Updated on April 29th, 2022 by Bob Ciura
The primary goal of dividend growth investors is to generate a rising stream of dividend income over time. With this in mind, dividend cuts are a dividend growth investor’s worst nightmare.
For this reason, we recommend investors looking for quality dividend stocks start with the Dividend Aristocrats, a group of 66 stocks in the S&P 500 Index, with 25+ consecutive years of dividend increases.
You can download the full list of all 66 Dividend Aristocrats below:
Fortunately, there are actionable steps that investors can take to reduce their chances of experiencing a dividend reduction. To understand these steps, we must first understand the motivations that cause companies to reduce their dividend payments.
In this article, we explore the three main reasons why companies cut their dividends.
Table of Contents
This article on why companies cut their dividends is divided into the following sections:
Reason #1: Business Downturn
Perhaps the most common reason why a company cuts its dividend is due to downturns in the underlying business. When a company’s earnings decline to the point where it can no longer cover its dividend, then a dividend cut becomes inevitable for its management team.
This happens more frequently during recessions and other periods of economic decline, when corporate profits typically drop as the economy contracts. A notable example of this was the coronavirus pandemic that started in early 2020. Many businesses were forced to shut down during the pandemic, which caused their revenue and earnings to fall. In turn, many companies cut their dividends during 2020-2021.
A striking example of this is The Walt Disney Company (DIS), which suspended its dividend in May 2020. The pandemic hit many of Disney’s businesses hard, especially its theme parks and resorts segments. As a result, the company posted a net loss of more than $2.8 billion in 2020. This prompted the company to suspend its dividend.
Fortunately, Disney’s profits have recovered as the economy has reopened. The company returned to a profit of nearly $2 billion in 2021. While Disney has not yet returned to paying dividends to shareholders, there is a good chance the company could reinstate its shareholder payout soon if it maintains strong profits this year.
Reason #2: Too Much Debt
Taking on too much debt is likely the second most common reason why a company chooses to reduce its dividend. When a company levers up its balance sheet, it increases the proportion of debt that is funding every dollar of assets. The obvious effect of this is to increase the company’s interest payments, but it also creates significant volatility in the company’s book value. If a company’s assets are levered up 10-to-1, then a 10% decline in the value of its assets results in a 100% drop in shareholders’ equity.
While there are many, Kinder Morgan’s 2016 dividend cut is likely the most prominent example of a debt-related dividend cut. The company reduced its annual dividend from $1.93 per share to $0.50 per share in a move that sent its share price plummeting.
At the same time, Kinder Morgan had to scramble to find additional liquidity to cover near-term liabilities, eventually securing $2 billion of additional dry powder in the form of a term loan and an extension to an existing unsecured credit line.
Looking at the company’s leverage levels leading up to the dividend cut, it is no surprise that Kinder Morgan was forced to cut its dividend. The company’s debt levels rose to remarkable heights following its 2011 IPO (note that Kinder Morgan entities had previously been publicly-traded, but this was a re-issuing of the common stock to the public markets).
These rising debt levels resulted in unsustainable debt services charges. At the height of the company’s leverage, Kinder Morgan’s net-debt-to-EBITDA ratio was a remarkable 8.38.
Another more recent example of a dividend cut caused by overleverage is the dividend reduction of L Brands. In the company’s press release announcing the dividend cut, the company stated the following:
“After extensive review, the Board of Directors plans to reduce the company’s annual ordinary dividend to $1.20 from $2.40 currently, beginning with the quarterly dividend to be paid in March 2019. The planned reduction will result in a dividend payout ratio that is more consistent with the company’s past practice, and a dividend yield in line with relevant comparisons. The approximately $325 million in cash made available from the dividend reduction will be utilized primarily to contribute to the deleveraging of the company’s balance sheet over time. The Board was assisted in its assessment by its financial advisors BridgePark Advisors and PJT Partners.”
While L Brands’ leverage was not quite as remarkable as Kinder Morgan’s (its net-debt-to-EBITDA ratio peaked at 2.5x compared to the 8.4x exhibited by Kinder Morgan), it again shows the perils of investing in dividend stocks with high amounts of balance sheet leverage.
For investors looking to avoid this type of dividend cut, implementing cutoffs with respect to leverage metrics (such as the debt-to-equity ratio or the net-debt-to-EBITDA ratio) is an excellent place to start.
Reason #3: Change in Capital Allocation Policy
The third – and perhaps most inexplicable – reason why a company would choose to reduce its dividend is due to a change in capital allocation policy.
More specifically, sometimes corporations will reduce their dividend not because they are forced to, but because they want to. This is usually because there are other places they would prefer to allocate their capital, such as:
- Share repurchases
- Debt paydown
- Capital expenditures
One recent example of this is the dividend cut of AT&T (T). The company cut its dividend despite dividend payments that were substantially less than its adjusted earnings-per-share.
However, AT&T was facing multiple problems, including a number of legacy businesses that were no longer growing, a stretched balance sheet from various acquisitions over the years, and a desire to invest in new growth areas such as 5G.
In conjunction with the company’s spin-off of its media assets, now trading independently as Warner Bros. Discovery (WBD), AT&T cut its quarterly dividend from $0.52 per share to $0.2775 per share in March 2022.
Related: AT&T-Discovery Merger & Spinoff | How Should Shareholders React?
At the time the decision was made, AT&T’s CEO had this to say about the company’s plans to redirect cash flows back into future growth initiatives:
“I’d much rather be pouring some of that cash back into the infrastructure of this business to [generate] returns at a higher level than what we pay out on the dividend. So it’s time to make that transition for this company”
While a dividend cut can be extremely frustrating for its shareholders, it is not the worst characteristic of this type of dividend cut.
Instead, the worst part of a capital allocation-related dividend cut is that it is unpredictable. In general, it is difficult for shareholders to anticipate how a company will allocate its capital moving forward unless the company provides specific guidance on allocation decisions.
One way to avoid dividend cuts is by looking for companies that have long histories of rising dividend payments. This shows that a company’s management team is shareholder-friendly and prioritizes consistently delivering cash payments to shareholders over time.
Investing in these types of companies – those with long and successful dividend growth track records – is an excellent way to avoid dividend cuts from management teams that no longer want to prioritize their dividend payments to shareholders.
Final Thoughts
As dividend growth investors, we want to minimize (or ideally eliminate) the chance that a company in our portfolio cuts its dividend. Understanding why companies choose to do this helps us to achieve this over time.
In this article, we outlined the three mains reasons why companies cut their dividend. The three reasons are:
- Business Downturn
- Overleverage
- Change in Capital Allocation Policy
Looking for companies that do not exhibit these characteristics can help you to avoid dividend cuts in your portfolio moving forward.
At Sure Dividend, we often advocate for investing in companies with a high probability of increasing their dividends each and every year.
If that strategy appeals to you, it may be useful to browse through the following databases of dividend growth stocks:
- The High Yield Dividend Aristocrats List is comprised of the 20 Dividend Aristocrats with the highest current yields.
- The Dividend Kings List is even more exclusive than the Dividend Aristocrats. It is comprised of 44 stocks with 50+ years of consecutive dividend increases.
- The Dividend Achievers List is comprised of ~350 stocks with 10+ years of consecutive dividend increases.
- The High Yield Dividend Kings List is comprised of the 20 Dividend Kings with the highest current yields.
- The Blue Chip Stocks List: stocks that qualify as Dividend Achievers, Dividend Aristocrats, and/or Dividend Kings
- The High Dividend Stocks List: stocks that appeal to investors interested in the highest yields of 5% or more.
- The Monthly Dividend Stocks List: stocks that pay dividends every month, for 12 dividend payments per year.
- The Dividend Champions List: stocks that have increased their dividends for 25+ consecutive years.
Note: Not all Dividend Champions are Dividend Aristocrats because Dividend Aristocrats have additional requirements like being in The S&P 500. - The Dividend Contenders List: 10-24 consecutive years of dividend increases.
- The Dividend Challengers List: 5-9 consecutive years of dividend increases.
