To figure out if a company will need to cut its dividend, start by determining the resiliency of that company’s cash flow.
So says Andrew Zimcik, a member of the fundamental equity team at Connor, Clark & Lunn Investment Management. His firm manages the Renaissance High Income Fund.
Evaluating a company’s cash flow, he adds, helps you “gauge whether or not [a] company can sustain dividend payments across the business cycle.”
Zimcik also looks at a company’s financial statements to assess its dividend outlook. “We come up with our own estimates for the payout ratio, which is to say the amount of cash a company pays in dividends as a percent of [the] cash it brings in every quarter.”
Breakdown of analysis
The energy space has been ripe with dividend cuts, says Zimcik, but one example from outside of that sector is Major Drilling. That company sells drilling services to mining companies, and “it cut its dividend by 80% in March of this year. We didn’t own the stock leading up to [that], and we still don’t own it.”
But, prior to the cut, the company was financially strong, says Zimcik. And, it still has more cash than debt on its balance sheet. However, “the outlook for the drilling industry was rapidly deteriorating.”
That was a problem, he adds, because “Major [Drilling] generates the majority of its revenue from exploration drilling. And if we look at industry-wide mining exploration drilling (which peaked in 2012 at about $22 billion), it’s now down over 50%.”
Another clue that the company was heading toward a slump was the marked decrease in its drilling rig utilization, says Zimcik. That measurement refers to “how much of its drilling fleet is being used to generate revenue at any given point in time.”
The company’s utilization rate, he notes, will typically peak at about 80%. “But it had fallen to lower than 35% before the dividend cut, with no sign of turning around.”
“We like the management team and think cutting the dividend was the right thing to do for the long-term health of the business,” says Zimcik. “[But] the shares are still down about 50%, and we’ve been glad to avoid owning them.”