Once, a company slashing its payout would send investors running for the exits. What's changed? Chalk it up to the financial crisis
Discover Financial Services (DFS) said Mar. 19 that its dividend would shrink by two-thirds. It's cutting its annual payout to shareholders from 24¢ to 8¢ per share.
Just a year or two ago, such a move would have shocked investors. Dividends were traditionally regarded as a sign of financial strength, so cutting them was a black mark on a company's record. "A dividend cut used to mean failure," says Michael Yoshikami, president and chief investment strategist at YCMNET Advisors. Now, he says, "The stigma of cutting a dividend is not what it used to be."
The reason is the financial crisis, which has made capital scarce, and the recession, which has hurt revenues and profits at many firms.
Dropped Like a Rock
For Discover, which also announced sharply lower earnings on Mar. 19, the reaction from investors was mixed. At first, the stock actually opened higher. Analyst reports dwelled on financial results, not the dividend cut.
Later in the day, and after executives spoke on a conference call about the results, Discover shares dropped like a rock on a bad afternoon for many other financial stocks. Shares ended the day down 13.3%, to 6.28.
Dividends aren't a big priority for investors these days, says James King, president and chief investment officer at National Penn Investors Trust. Now, "the focus is on an entirely different set of variables," King says. "The primary focus is: Are these companies able to survive in this current environment?"
Cash is King
Dozens of companies have slashed dividends in an effort to save cash—cash executives and investors believe they may need to survive a worst-case economic and financial scenario. According to Standard & Poor's, 43 companies in the S&P 500 have cut or suspended dividends so far this year, a $41.8 billion drop in shareholder payouts. In the first three months of last year, 12 companies cut payouts, and in 2007, only two cut dividends through Mar. 31.
Some of the most prominent dividend cuts in the past month came from General Electric (GE), U.S. Bancorp (USB), and Wells Fargo (WFC). In all three cases, stocks were underperforming their sector before the cut, but dramatically outperformed their sector after the reduction, King notes.
In a typical reaction, Keefe, Bruyette & Woods (KBW) analyst David Konrad praised U.S. Bancorp's dividend cut as "a long-term positive, as it allows the company to preserve capital."
Financials Lead the Way
In the current environment, more capital can be a big advantage. Cash-rich firms don't need to borrow money in tough credit markets, Yoshikami notes. "Now, it's actually considered prudent cash management," he says.
Not surprisingly, dividend cuts are particularly common among financial stocks, hit hard by the subprime mortgage crisis. Financial stocks last year accounted for 30% of S&P 500 dividend income, according to S&P. Now, financial dividends make up only 10.6% of the total.
To stay afloat, many of those financial firms also have been forced to take billions in bailout funds from the federal government.
Some Cuts are Mandated
There are signs that executives—and investors—are eager for financial firms to pay this bailout money back as soon as possible. They want to cut the strings that regulators and legislators attach to bailout funds. Conditions on the funds could include not just regular interest payments to the government, but also limits on executive pay, mandated dividend cuts, and requirements that banks boost lending.
Discover Chief Executive David W. Nelms said Mar. 19 that the dividend cut "will help us maintain a strong capital position in the midst of this uncertain environment." But he also cited a "desire to repay [the U.S. Treasury] as soon as it is prudent to do so."
Standard & Poor's senior index analyst Howard Silverblatt predicts S&P 500 dividend income will fall 22.6% in 2009.
So many dividend cuts are making it tough for investor looking to earn cash off their equity investments. "There's no real source for steady income," says Dan Crimmins, chief executive and founder of DPC Wealth Management. He worries individual investors will end up taking too many risks, buying higher-yielding but riskier investments to make up for lost dividend payments.
This era—when companies can cut dividends with little or no backlash from investors—won't last forever, King says.
Eventually, the economy will recover and again companies will be harshly punished if they can't provide shareholders with steady income. But for now, most investors would rather see their stocks survive the recession than provide some extra income this year.