Do they pay my dividend first?

Posted by on July 31, 2008 in Investment Information

No. As a matter of fact, a company’s option to pay a dividend on your stock is shockingly low in its list of priorities and legal obligations to a company’s stakeholders. In corporate finance, there’s a saying that “debt takes before equity” which means, in plain English, that a company has to satisfy its debt obligations before it satisfy its obligations to the equity-holders in the ordinary course of business. Specifically, the major legal obligation to debt-holders (which are primarily holders of corporate debt issued by the company and bank loans) is the timely payment of interest payments at prescribed times under debenture and/or loan terms (as the BCE legal challenge reinforced, bond-holders have this right but at the cost of having little say in the direction of the company as long as the debt is paid). This must be paid before a dividend.

But, there is more. In large debt issues, the market typically demands the insertion of “restricted payments” in the terms of the issuance of the corporate debt. In essence, and there are very many variations of restricted payments, if a company’s debt to equity ratio or debt service level or some other ratio goes above a certain ratio then it must suspend certain payments, including dividend payments, in order to bring those financial ratios to a point that lenders are comfortable there is enough case to run the business and make the loan payments (the ratio is negotiable and depends on the company and industry). As a good example, Russel Metals had free cash flow (free cash flow is cash flow from operations minus capital expenditures) of approximately $125 million and paid $110 million in dividends for the 2007 fiscal year. This is an aggressive dividend payment strategy with little room for error; the margin of error is, in fact, so small that the company specifically mentioned in its annual report that they are still out of the restricted payment range. If any company gets there, then it may have to suspend its dividends or free up cash other ways. If they make restricted payments before paying the loan, the entire loan defaults and is due and payable immediately.

But, there’s even more. Most companies submit articles of incorporation (which is analogous a company’s constitution) that grant preference of dividend payment to preferred shares over common shares (hence, the name preferred or preference shares). Some give primacy of payment to common shares but the whole point of preferred shares is a holder forgoes voting rights for better certainty of payment so most company’s will favor preferred shareholders over common shareholders. Normally, this wouldn’t be a big deal. But, banks have been issuing preferred shares like drunken sailors to prop up their balance sheets. For example, the Bank of America had issued approximately 2.8 million preferred shares as of June 30, 2007. A year later? Try approximately 24 million preferred shares. This puts a strain on the company’s cash flow and its ability to raise common share dividends. Imagine what would happen if there is one more shock to the banking system? With debt and preferred share payment obligations, it would be difficult to maintain the common share dividend.

In essence, here is a general list of priorities:

  1. Pay the debt-holders
  2. Pay the bank (#1 and #2 may flip demanding on the terms of each)
  3. Pay the preferred shareholders if that is what your articles of incorporation state
  4. Pay common share dividends.

What does this all mean to you if you are a dividend investor?

  1. Watch free cash flow closely (it is reported in the annual financial reports). The higher the better since cash flow from operations (or operating cash flows) is cash left over after paying off debt. Thus, by very definition, the higher the free cash flow, the better the ability to maintain or increase the dividend. The “prestigious” dividend payers, such as GE and Johnson and Johnson, always maintain increasing levels of free cash flow (although there is a down side to a high free cash flow which I will address at a later time).
  2. Get nervous if a company is issuing more debt whether through corporate debt or preferred. This means more people getting paid out before you. While share buy-backs are encouraging signs of a company’s health so is the retirement of corporate debt and preferred share issues.
  3. Rely on history. Company’s that have consistently raised dividends over long-period of time tend not to suspend or decrease dividends since it is in their corporate DNA to generate the cash flow to pay dividends and many investors invest in reliance of continuing dividend payment. A suspension or decrease could cause serious damage to the share price. As a warning though, watch the percentage of dividend payment. Some companies got overly generous this decade and began to increase dividends over and above historical norm since they thought the boom would last forever. The question becomes did they reach too far?

As always, rely on your dividend blogs as your source for all things dividend. Several of them have teamed up and formed Div-Net: the dividend and value network. This would be a good place to start if you want to learn more about dividends and specific stocks.

Well, I am off until August 11. I am taking a small vacation from the blog. I’ll be returning fully charged up with some old and new faces (yes, Preet and I have scheduled another exchange of thoughts). Until then, enjoy yourselves.

2 Comments on Do they pay my dividend first?

By Thicken My Wallet » Blog Archive » 5 troubling signs for dividend/income trust investors on August 11, 2008 at 5:01 am

[...] Do they pay my dividend first? [...]

By Dividend Growth Investor on September 9, 2008 at 1:43 pm

TMW,

Thanks for the article and link to The Div-Net.

Best Regards,

Dividend Growth Investor

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