The Next Dividend Cut?

By Chad Henage - June 20, 2012 | Tickers: AFG, CINF, PGR | 0 Comments

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I've studied a lot of companies over the years, and there are certain criteria I look for in a stable dividend growth company. Generally speaking, I think companies like Cincinnati Financial (NASDAQ: CINF) are undervalued. Many insurance companies sell for a significant discount to their growth rate. In addition, several of these companies have strong dividend growth records. Here is the problem, Cincinnati Financial is not one of these undervalued companies. There are two potential problems, the stock appears overvalued, and the dividend could be in trouble.

First, let's address the idea that Cincinnati Financial could be overvalued. The best way I'm aware of to see if a stock is fairly valued is to compare it to other companies in the same field. Cincinnati Financial counts companies like American Financial Group (NYSE: AFG) and Progressive Corp. (NYSE: PGR) as direct competitors. Let's see how the three stack up:

You can see that though Cincinnati Financial has the lowest growth rate, it also sells for the highest forward P/E ratio. While the company's current yield appears attractive, it's not enough to account for the stock selling for over 23 times forward earnings, in my opinion. I'm sure that the dividend and expected dividend growth is a factor in why the company is so highly valued.

There is one problem, the company's current dividend might not be sustainable. When you look at the company's free cash flow payout ratio, the trend is clear. In 2009 and 2010, the company paid out about 50% of its free cash flow. In 2011, this payout ratio jumped to 106.25%. This wasn't from huge adjustments in operating cash flow, this was directly related to a significant drop in net income. In the last three years, the company's net income has dropped a total of 61.57%. The company's free cash flow situation is something that investors need to keep a close eye on. If the current dividend might not be sustainable, you would expect that dividend growth has slowed recently, and that's exactly what's been occurring.

Take a look at Cincinnati Financial's dividend growth over the last several years:

You can see that it looks like the company didn't increase the dividend at all in 2009. However, because of the way the 2008 dividend increase was handled, the company effectively increased the dividend twice in 2008 which covered 2008 and 2009. Even with this, the company's dividend growth has all but disappeared in the last three years. In fact, the company's most recent increase was the smallest increase of the last 10 years. The obvious reason is the cash flow issue we looked at above.

Slowing dividend growth, and a very high free cash flow payout ratio, are not traits you would expect from a dividend aristocrat. Investors in Cincinnati Financial need to keep a close eye on the company's free cash flow payout ratio. If this ratio climbs above 100% for a second full year, the company may have to cut the dividend.  Since the stock already sells at a significant premium to its expected growth rate, I would be concerned about any chance of a dividend cut. At best, shareholders should expect moderate increases in the dividend if at all. I don't think it's unreasonable to say that these increases might not be more than 1% for the next few years, until the company gets on firmer financial ground. I would avoid Cincinnati Financial because the risk of a dividend cut, or the company breaking their streak of dividend increases, seems too high at this time.

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