A recent
Wall Street Journalarticle pointed out a frightening
trend re-emerging on Wall Street as the credit market starts
to thaw. Unfortunately, the economically illiterate financial
engineers who brought you the last credit bubble have
apparently returned … with a vengeance.
And they've brought back with them one of the worst ideas
ever to rear its ugly head in the heat of the last credit
bubble: Borrowing to pay dividends. If ever there was a
completely avoidable mistake that far too often leads to
catastrophe, that'd be it.
Unnecessary risk
In that
Journalarticle, aircraft-parts manufacturer
TransDigm (NYSE: TDG) was called out for
borrowing $425 million, $360 million of which will be paid as
a special dividend. That act of financial engineering brought
with it a debt downgrade at Moody's to the junk rating "B3."
So not only is the company engaged in the
extremelycyclical business of making aircraft parts,
but it's potentially putting itself in long-term financial
peril to make a one-time payout.
Perhaps it hasn't learned the lessons of leveraged
failures like Cerberus' debt-fueled buyout of Chrysler, or
the bankruptcy that Dex Media went through after borrowing to
pay a dividend to its private-equity owners.
A better way to pay dividends
Don't get me wrong. Well-designed dividends are
fantastic. Throughout this economic meltdown, I've used
changes in companies' payouts as
signals of their true financial health. Likewise, the
payments themselves have provided
important ballast against a stagnant economy. But for a
dividend to be a positive for a company and its investors, it
needs to have the following characteristics:
1. It needs to be paid out of operating cash
flow. When a company borrows to pay a dividend, it's
clearly not sustainable, as bondholders will soon tire of
taking on excessive risks to reward stockholders. However, a
dividend that's paid from operating cash flow has a much
higher chance of continuing as long as that business can
operate profitably.
2. It should let the company retain
financial flexibility. By borrowing to pay a
dividend, a company obligates itself to
long-terminterest coupon payments and eventual
principal repayment (or refinancing), for the sake of a
single payment. Those coupon payments increase the burden a
company must clear to earn a profit every year, and the debt
itself reduces a company's ability to borrow cash to expand
its business. Contrast that to a dividend paid out of
operating earnings, which carries with it no such long-term
liability.
3. It ought to drive shareholder-friendly
management behaviors. When a company gets serious
about its dividend, it starts structuring its operations
around ensuring its dividends can continue to be paid
for the long haul. That requires the company to
prioritize:
andoperate the business.
A few names
Here are just a few companies that have consistently
raised their dividends over time, and have done so again
without taking on extra debt:
Company
Year-Over-Year
Dividend Growth
Payout Ratio
Reduction in Debt, Most Recent 10-K vs. Prior-Year
10-K
(in Millions)
Cash From Operations / Net Income Ratio
Exxon Mobil (NYSE: XOM)
12%
26%
$141
1.16
Abbot Laboratories (NYSE: ABT)
11%
43%
$675
1.25
Lowe's (NYSE: LOW)
 6%
27%
$620
2.11
Archer Daniels Midland (NYSE:
ADM)
10% Continued... |