Are Dividend Cuts Always a Bad Thing?

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As a dividend growth investor, or just an investor in general, it may kill your soul when one of your stocks decides to cut, or even eliminate, its dividend -- especially if it craters the stock in the process. But is it always a bad thing when companies decide to lighten up on shareholder payouts?

Could a cut actually be good news?

Back in May, when I purchased shares of Nokia (NYSE: NOK), it wasn't for the outrageously high dividend. I was buying into the turnaround story. I had an almost 100% intuition that the dividend wasn't going to be there waiting for me for long. In fact, as a shareholder and a fan of the company, I wanted them to cut the dividend to help free up some cash to assist in the turnaround. Sure enough, the dividend went bye-bye.

Nokia cut off a significant stream of cash that once went to shareholders, but this was probably a good move, considering the burning of their cash pile had been a major concern going forward. The company also managed to achieve profitability ahead of schedule in the following quarter.

I would much rather see the company get their cards in order and maintain constant profitability, before seeing them distribute a ton of cash that is better invested in the company's turnaround. Forbes seems to agree. Let's face it, the dividend cut was screamingly obvious, and in the long run, it should help the company become profitable again. It's not like the shareholders are the only ones suffering, as Mr. Elop (Nokia's CEO) took a pretty sizeable haircut to his pay package as well. 

A safer yield than before...

Another company I have owned (and have since ditched) was Exelon (NYSE: EXC). I was fortunate enough to dump them before the officially announced cut, but had a good idea it was coming. Like Nokia, Exelon will likely use the excess cash to help invest more into the company. Unlike Nokia, however, the company cut its dividend, as opposed to scrapping it completely. Unlike Nokia, the company also decided to do the opposite of cutting its CEO's pay -- hiking the top two executives salaries in 2012.

Buying Exelon now is certainly much better than buying before the cut, however. The dividend payout is safer, and the company is the leader in nuclear power. Exelon, whose margins were squeezed by low natural gas prices, could actually see a major benefit from natural gas as well, if the gas picks up as an energy source in the States, as many are predicting.

The extra retained cash should also help the company invest in improvements and maintain its credit rating. The Exelon of today seems much better than the Exelon of the past.

Cutting dividends and debt? Or hiding something?

Another recent dividend cut came from the telephone company, CenturyLink (NYSE: CTL). The company has struggled to compete against bigger competitors such as AT&T and Verizon, and seems to have too heavy of a reliance on the dying landline business.

According to the company, they will "utilize a portion of [their] free cash flow generated in 2013 and 2014 to repay debt and maintain leverage at less than 3.0 times EBITDA." This sounds good at first, and keeping cash from shareholders to improve financial stability sounds like a great idea for the company's long-term prospects -- but that's not all folks.

The company has also declared that their "board has authorized the repurchase of up to an aggregate $2.0 billion of the company's outstanding common stock. The company expects to execute this share repurchase program primarily in open market transactions, subject to market conditions and other factors, and expects to complete the program by its scheduled termination date of February 13, 2015CenturyLink intends to fund the share repurchase program primarily with free cash flow generated by the business."

Even if you are a fan of buybacks, doesn't this seem a little sketchy? Why cut the dividend by 25% -- effectively cratering your stock over 20% in the process -- just to buyback stock? Maybe, they are looking to prop up earnings per share amidst declining cash flows in the future. Or maybe, I am missing something here.

If the company's new capital allocation plan works, then it works. The bottom line is that CenturyLink plans to increase its cash position, continue to offer a competitive dividend with a more sustainable payout ratio, and eliminate more debt. If the buyback jump-starts the share price in the process, maybe this is a good thing for long-term shareholders.

The bottom line

Dividend cuts can be seen as good if they are already assumed, and somewhat baked into the price. A dividend removal to a speculative stock like Nokia is usually good if the saved cash helps the company turnaround and achieve probability. The dividend can be restored later when earnings are consistent.

It's less thrilling when a company like Exelon, a utility usually bought solely for its yield, reduces it dividend payout, while execs fail to feel the same pain. Buying Exelon after the dividend reduction, however, is much more soothing for a shareholder. Once cut, the chances of the dividend being cut again are unlikely. Exelon now appears like a good value play with a much more sustainable dividend. Its credit rating should also be safer with more cash on its books.

CenturyLink sends mixed signals. I would probably avoid this one, or watch it closely to see what direction the company is heading towards, and how the new capital allocation program is faring. If CenturyLink starts to turn around, and strengthen financially in a sustainable way, they might also make a good value play.

Dividend eliminations and reductions aren't always bad, especially if they improve a company's long-term fundamental picture. It sure stinks being the shareholder left with the bag, though.

Joseph Harry owns shares of Nokia. The Motley Fool recommends Exelon. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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