If there is one thing that the downturn in the oil market taught investors, it is that management teams really don't have much visibility into the future. What was thought to be a clear line of sight one quarter can quickly be clouded over by an unforeseen event. This led to some very disappointed investors who have seen their income streams evaporate after management teams overestimated their ability to maintain these payouts. These examples serve as a warning that a large dividend today could be gone tomorrow.
So much for the period of sustainability
Offshore driller Seadrill (NYSE:SDRL) is a prime example of a company that thought its dividend payment would be safe for a couple of years. In mid-2014, the company boasted of a very robust dividend that was supported by a strong contract backlog. In fact, in its second-quarter earnings release the company wrote that:
The Board has resolved to maintain the regular quarterly dividend at US$1.00 per share. The Board had communicated earlier that this dividend level is sustainable until at least the end of 2015...the Board is pleased to report that we feel increasingly comfortable that this period can be extended well into 2016 without any significant recovery in the market.
In other words, Seadrill was so confident in its ability to pay its dividend that it was basically assuring investors that the dividend wasn't going anywhere for at least the next two years. It was an assumption built on three premises: the security of its contracts, its unfettered access to the capital markets, and the long-term growth of deepwater drilling.
Despite what seemed to be a solid foundation, 90 days later Seadrill released its third-quarter report and wrote the following:
Since our last quarterly report a number of developments have affected [the] factors that dictate our dividend distributions. The most significant impact has been the uncertainty in the macro environment. The Board views the deterioration in oil prices as an indicator of more broad demand growth concerns and must approach the current macro environment with an element of caution...In light of the changes that have taken place since our last report, the Board has taken the decision to suspend dividend distributions for the time being.
What was thought to be clear visibility on the dividend for the next two years turned out to be a complete lack of it even over the shortest of time periods. That's largely due to two key changes: Outside funding became tougher to obtain while offshore drilling activity noticeably slowed. Seadrill likely could have handled the slowdown in activity for a while, but it couldn't handle having its access to the capital markets shut. That is what forced it to internally fund its capital needs with the cash flow that had been earmarked for dividend payments.
So much for clear visibility
Energy infrastructure giant Kinder Morgan (NYSE:KMI) recently ran into the same sort of trouble. On the company's second-quarter conference call this year, founder Richard Kinder said that:
We raised the dividend to $0.49 for the second quarter. We're on track to meet our target of declaring $2 for full year 2015 with substantial excess coverage, even after adjusting for the current commodity prices. And we expect to grow our dividends by 10% each year from 2016 through 2020.
In other words, the company had clear visibility to grow its dividend by 10% per year through the next decade. That was largely based on its strong fee-based asset base that secured its cash flows under long-term contracts as well as its visible backlog of fee-based projects.
Despite that security, the company did have some exposure to commodity prices, which was eating into its cash flow cushion. Because of this, it had to tone down its near-term dividend growth forecast a quarter later and instead introduced a dividend growth range of 6%-10% for 2016.
That said, like Seadrill before it, Kinder Morgan relied heavily on the capital market to fund its growth and with its stock price starting to slide, it could no longer issue equity at a favorable rate. Furthermore, with the credit market starting to deteriorate, it left Kinder Morgan having to choose between its dividend and maintaining its investment grade rating. In the end, it made the tough choice to reduce its dividend by 75% because:
This dividend enables the company to use a significant portion of its large cash flow to fund the equity portion of its expansion capital requirements, eliminate any need to access the equity market for the foreseeable future and maintain a solid investment grade credit rating.
With the company reliant on the capital market to fund its growth, it was left with no real viable option but to divert its cash flow from paying dividends to funding its growth after its access to the capital markets was surprisingly shut.
Dividend visibility is a tricky thing. More often than not, companies boast of dividend security based on the security of their cash flow, which they also assume will give them unfettered access to capital. Unfortunately, the capital market can change on a dime, which has forced companies to quickly change course on their dividend pronouncements. This is a reminder to investors that a dividend is only secure if it's a small portion of its overall cash flow. Companies that pay out a big percentage of their cash flow can run into trouble when either that cash flow starts to fall or the capital markets begin to seize up.
Matt DiLallo owns shares of Kinder Morgan and Seadrill and has the following options: short January 2018 $30 puts on Kinder Morgan and long January 2018 $30 calls on Kinder Morgan. The Motley Fool owns shares of and recommends Kinder Morgan. The Motley Fool recommends Seadrill. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.