Dividend yield stocks and their debt load, part 2

Yesterday, I began a series looking at the implications of dividend yield stocks that carry large debt loads. In particular, I addressed what a large debt load is and analyzed why having a large debt load may not per se be such a bad thing if that debt is not maturing soon. Today, I continue the series.

How do lenders’ treat dividend yield companies with large debt loads?

As the BCE example showed, in a non-bankruptcy context, debtors have priority to payment of interest over shareholders at the expense of foregoing any upside. This includes a priority of the debtholders to be paid interest over the shareholders being paid dividends. Such prioritization is set out in law (in that a company may only declare a dividend after the company has paid its expenses which would include interest on loans) and in the loan agreement.

In most loan agreements, a borrower is restricted from making certain types of payments in priority to the lender. In the dividend context, a lender may have enough leverage to force a borrower to set a cap to the amount of dividend it can pay if the lender believes the borrower would be hard-pressed to pay off its loans and declare a dividend at the same time. Complex formulas are set out in loan agreements that basically allow borrowers to increase dividends in a corresponding ratio to the reduction of debt.

These restrictive loan covenants (a covenant is a legal obligation typically not to do something) are typically disclosed when a dividend payout ratio is abnormally high (a payout ratio is the amount of dividend paid/earnings). For example, Russel Metals has a dividend payout ratio exceeding 90%. For fiscal 2007, its free cash flow was $125 million of which $110 million was paid out in dividends. With relatively small breathing space, it declared in it fiscal 2007 statements that it continued to be on-side of its restrictive covenants to senior noteholders

In some cases, the lenders may have leverage to force a company to suspend its dividend. For example, the BCE privatization will result in BCE assuming massive amounts of debt. As a means to protect their collateral, the lenders have negotiated the suspension of the dividend as a means to save cash (in other words, the lenders want to make sure there is cash in the bank to pay their loan or, in a worse case scenario, ensure a better recovery on default). In other words, the lenders have forced the company to ensure, by the suspension of a dividend, that the debtholders rights to interest payments take precedence over the shareholder’s dividend.

The BCE example is especially relevant in our current context as companies that are highly leverage AND whose’s loans are maturing may be forced to cut its dividend as a condition of loan renewal. Without a readily available market of lenders out there, one could see a lot of lenders forcing the borrowers to cut dividends to ensure their loans are protected.

Thus, we come back to the analysis that it is not so much how much debt a company has but whether it is maturing soon. In this credit environment, companies seeking a renewal of debt may be forced to adjust their dividend policies to satify lender’s concerns. Meanwhile, a competitor with greater amounts of debt but locked into medium to long term maturities may not face such pressures. As they say in life, timing is everything.

What about cash?

Cash is king and can buy you out of a lot of trouble. Most lenders require borrowers to maintain certain debt to equity ratios and, the healthier the ratio, the cheaper the cost of borrowing becomes. Since cash adds to the equity portion of the ratio, companies can obtain money cheaper. Cheaper costs of borrowing means more fiscal flexibility to maintain or increase the dividend. As shown above, greater amounts of cash in the bank also mitigate against the lender’s interfering too greatly in a company’s dividend policy.

In a worse case scenario, a large amount of cash in the safe also gives assurances to investors that a dividend can be paid since a company would be relying on cash in the bank rather than some future projection of business growth (dubious in these times) to pay its dividends.

Thus, TransCanada has a staggering $15.53 billion in debt but it is mitigated by the fact it hold $1.96 billion of cash in the bank. Its largest rival, Enbridge, has only $9.71 billion in debt but has less than $1 billion in cash. As a lender, TransCanada may actually appear to be the better borrowing candidate given its pledge of security also includes a lot of cash than Enbridge even though the latter has a debt level that as an absolute number appears “safer” on first blush.

What does this all mean?

A company carrying a higher than normal level of debt is, in and of itself, nothing to be alarmed about as an investor relying on dividend payments. However, there are a few warning signs to pay attention to:

1. It is not the absolute dollar figure of debt an investor should be worried about but debt/EBITDA ratio. A ratio outside industry norms should set off alarm bells since high debt servicing impairs a company’s ability to pay a dividend.
2. The amount of debt maturing in the short-term is also important in an environment where the cost of capital is increasing. If a company cannot grow faster than the increased costs of servicing debt, it will impair its ability to maintain or increase its dividend.
3. Companies with high dividend payout ratios and are highly leveraged with much of that debt coming due should be viewed cautiously given it may give lender’s opportunities to interfere negatively in the dividend policy of a company.
4. Cash is king. Dividend paying companies with high levels of debt but with large holdings in cash may be safer candidates to lend to, which allows greater financial flexibility to maintain or increase a dividend.