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Should I be worried if my stock didn’t increase its dividend?

Posted by admin on May 29, 2008 in Investment Information

It is reporting season for the banks; historically famous for service fees, cozy hours and annual dividend increases. But should you be worried if your bank, or any stock for that matter, doesn’t increase its dividends when it is regularly does? It depends. In the absence of context, a dividend increase is a good thing. It means the company is making money and has free cash flow to increase its dividend. An annual dividend increase also means that management is confident in the business going forward because it can absorb increased dividend payments to shareholders.

Conversely, a business that halts an annual dividend increase after years of making them is usually a troublesome sign. Is the business running short on cash? Are creditors pounding at the door? Is this the beginning of the end?

Context is everything in life. In some cases, a stock which doesn’t increase its dividend does not necessarily equate that the sky is falling. Could a lack of a dividend increase actually be a good thing in some situations?

1. Yes, when the cash normally used to increase dividends is being used to expand the business. Take the case of TransCanada Corporation. TransCanada announced in March that it would be acquiring a substantial generating station in Queens, New York for $2.8 billion. Analysts believe, given the size of the deal, TransCanada will not be increasing its dividend any time soon (time will tell). But is this really so bad if, in the long-term, the integration of this generation station will mean more free cash flow to increase dividends aggressively in the future? Pipelines are heavily regulated industries with prices set by governments. The result is that profit margins get squeezed over time (after all, the government needs to be perceived as keeping energy prices low) and, as a shareholder, I would rather have TransCanada use some cash now to expand the business than let its business decline over time (and, yes, I added to my position in the bought deal at $36.50/share).
2. Yes, when the industry faces a great deal of uncertainty. RBC was taken to task earlier this year for not increasing its dividend in the midst of the liquidity crisis caused by ABCP/sub-prime mortgages (I am a shareholder of RBC). However, remember RBC didn’t make $5.4 billion in profits last year without knowing a thing or two about growing a business and managing risk. A temporary halt to dividend increases to an industry in flux is a good thing if it gives financial flexibility to ride the crisis out or to buy out a competitor on the cheap. Those who criticized RBC for not increasing their dividends also over-looked the fact that RBC made $4.5 billion worth of acquisitions in fiscal 2007; it was using its free cash to expand. Cash is king in a crisis. It allows you significant breathing space and buying opportunities so why limit yourself financially by increasing the dividend? There’s also some interesting speculation about RBC- it didn’t increase its dividend and has quietly raised over $1 billion in new financings (mostly through preference share issues)- what is it stock-piling cash for?
3. Yes, when your competitors are expanding and you need to keep up. Pfizer Inc., the world’s largest pharma company, has a dividend yield over 6.5%, hordes of cash and keeps increasing its dividend (I am a shareholder of Pfizer). But it is subject to heavy criticism from analysts. Why? Phara is a research intensive industry- someone is always researching the next big thing in this industry and if you don’t pour your free cash into more research and development, over time, your competitive edge will erode. In Pfizer’s case, this is doubly the case since all their big drugs are coming off patent protection and they need to find other drugs to take its place. I read that Pfizer now spends more on marketing than R&D. Not a good thing in this industry. In very innovative or research intensive industries, your free cash could be utilized more efficiently by keeping one step ahead of your competitors than paying large dividends. This is why even large, established technology companies don’t increase dividends that much- they need the cash to find ways to keep ahead of their competitors.

Dividends increases are a double-edged swords for companies. They attract a lot of shareholders like you and me but it is a fine balancing act between increasing dividends to keep shareholders happy and using free cash to expand the business (which is why the dividend payout ratio has to be tracked carefully). In situations where the business needs to expand, the industry is in flux or the competitors are investing large amounts of money to beat you, a dividend increase may actually set a business back in the long-run.

A mechanical cry to increase dividends year after year, in some cases, is really a penny wise, pound foolish strategy. This is why it is important to know what you are investing in so you can make a proper determination if a lack of a dividend increase is a sign to buy or sell.