blamed for the struggles of the industry. However, Callaway was forced to issue preferred shares in June 2009 in order to remain in compliance with financial covenants. Six bad months was all it took, suggesting that the balance sheet was not effectively managed and that prior dividend payments should have been retained by the company. That same month, management was forced to do the inevitable; the dividend was finally cut. At this time, the stock was trading right around $5/share, a 66% dive from where it had been three long years ago. All the dividend payments that shareholders had pulled in were washed away, along with much, much more.

But management didn’t learn the lesson and cut the dividend for the time being. Instead, management kept (and continues to) paying dividends to investors: at a penny per share. Today, management is required to pay more than $10 million a year on preferred shares, and willingly pays an additional $2.5 million to common stock holders. This is while Callaway continues to bleed cash through their core business and competitors are increasing investment in international operations in preparation for the growth that will likely surface from the addition of the sport to the Olympics starting in 2016. As an investor in Callaway, I feel that management is forfeiting an opportunity to build (and maintain) the long term value of the business in order to say “we still pay a dividend”. Considering management’s goal of building long term shareholder value, it baffles me that they think the best idea based on the current economic environment is to pay investor a paltry 0.49% dividend yield per annum.

About the author:

Alex Morris
I am a recent graduate from the University of Florida; I received a finance degree as well as a real estate minor during my time at UF. I will be sitting for Level 1 of the CFA Exam in December 2011, as well as for my series 65 exam. I am a value investor, plain and simple.

Rating: 3.9/5 (18 votes)

Comments

donli
Donli premium member - 3 years ago


Makes sense. I remember there was an article by Jason Zweig, saying that Washington Mutual was paying a lot of dividends 1 year before the crash, it was fatal.
Alex Morris
Alex Morris - 3 years ago
Thanks for the comment Donli. As noted, simply paying a dividend is not a sign of strength; investors must check that it is in shareholders best interests to be doing so.

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