The Globe and Mail ran an interesting feature on Saturday on the debt loads of various Canadian companies (unfortunately, the link did not publish the chart of publicly traded companies with the most debt load and cash). The article explored the implications of a world without cheap money to large publicly traded companies who may have built their company on readily available capital. One particular facet of this topic not explored is the relationship between large debt loads and dividend payments. Will tightening lending criteria mean that companies may have to slash dividends to horde cash?
What is an acceptable level of debt?
Let’s start with what an acceptable debt load is for any company. As usual, the answer is that it depends. The Globe article listed Brookfield Asset Management (BAM) as carrying approximately $35 billion in debt or having a debt/EBITDA ratio of 8.42 (EBITA = earnings before interest, taxes, depreciation and appreciation or, in a simplistic sense, profit before accounting entries are made). This may seem astonishing until you consider that BAM is an infrastructure company that relies upon leveraging to buy billion dollar assets
Having said that, prudent lending standards dictate that in non-real estate or start-up cases, a company ideally should not incur a debt load of more than 3-4 times earnings (one justification is that a company traditionally sells for at least 3-4 times earning so the lender get its money back if the company sells itself).
Thus, TransCanada Corp. and Enbridge Inc., two high dividend yielding stocks, carring a debt/EBITDA ratio of 3.94 and 5.54 respectively tend to be on the high side of debt loads (all stats are from the Globe article linked).
What exactly then is the relationship between debt levels and dividend payments? Generally, the more debt the company has the more interest it has to pay to maintain the debt. Interest payment obviously eat into the cash flow and cash flow growth is the life-blood of paying and increasing a dividend. At some certain level of debt servicing, a company either cannot pay a dividend or must slash its dividend given the business imperative is to service the debt and not to return cash to shareholders.
A good example would be Rogers Communication Inc. who built a company on mountains of debt and was not a dividend payer until recently when it retired a lot of debt or generated profits greater than its debt servicing (its debt/EBITDA ratio is a healthy 1.5). With this relatively low level of debt, most anticipate Rogers to increase it dividends going forward.
Is a high-level of debt mitigate against dividend increases?
Not necessarily. Taking a debt/EBITDA is not the end all and be all. As has been pointed out, its not the debt you have on the books but also the debt that is maturing in the short term. If a dividend payer had the majority of its debt locked in for the medium to long term, it has locked in its debt servicing costs and can focus its attention on growing its revenues.
But, what happens if there is a lot of debt maturing in the short-term. In this lending environment, one would suspect the debt would only be renewed at higher fees and higher interest rates. Both obviously cut into cash flows.
Thus, it would appear that a company with a large debt load could continue to pay or increase its dividends if the debt servicing was locked in for the medium to long term but a company with a large debt load- a large portion of which is maturing- would be less likely to increase its dividend. This analysis assume that a company could not growth its business faster than the increased expense of paying interest. If it organically can then a company seems to have avoided the double trap of too much debt and too much of it is maturing too soon.
To us some real examples, Enbridge not only has a debt/EBITDA over 5 but has $2.33 billion of $9.71 billion debt maturing in 2009. Fortis, another dividend stalwart, has a debt/EBITDA ratio os 5.63 and has $.139 billion of $5.65 billion of debt maturing in 2009. Both would be candidates not to increase their dividends if you assumed neither, in this economic environment, could organically grow its business faster than the increased costs of servicing debt.
Tomorrow, I will conclude this series but looking at the role of cash on hand and legal impediments to paying dividends if the company is awash in debt. Please note that I own both TranCanada and Fortis.
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