Investment Update on dividends

Stress tests of dividend resilience don’t normally consider the possibility of zero revenues. But faced with this temporary reality, companies are working to ensure finances remain robust.

Key points

• A synchronised global shutdown presents a unprecedented challenge to dividends
• Some companies won’t be disrupted, but most will see a partial or total cut to revenue
• Financial stress is a distinct possibility for many companies in the worst-hit sectors
• Surprise cuts from Rentokil and Persimmon highlight widespread dividend review
• Our best ‘guesstimate’ is FTSE All Share yield reduces to circa 4% in 2020
• We can’t be sure, but we expect cuts to be temporary and dividends to resume in 2021
• This crisis highlights the merits of dividend growth over absolute yields

The Covid-19 pandemic has been a profound shock for societies and economies the world over. For the first time in modern history, the world has experienced a synchronised shutdown of the majority of economic activity and the enforced quarantine of almost entire populations. This has created an unprecedented dilemma for companies, with large numbers of them withdrawing completely from providing any estimate of future sales and profits.

As mass shutdowns cause a sudden and sharp drop in cash flow for many companies, the threat to dividend payments is a great concern for many investors, especially our clients who rely on them for income. Cuts to dividends may indeed be larger than normal; many issuers are in hard-hit sectors, have more debt on their balance sheets (‘financial gearing’), and historically have paid very high dividends relative to their net income.

A lucky few, disruption for most

Some companies may barely notice this period of disruption: providers of consumer staples, such as British American Tobacco and Unilever; utilities such as National Grid; and pharmaceutical companies, such as AstraZeneca, which develop essential drugs. A few may actively benefit from it – for example Amazon, through increased home delivery orders (now that high street shops are closed), in addition to extra demand for its Web Services offering.

However, most businesses will see a partial – and in some cases almost total – cessation of revenue for an indeterminate length of time. During this period they will be carrying fixed costs – rent, IT services, salaries (though UK government financial help to ‘furlough’ staff rather than make them redundant will partly mitigate this), taxes and of course interest payments on debt – which could well push them into making losses.

Ordinarily maintaining dividends would be a priority for management teams, but we are in extraordinary circumstances. That may make managers feel less blameworthy for cutting unaffordable dividends, especially if other companies are cutting too. Even as long-term investors we should prepare for this eventuality. There are some areas of the market which will clearly see more significant downside to earnings, such as travel, leisure, retail, oil and mining. Where this is coupled with high levels of debt relative to earnings and cash flow, this will at a minimum lead to dividend cuts, if not financial stress and restructuring (potentially a bad outcome for equity holders) or even bankruptcy. Consumer staples and healthcare companies ought to maintain or increase their dividends even in tougher economic conditions given the relatively less cyclical nature of their demand. Travel, leisure and retail companies are in the eye of the storm and if they carry higher gearing they will likely need to cut dividends.

Even companies with hitherto conservative and appropriate levels of financial gearing could face difficulty in these exceptional economic circumstances. This is leading them to reassess dividends, which are usually considered a measure of a company’s strength, prestige and dependability, nowhere more so than in the UK. In this environment management teams will probably err on the side of caution and, if in doubt, suspend dividends now during the period of maximum uncertainty, potentially reinstating them later in the year once the crisis has been dealt with and economic activity returns to more normal levels. Previous economic downturns, even the global financial crisis, may not be very helpful models for the dividend outcome this time.

Prudence, but also pragmatism

This past week saw surprise dividend suspensions from Rentokil and Persimmon, companies that we would have considered in a strong position to maintain their payments. This highlighted just how widespread the review of dividends has become, and led us to reassess the potential extent of cuts across the UK market.

Rentokil supplies what we considered to be essential services in pest control, hygiene and disinfection. Housebuilders like Persimmon typically have net cash on their balance sheets, having learned the lessons of the global financial crisis the hard way. They also benefit from government schemes such as ‘Help to Buy’ which are very likely to be sustained or increased in the current environment of fiscal largesse.

What hadn’t been foreseen was that Rentokil’s trading has deteriorated significantly in just the last couple of weeks – a large proportion of its customer base are hotels, restaurants, schools and offices, all of which are now closed and themselves looking to conserve cash. Rentokil sees increased demand for its hygiene and pest control services once the immediate crisis is over, and a rise in global hygiene standards generally, but to benefit from this higher demand, it needs to have the financial headroom, and hence has suspended its dividend as well as cutting executive pay and ending all discretionary capital spending. For Persimmon there was clearly an element of prudence, but also potentially an element of pragmatism as management retain firepower to take advantage of opportunities to pick up land or other assets at heavily discounted prices.

How deep will the cuts be?

The ultimate extent of dividend cuts depends on how quickly the coronavirus can be brought under control. If containment measures are less successful than they have been for example in China and South Korea, and have to be kept in place for longer than two to three months, then many if not most companies may have to suspend or at least reduce payments.

The timing of the crisis is particularly unhelpful. Given the vast majority of companies have December or March year ends, the second and third quarters are the two most significant for dividend payment, each representing just under a third of the annual total because they include the final dividend.

The UK market is uniquely focused on dividend income, which has indeed been a significant contributor to total return. In the US, for example, there is a much greater focus on returning capital to shareholders via share repurchases as well as dividends. The UK market is also very reliant on a small handful of large dividend payers, with the top 5 representing 34% of total dividend payments in 2019, and the top 15 representing 64%. These companies are often in sectors with relatively little structural growth, like oil, miners and banks. Those three sectors are all cyclical, or sensitive to economic cycles, so the broader economic outlook will be critical in determining their dividend policies in 2020.

Attempting to predict the dividend outturn at this point is merely a guesstimate, but we’ve attempted a rough guess using very approximate assumptions about dividend cuts or growth for different sectors. For the three key sectors of oil, miners and banks we assume no recurrence of special dividends, with miners’ ordinary dividends falling 10% while oil and banks’ fall 25%. Clearly there are much worse scenarios than this, and there could also be a more benign one where these sectors keep payments more or less flat. We then assume that a number of sectors such as travel and leisure, general retail, construction and housebuilding suspend all dividends.

Based on these assumptions, which we emphasise are highly susceptible to being proved wrong, then the notional 5.9% dividend yield on the FTSE All Share (which is based on the historic 2019 dividend payout), becomes a 4.1% dividend yield. It is also worth noting that the vast majority of the dividend suspensions that we expect to see in the next couple of quarters will likely be temporary in nature, and restored later in the year or in 2021. In some cases the dividends foregone may even be repaid later, provided that the coronavirus impact does not in some way lead to permanently reduced consumption. And there is little sign as yet of that happening in China.

The temporary shortfall in income in 2020 will be very difficult for clients, but there may be a case on this one very exceptional occasion for financing outgoings by dipping into cash weightings or other parts of the portfolio that have held up better such as ‘diversifying’ holdings that have a tendency to be uncorrelated with equity markets.

Considering your options

While there remains huge uncertainty about the duration and depth of the coronavirus crisis, it is clear that dividend suspensions are going to be a significant problem, particularly in the UK equity market. Other options for income may need to be considered, and professional advice on this should be considered.

Events are moving quickly, but our current thinking is that the dividend shortfall will be a purely 2020 phenomenon, with most companies resuming normal dividend payments in 2021. Even if we get significant drops in dividend payouts, a yield of c.4% on UK equities still looks attractive relative to yields on other assets, coupled with a hoped-for recovery in share prices over the medium to longer term.

This crisis has highlighted the high exposure of the UK market to cyclical sectors with high initial dividend yields but little prospect of dividend growth. In particular the UK market has a low weighting in technology, which pays little or no income but has not only outperformed significantly on a global basis over the long term, but also during this crisis. For better long term income and returns, we strongly believe that dividend growth potential is more important than the absolute level of current yields.