The Long-Term, Cash Squeeze, High Dividend Growth Strategy

The long-term, cash squeeze, high dividend growth strategy is commonly used by companies all over the world. Many investors are misled by the offset that occurs in company data when this strategy is deployed.

The following is a short post describing this strategy, why companies use it, and how it might affect future dividend growth.

The Long-Term, Cash Squeeze, High Dividend Growth Strategy
A company’s free cash flow (cash from operations minus capital expenditures) can be used for any corporate purpose whatsoever. A superior dividend grower (SDG) should have a management commitment to using “excess” cash flow to increase its dividend payouts.

Another popular use of cash is to purchase the company’s own stock, referred to as a “buyback program” or simply as “buybacks”.

One result of large buyback programs is to reduce the number of shares outstanding. This in turn does two things to a SDG.

First, such a program will boost the increases that are reported for earnings per share, at percentage levels greater than the percentage increases in net income.

For example, because of fewer shares outstanding, earnings per share amounts might increase 7%, while net income amounts would increase only 3% or 4%.

Secondly, because there are fewer shares outstanding, it takes less money to pay increasing dividends.

From this perspective, a buyback program makes corporate earnings look good, has a tendency to boost the price of the stock, and helps to maintain large dividend increases.

Thus, a significant buyback strategy combined with a commitment to a 10% dividend growth may be a laudable corporate financial strategy.

The strategy described above works very well when there is enough free cash flow to support it. This strategy also works fairly well even when the expense of buyback and dividends exceeds the cash to support it, simply by increasing net debt, reducing working capital or other temporary means.

In fact, this can go on for many years within some companies. That is, buybacks and dividend increases are not consistently supported by increases in revenues and net income, but rather by debt, retained earnings and other means.

The longer this process continues, and the greater the difference between money made and money spent, the greater becomes the threat to continued high dividend increases.

When there is not enough free cash flow to support such a strategy, it can be called a “cash squeeze” investment philosophy.

We do not know of a simple, easy way to monitor companies for the long-term occurrence of such a “squeeze” process. This is a very complex financial strategy, and can be occurring on almost a “stealth” basis.

In order to see this financial strategy at work, selected data for a five year period will be examined for company X (the name of this company has been removed, however all data presented below is accurate and from a real company).

First of all, let’s look at the positive side of this strategy.

The dividend growth of company X has been very healthy with a CAGR of over 11% for the last five years.

Over the same time period, earnings per share have increased at the rate of 4.89% ($3.23 to $4.10), and the price of the stock has gone from about $65.20 to $88.11, for a CAGR of 6.27%.

On the other hand, revenues have increased at a rate of 2.44% per year, and net income has only increased a paltry 1.55% per year.

Company X’s free cash flow has actually gone down so that payout ratios are now beginning to rise from historical levels.

How has this been done? X has an active buyback program, and has reduced its outstanding shares by 14% or about 2.7% per year over this same period. In addition, X’s total debt loads are beginning to rise in order to support this strategy.

There will be a point in the future where X will run out of the financial flexibility needed to continue this strategy at the same level.

This future point could be years away, but the threat to the increase in their dividend is building up to an extent that it no longer would qualify as an SDG.

As evident from the example presented, an individual investor could easily be misled by this complex financial strategy. When you research a company for your portfolio, regardless of your investing strategy, ensure that you fully understand the data presented, as well as the story behind that data.

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