3 Reasons a Company May Choose to Cut Its Dividend

Source: Pictures of Money via Flickr.

Dividend stocks provide the foundations on which great retirement portfolios are built.

On the surface, a dividend yield of 2%, which is the average yield of the broad-based S&P 500, might not seem all that impressive. However, looks can be deceiving.

For starters, a dividend that's paid with regularity, and that grows each year, often demonstrates to investors the near-term and long-term health of a company's business model. With the exception of special business models, such as real estate investment trusts, a company is under no obligation to split any percentage of its profits with investors -- so businesses that choose to pay dividends likely do so with the expectation that they have years of strong growth ahead. Translation: dividend-paying companies are usually safer bets for long-term appreciation than non-dividend paying stocks.

A 2% dividend yield can also be a blessing over time when it comes to outlasting stock market corrections. Since 1950, we've had 33 stock market corrections in the S&P 500 of at least 10%. In each and every instance the market eventually eclipsed the highs it had reached before the correction (although some corrections lasted longer than others) -- and the dividends paid by high-quality companies helped reduce the temporary downside for investors.

Lastly, a dividend payment can really supercharge your retirement nest egg. Instead of pocketing your dividend payments, reinvesting them back into more shares can compound your gains and stipends over time. Who knows, you may even retire earlier than expected!

Source: Flickr user TaxRebate.org.uk.

Three reasons a company might cut its dividend
But dividend payments can be a two-way street. Not all dividend-paying companies are healthy, and in some instances even healthy companies look at cutting their payouts to shareholders. Today we'll take a look at three primary reasons why a company might consider cutting its dividend.

1. The business model is changing
Probably the most common reason a company will cut its dividend is because its business model has changed and its long-term growth thesis is no longer valid.

Source: Frontier Communications.

Take one of the stock market's dividend darlings, Frontier Communications (FTR), as a prime example. In the 2000s Frontier was generating substantial margins and cash flow from its landline assets in rural communities. In 2010, Frontier announced the purchase of rural landline assets from Verizon in 14 states. Unfortunately, the deal hasn't worked out as well as Frontier had hoped. Rural landline customers continue to cancel their service as wireless coverage pushes into rural markets. Left holding the bag, Frontier has had to expand its business focus and shift its efforts to broadband in order to support its cash flow and current 8% yield. Since the deal was announced Frontier has slashed its dividend twice for a cumulative reduction of nearly 60%.

Who might be next? PDL BioPharma (PDLI) in the healthcare space is a prime candidate to have its dividend slashed in the coming years. PDL BioPharma, which is yielding more than 11% right now, is a royalty-based company that reaped substantial benefits from its Queen patents. However, that patent gravy train officially expired in Dec. 2014 when it lost its Queen patents. Once the remaining stock of Queen patent-covered therapies is sold off (which should take anywhere from 12 months to 18 months), PDL's revenue is going to fall like a sinking concrete block in the ocean, going from an estimated $631 million in 2015 to a projected $73 million by 2017. With PDL paying out $0.60 per year and projected to earn just $0.09 in EPS by 2017, this is a company whose business model could necessitate a massive dividend cut.

2. The company needs cash now
Sometimes the business model is just fine, but a company just needs a large sum of cash in order to complete the purchase of rival company or undertake a specific project.

Source: Flickr user Mark Moz.

First Niagara Financial (NASDAQ: FNFG), a northeastern U.S.-based retail and commercial bank, announced that it was halving its dividend payout in Dec. 2011, as well as offering $450 million in common stock, in order to help fund the purchase of 195 retail banking branches from HSBC for $1 billion. As a smaller bank it would likely have been difficult following the Great Recession to raise the sort of capital needed to complete this purchase. In order to ensure it had adequate capital, First Niagara bit the bullet and cut its payout to investors.

However, companies in need of cash now aren't limited to just small- and mid-cap stocks. Sometimes behemoths cut their dividends in order to reduce their cash outflow to fund merger and acquisition activity. In 2009, Pfizer (PFE -1.05%) agreed to buy rival drugmaker Wyeth for a whopping $68 billion, which included $22.5 billion in cash. Pfizer slashed its dividend by 50% in order to save $1 billion per quarter to help fund the deal at a time when banks were extremely tight with their lending practices. Pfizer has boosted its payout a number of times since 2009, but is still paying 12.5% less per quarter than it was prior to the announced Wyeth buyout.

3. Growth is slowing (likely from competition)
Finally, some companies have to cut their dividends because their growth rate is slowing due to competition from rivals. This isn't a case of a business model being broken, so much as it's a function of competition within an industry heating up.

Source: Wynn Las Vegas.

A good example here is high-end casino and resort operator Wynn Resorts (WYNN -1.88%), which cut its payout by 67% to $0.50 per quarter from $1.50 in April. Wynn's business model entails catering to the tourism industry in Las Vegas, but also profiting from robust growth in Macau, where China's superior GDP growth has led to the rise of a new middle- and upper-class.

Unfortunately for Wynn, it's not the only casino and resort operator in Macau. With a crowded playing field and a slowdown in China's annual growth to 7% from its three-decade average of 10% annual growth, Wynn has run into a rough patch. Over the long run its strategy of focusing on more affluent customers should be successful, but it's clear there will be bumps in the road from time to time.