When Slashing a Dividend is the Right Move
Maxxwell A.R. is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
There is more to income investing than chasing high yields. For instance, does a company have a steady history of paying its dividend? Is the dividend sustainable with future earnings potential? These questions and others need to be answered before jumping into any investment because, let’s face it, no one wants to wake up to the unexpected slashing of a dividend.
However, there are times when dividend slashing is the right move. If a company finds itself in a difficult position, it may suspend or reduce its dividend temporarily to ensure a healthy financial future. This was beautifully orchestrated by Ford over the last several years, which recently reinstated a dividend to shareholders.
When Knightsbridge Tankers Limited (NASDAQ: VLCCF) announced lower than expected 1Q12 earnings last week, the company moved to reduce its dividend from a hefty $2.00 to a still rather hefty $1.40 (12.7% yield at $11 per share). Despite already trading well below book value, the news sent shares down more than 10% in the next few trading sessions. This was clearly an overreaction, but it creates a great opportunity for savvy investors looking for a great dividend.
A question of value
If you thought the recovery in Europe was moving slowly, then you clearly aren’t familiar with the tanker industry. Sluggish demand over the past several years has dramatically decreased charter rates and led to an industry full of overcapacity. As a result of uncertainty over receiving certain charter payments, management made the prudent decision to lower the quarterly dividend from $0.50 to $0.35 per share. It turns out European countries are having trouble even paying for their imports to arrive on their shores.
Although it is easy to perceive the announcement as bad news, I argue that it was the right move. A quarterly dividend payout of $0.50 meant the company was paying out 150% of earnings. The new distribution of $0.35 is still 110% of earnings, but it is one of the most sustainable in the industry. I know that sounds nearly impossible, so let us take a deeper look at the meaning of value in the tanker industry.
Jumping fleet first into value
The first big advantage that Knightsbridge holds over its competitors is its fleet. The overcapacity in the industry has crippled companies like Frontline Limited (NYSE: FRO), which recently sold off assets and restructured debt to stay afloat. Knightsbridge not only owns a sustainable amount of ships, but also the right size of ships. It is much easier to lease out one Very Large Crude Carrier (VLCC) than two or three smaller Suezmax carriers. The following table shows the nimble Knightsbridge fleet:
Source: Knightsbridge Tankers Limited 1Q12 Presentation
As long as Knightsbridge can continue to find work for its two spot market carriers, investors won’t need to worry about vessel leases or contracts until 2014, although companies typically find suitors quarters before expiration.
Sustainability: Knightsbridge or the field?
How exactly can a 110% payout ratio be sustainable? It isn’t. It is important to remember that dividend distributions incorporate future earnings into the equation. With that in mind, Knightsbridge has only paid out more than 100% of earnings once (2011) since 2008, so management must be optimistic that the company’s 2012 EPS will exceed the current annual payout of $1.40.
The company has reduced debt and grown assets in recent years. It is especially important to note the company’s growth during the economic downturn and strong bounce afterward, something that can be attributed to its Goldilocks fleet size. Despite this, the company trades well below book value of $14.53 – a 32% premium to $11 per share!
A quick look around the industry only solidifies Knightsbridge as the best value play. Teekay Corp. (NYSE: TK) has a 4% dividend, but has recorded negative EPS in three of the previous four quarters. The company is trading at 1.52x book value, has a high debt to assets ratio, and has been struggling to grow profits with its fleet of 18 smaller crude carriers.
Previously mentioned Frontline Limited had a negative EPS in four of the previous five quarters, but still manages to pay a 4% dividend. Last year the company sold $1.428 billion in assets in a restructuring deal, which explains the nasty dive in assets in the chart below. Despite reducing the monetary value of its liabilities the debt to asset ratio now stands at 80%. The company has slowly moved in the direction of its fair book value of $2.58 per share, which may jeopardize future dividend distributions.
Nordic American Tanker Shipping Limited (NYSE: NAT) struggled mightily since 2009 with a quickly deteriorating profit margin. Much like Knightsbridge, however, the company was able to ride the recovery in oil prices with its fleet of 20 Suezmax carriers.
The company has one of the lowest debt levels in the industry – even after purchasing three new carriers – but remains significantly undervalued. With a fair book value of $18.30 (32% premium to $13.50 per share) and a nearly 8.5% dividend, what’s not to like? Unfortunately, Nordic American’s dividend is not very sustainable. In the last three years the company has registered an EPS of -$1.52 (2011), -$0.02 (2010), and $0.03 (2009).
Foolish bottom line
If Nordic American can become profitable it may challenge Knightsbridge for the best value play in the industry. Until that happens, it is easy to see that Knightsbridge is the company to keep an eye on. Based on 1Q12 earnings the company has a fair book value of $14.53, which is a 32% premium to $11 per share. At fair value the company’s dividend yield isn’t so eye-popping (9.64% vs. current 12.7% yield).
Knightsbridge has a history of paying a hefty dividend in good times – when it can afford to – and responsibly cutting back when it sees uncertainty ahead. So the next time a company slashes a dividend, don’t panic and run for the doors. Take a deeper look into advantages and disadvantages with competitors – not just P/E – to see if the slash is justified and will help to make your investment more stable in the long term.
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