Merck has consistently paid the same amount in aggregate dividends to shareholders for more than a decade (over $5 billion).
Corporate Finance Topics
Dividend Payouts: Suspend or Keep Going?
In corporate finance there is the common notion that once you start paying dividends, you've got to keep them going.
Even in the early days of the pandemic a year ago, companies knew the going would get rough; revenues will disappear and cash flows would decline. But they still contemplated scenarios of being able to maintain some level of equity payouts.
To cut them or suspend would send a sour signal to the market place. Company CEOs and board members, of course, are judged (almost too often?) by share value. Cutting or suspending the dividend because the company is headed into a downturn (just like 2020) or wants to redeploy the cash more prudently inside the company could send the stock price swirling downward.
Tampering with the dividend payout is not an easy financial move--even when the company needs to retain cash in current times (2020 heading into 2021). Equity investors have expectations about company performance, but they also have expectations about dividend payouts. Many will have bought the shares primarily because of a predictable payment.
Many large U.S. companies maintain the pattern: Pay about the same amount in total in dividends every year, but repurchase shares to show a higher dividend payout rate (per share).
Merck is a good example. It has paid out at least $5.1 billion in annual dividends the past seven years. In the years to come, it will likely continue to pay out at similar levels. Over that period, it has bought back stock at amounts of at least $3 billion a year. In fact, over the past five years, over $45 billion in cash has exited the balance sheet to take care of shareholders.
(In a recent analysis, Forbes wrote, "Few industries offer up safer dividends than pharma stocks." Market analysts try to predict companies and industries where there may be cuts or growth, based in part of operating cash flows and cash reserves on the balance sheet. Merck pays a 3.5% dividend yield today, a rate that has increased partly because of stock buybacks and its ability to ensure the $5.1 absolute payouts above.)
Or perhaps the goal is to increase the dividend steadily from year to year, as long as the company is profitable and stable and even if the company is not growing and expanding significantly (at least based on top-line revenues). PepsiCo is a good example. Its dividend payout has increased from $3.1-$5.3 billion over the past nine years, all while buying back shares. Hence, rewards have increased absolutely and based on payout rates (dividend amount per share). The increased dividend rate, for sure, makes the stock attractive to large swaths of investors who might otherwise be turned off the lack of top-line revenue growth.
In 2021, let's examine Exxon Mobil. For its fiscal year 2020, the company will report a 30% decline in revenues, much of that blamed on declining demand and falling prices during the pandemic year. (The company has also been reluctant to move rapidly into "green" projects--sustainable and renewable energy.) It will report a staggering loss of $22 billion, as it couldn't reduce operating costs as quickly while revenues spiraled downward.
Yet in 2021, it will hustle to pay a promised dividend to shareholders this quarter, resulting in a dividend yield of about 6% and providing comfort to dividend-seeking shareholders who might otherwise have wanted to sell the stock. (The company's share price has actually increased steadily since Oct., 2020.)
Dividends, in theory, are a reward for outstanding performance, a payment to equity investors who take risks and look for current and long-term rewards. Corporate financial managers try to decide whether the cash is better paid out as reward or better to retain for reinvestment within the company in a promise to reward shareholders even better in the future.
Shareholder activists, of course, may have a different agenda, a different interpretation of the role of corporate managers, and an expectation that some of that reward should come now.
When equity investors see the signal from a suspension or cut in payout, values plummet (a) because investors sense future cash flows and performance can't sustain the same payout and/or (b) because the move encourages investors to sell shares, the same investors who purchased the shares primarily because of the dividends.
Some notable and reasonably strong companies have dared not to go down that pathway for now (e.g., Netflix and Amazon), if only to manage expectations of the marketplace.
In 2020, some companies had no choice but to cut or suspend. As CoVid swamped the country and globe, corporate earnings began to decline quickly. With uncertainty ahead, with a recession appearing like an avalanche, and as companies wrestled with operating costs and disappearing markets, suspending the dividend is the right next step.
(U.S. banks, when the pandemic commenced, peeked at potential loan losses, surveyed the scene, and proceeded to schedule dividend payouts, knowing the Federal Reserve was deliberating whether to force banks to cut or eliminated them. The Federal Reserve guided banks immediately by permitting them to pay out anything already declared and allowed U.S. banks to pay dividends, but not increase them. Mid-year stress tests assured them banks had sufficient capital to withstand upcoming losses.)
Some market analysts might ask whether a dividend cut or suspension could lead the company to take advantage of depressed stock prices to repurchase under-valued shares at lower prices. Would company financial managers dare plan a dividend cut, knowing it could depress stock prices, but give them an opportunity to consider cheap buy-backs? Hence, the plan would tolerate an initial drop in price with hopes that the repurchases would vault share price much higher later.
Yes, the company would buy back shares at a lower price (a) because the values are trading too cheaply and (b) because the repurchases can prop up value again. To do so, of course, means they will have had resources (cash reserves) to do the buybacks.
There are problems with this approach, beyond investors and the market finding out company managers are playing a financial game to boost shares over a longer term. The problem is centered about the communication or possible deception of the plan, not the legality of it. The company would be better off announcing up front it will use cash reserves to buy back shares instead of paying the dividend. Shareholders are more comfortable understanding company strategy instead of being fooled by it.
Often many have bought the stock because of the dividend and/or because they expect the dividend payout rate to remain the same or increase over time. (A subsequent buy-back might lead to an increase in share value, but it wouldn't appease those who still covet the quarterly cash payout.)
But most ongoing companies, however, don't hope for or plan for stock values to decline--even for a temporary juncture to allow for a cheap buy-back. So it's not a scenario (the scenario of cutting dividends to buy back shares cheaply) they wish for or would likely pursue..
Many companies, too, must respond to activist shareholders who become detectives to figure out such financial engineering or who might have a very different agenda for how to boost share price. (Activist shareholders, ironically, are often accused of pushing for financial-engineering maneuvers to boost share values.)
But most ongoing companies, however, don't hope for or plan for stock values to decline--even for a temporary juncture to allow for a cheap buy-back. So it's not a scenario (the scenario of cutting dividends to buy back shares cheaply) they wish for or would likely pursue..
Many companies, too, must respond to activist shareholders who become detectives to figure out such financial engineering or who might have a very different agenda for how to boost share price. (Activist shareholders, ironically, are often accused of pushing for financial-engineering maneuvers to boost share values.)
In uncertain or tough times, such as 2020, the company, too, can cut the dividend or suspend it to concentrate on using the same cash to pay down debt, to offset operation cash-flow deficits, or to redeploy for capital expenditures. All likely more prudent and better use of cash in a downturn. Companies suspend the dividend and focus on reducing debt and improving performance, and then resume it when profits return. That happens often.
During a downturn, for smaller or non-investment-grade borrowers, bank lenders will have had financial covenants in place that might have forced companies to reduce or suspend dividends to ensure they are able to meet debt requirements (ongoing principal and interest payments) comfortably.
In loan negotiations with companies that lack bargaining power, the lender may attempt to include a financial covenant that requires the company to cut the dividend if it doesn't meet certain performance targets (operating cash flow, revenue growth, cash reserves, debt ratios, e.g.) or if its credit rating (S&P, e.g.) falls a notch or two. That is an objective tactic to get the company to focus on what banks deem to be higher priorities--servicing debt instead of rewarding shareholders.
Working Capital: How Much to Fund, How Long to Fund
No matter the size of an operating company or even the industry in which it operates, company financial managers (from the CFO to the treasurer and downward) seek to determine the amount of funding necessary to support ongoing operations.
This is normally referred to as working-capital funding. What amounts in funding (from bank loans, other debt or cash reserves) are necessary to support the daily business, or namely current levels of inventory and receivables?
Conventionally the company will have bank credit lines or access to other forms of short-term debt (commercial paper, e.g.) as standby arrangements if and when necessary.
But starting from scratch, the company can work with its bankers to determine more precisely the amount of funding necessary (at different points of a year, adjusting for seasons) and the tenor of the funding requirement. A financial goal could be to reduce the funding costs associated with ongoing operations (the day-to-day activities, rather than capital investments) as much as possible and borrow only when it must.
Bank and debt analysts also estimate what those ongoing funding requirements will be. They, too, are aware that as a company evolves (or grows), its working-capital funding requirements can change. A growing company will likely have increasing amounts of inventory and receivables that will require higher amounts of working-capital funding.
In that respect, analysts will measure working capital needs based on WC/Revenues ratios. They expect the ratio to remain constant, but a constant ratio suggests revenue growth will require concommitant working-capital-funding increases.
More technically, in the analysis of operations and working capital, analysts and corporate-finance managers focus on net working capital, which directs attention to inventory, receivables, payables and expenses (or "NWC = (Inventory + Accounts Receivable) - (Accounts Payable + Accrued Expenses).
A quick calculation results in a fairly good estimate of the company's short-term funding requirement. But the company will also seek to determine how long the funding is necessary, or the tenor. It doesn't help if a company requires $50 million in funding for 180 days, but banks only offer it for 90 days.
Financial analysts, as a result, determine "days on hand" (DOH)--an estimate of the length of time inventory and receivables remain on the books and length of time before suppliers and expenses must be paid.
(The conventional way of estimating how long it takes to sell inventory is DOH = Inventory/Cost-of-revenues x 360, as cost-of-revenues (or cost of goods sold in aggregate) represents all inventory that has gone through the cycle for the entire fiscal year.)
Suppliers who grant terms and permit the company a designated amount of time to pay are essentially permitting the company to fund inventory without having to tap bank lines. (Analysts call that arrangement or privilege spontaneous financing.) At some point, however, suppliers must be paid, and often they must be paid before inventory is sold and receivables are collected.
If "days on hand" for suppliers is determined to be 30, then in effect, the supplier is providing free funding for up to 30 days, funding the company would otherwise have had to tap from banks and pay interest on.
Think of it this way. Suppose Inventory = 100 and AR= 100 on a certain reporting date.
The AR is old inventory that has been converted to the receivable that still needs to be collected. The INV represents new inventory (for a new operating cycle) that requires funding to put on the books.
The company, therefore, needs to fund 200 in assets before it receives cash through the operating cycle (sometimes called "asset-conversion cycle.")
The company, therefore, needs to fund 200 in assets before it receives cash through the operating cycle (sometimes called "asset-conversion cycle.")
But the supplier is offering some relief. If Accounts Payable = 50, the supplier is effectively granting that amount in spontaneous funding for a set number days. So based on this point in time, the company has a funding need for 200 - 50 = 150.
Of course, the company eventually owes the supplier the amount of 50. But for a certain number of days (based on suppliers' "days on hand" or DOH), it has access to spontaneous funding.
Of course, the company eventually owes the supplier the amount of 50. But for a certain number of days (based on suppliers' "days on hand" or DOH), it has access to spontaneous funding.
As for "days on hand," if it takes 60 days to sell the inventory (DOH = 60) and 20 days to collect the receivable and if the supplier must be paid within 30 days, then the tenor requirement in its funding arrangement must be at least 50 days.
In the meantime during the same cycle, as receivables are collected, the company will already have started a new cycle with new inventory received from suppliers--a step requiring more spontaneous funding.
As inventory transfers into receivables, then the company needs to replace it with new inventory while it waits for receivables to get collected. The cycle proceeds. As it waits for old receivables, old suppliers need to get paid because time has run out. Hence, that could be funded from cash reserves or the arranged external funding.
In this example, the funding amount is estimated to be about 150; the funding tenor is estimated to be at least 50 days. To have a cushion of comfort, when it turns to its fund-providers (banks, money markets, etc.), it may request amounts greater then 150 at tenors longer than 50 days.
In these arrangements, a bank will often provide financing without doing these precise calculations and estimates. Most banks providing working-capital financing will fund based on a "borrowing base," based primarily on having perfected liens on inventory, receivables and eventual cash coming in. Funds from the bank pay the suppliers, while the bank has a collateral claim on the assets on the books.
In these arrangements, a bank will often provide financing without doing these precise calculations and estimates. Most banks providing working-capital financing will fund based on a "borrowing base," based primarily on having perfected liens on inventory, receivables and eventual cash coming in. Funds from the bank pay the suppliers, while the bank has a collateral claim on the assets on the books.
The bank will lend up to the amount of the sum of inventory and receivables, but the bank will apply "haircuts" to those amounts, because it assumes (correctly) that some inventory could deteriorate in value over time (especially in a deteriorating scenario) and some receivables will not be collected. In that worst-case scenario, inventory will be sold at depressed prices and its customer base includes a significant amount of delinquents and those who will default.
The borrowing-base calculation represents what the bank is willing to lend; the company will ultimately borrow based on what it needs, an amount closer to "net working capital."
Risk Appetite, Risk Strategy, Risk Outlook
The result of a thorough financial analysis should be the analyst's ability to put together a comprehensive financial story about the company's financial condition and its ability to meet debt obligations (principal and interest payments) on an ongoing basis.
That may also mean the analysis presenting a financial rating of the company (1-10 numerical scale, for example, or qualitative rating ("excellent, good, poor, etc.")).
Risk Appetite, Risk Strategy, Risk Outlook
The result of a thorough financial analysis should be the analyst's ability to put together a comprehensive financial story about the company's financial condition and its ability to meet debt obligations (principal and interest payments) on an ongoing basis.
That may also mean the analysis presenting a financial rating of the company (1-10 numerical scale, for example, or qualitative rating ("excellent, good, poor, etc.")).
Whether the analyst resides at Fitch, S&P or Moody's or is examining clients, borrowers, counter-parties, and investments at a financial institution, the result is often a rating of some kind.
Ratings help others less familiar with the company understand its financial condition and helps others determine an appetite for risk--whether or not an institution should do a new transaction (loan or bond), engage with the company in any kind of credit-oriented relationship, or bring on board a new client. Investors can determine whether they have tolerance for such risk to invest or trade a bond issue.
Ratings also help debt investors and lenders determine the rewards they should achieve from the risks they take. We see that, of course, in debt pricing, bond yields, loan pricing, or credit spreads. The worst the rating, the higher the probability of default, and, therefore, the higher credit spread (or higher yield or higher loan interest) we'll want to earn from taking risks. (In that sense, big banks price loans using risk-ratings-based models. Bond investors use ratings to determine appropriate bond yields and bond prices.)
In analysis, the rating applied is the culmination of an integrated assessment of the company, a thorough critique of all important aspects of the company's business rolled up into one number or one alphabet rating.
The rating then should also accompany the analyst's overall outlook for the company going forward in terms of potential future ratings adjustments, future creditworthiness and prospects for future operating earnings within a designated industry. Outlook is often defined as positive, stable, or negative. Some institutions performing analysis define outlook based on what a rating could be in the next 12-24 months.
After the analysis, we decide what our posture (risk strategy) should be going forward. Or the analysis, along with the rating and outlook, makes it easy to determine the right risk strategy.
The rating then should also accompany the analyst's overall outlook for the company going forward in terms of potential future ratings adjustments, future creditworthiness and prospects for future operating earnings within a designated industry. Outlook is often defined as positive, stable, or negative. Some institutions performing analysis define outlook based on what a rating could be in the next 12-24 months.
After the analysis, we decide what our posture (risk strategy) should be going forward. Or the analysis, along with the rating and outlook, makes it easy to determine the right risk strategy.
If the rating is, say, CCC+ or "7" on a 1-10 scale, it obviously makes no sense to assign a risk strategy of "increase." It may be possible, on the other hand, to conclude with a AA- rating (or 2 or 3) and assign a risk strategy of "decrease," if there are signs of deterioration in the longer term.
The combination of a rating and outlook permits the lender/analyst/banker/debt-investor to decide a risk strategy: Increase, expand, grow carefully, remain constant, reduce exposure, avoid new exposures, limit, decrease, withdraw, exit?
Should the lender/investor increase exposure, maintain it, reduce, get out altogether, hedge it, request restructure, request collateral, onboard it, exit the relationship, etc.? And over what period of time
The combination of a rating and outlook permits the lender/analyst/banker/debt-investor to decide a risk strategy: Increase, expand, grow carefully, remain constant, reduce exposure, avoid new exposures, limit, decrease, withdraw, exit?
Should the lender/investor increase exposure, maintain it, reduce, get out altogether, hedge it, request restructure, request collateral, onboard it, exit the relationship, etc.? And over what period of time
If there is a decision to hedge the exposure because of risk concerns, how can it hedge and how willing is the institution to pay for the costs of a hedge? Could the cost of the hedge exceed the earnings (interest spread, e.g.) from the loan or investment?
Tracy Williams
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