Looking for Opportunity in Payout Cuts

May 7th, 2013 by Potato

There is a legitimate reaction of fear and disgust when a dividend-paying company cuts their payout. The cut can often just be the first of a series, and after all, companies that are growing with steady profitability don’t need to cut so it must be a clear sign of trouble. However it’s far from a certain sign: sure, Priszm and Yellow Pages went through a series of cuts before becoming worthless, and investors who bailed at the first cut (or earlier) were in the right — there was not just one cockroach. On the other hand, many companies have a clear plan and future path to follow with a dividend cut, and an over-reaction to the news can be a great buying opportunity.

Superior Plus was recently featured in the Globe and Mail with a very bullish article, yet just after cutting their payout nobody loved it despite the attractive price (indeed, it’s almost doubled from that point). The business was not growing, but it was not crashing at the time of the cut, either. The problem had been too much debt taken on in the past, and no wiggle room with a 100% payout ratio to get it paid off. By slicing the dividend in half, SPB laid out a plan to start paying that debt off in a meaningful way. This was in my opinion the wiser use of their cash, especially given the interest rates they had to pay on the debt. It shouldn’t have been the first cut of many — just a one-off cut, that would likely last for five years or so before going back up. Investors liked the company at $10 before the cut, then even though the underlying business hadn’t changed, were only willing to pay $6 for it after the cut (and now, back to $12).

Similarly, HR.UN had to cut their dividend when capital markets froze up in 2008 and they were caught with their pants down and a half-finished building. They used the cashflow they would have given to unitholders to fund the construction, with a plan to reinstate the dividend at the conclusion of the project. Partly due to this, and partly due to general market uneasiness, there was a point at which you could have bought H&R for roughly a quarter of where it is today. Even if you factor in that the overall market was down roughly 50% at the time, H&R had shed an additional $3/unit. So there might be some value to looking into companies that have recently cut their dividends in case there is an over-correction in the price.

I think Extendicare might fall into this category now. I bought some a few months ago on the thesis that their payout ratio was near the edge: they had refinanced some debt into low-interest long-term form, which is good, but profitability concerns with Medicare cuts left them dancing around the 100% payout mark. I figured they could go either way on a cut, but it would likely be shallow (to get them down to an 80% payout ratio), and that the US and its insurers were likely done trying to squeeze care homes for additional savings. Now clearly I was wrong on the depth of the cut, and possibly on the rounds of cost-cutting coming to an end, but I don’t think this is just the first of many: in the conference call they say that basically they can now fund the payout entirely from the more stable Canadian operations. That should make EXE a pretty decent buy at these levels (<$6). I wouldn’t be too surprised if 2 years from now it’s back at $8 and that‘s when all the bulls come out of the woodwork to exclaim in the press about what a great buy it is at that price.

Any other potential over-corrections to look into out there?

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