Dividend Freeze: How Should Shareholders React?

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Dividend Freeze: How Should Shareholders React?


Published on November 3rd, 2021 by Nate Parsh

At Sure Dividend, we place an immense value on owning stocks with growing dividends over long periods of time. This is because companies that are able to do so often have a goods or services that are in demand through all portions of the economic cycle.

We know that many dividend growth investors feel the same way and want to load up their portfolio with quality dividend stocks that have lengthy dividend growth histories, such as the Dividend Aristocrats.

You can download the full Dividend Aristocrats list with all 65 Dividend Aristocrats (plus important financial ratios such as payout ratios and P/E ratios) by clicking on the link below:

 

Companies also realize that shareholders have grown accustomed to receiving an annual raise.

However, sometimes investors encounter a dividend freeze, which is when a company decides to keep its dividend flat.

This article will explore a dividend freeze and why it happens, to help investors understand the mechanics of the pause of dividend growth.

We will also discuss some examples to help investors better understand if they should sell a stock following a dividend freeze.

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What is a Dividend Freeze?

One of the best aspects of a dividend increase is that it lets shareholders gain a window into how a company is performing. A larger-than-usual dividend raise can be seen as a very positive development, signaling to investors that the company might be expecting an uptick in business.

Even a raise that is in-line with the historical average can reassure shareholders that the underlying business is performing well, giving the investor motivation to maintain or increase their ownership of the stock.

However, a weak raise can have the opposite effect, giving shareholders the impression that perhaps business isn’t as strong as anticipated.

That said, many dividend growth investors don’t exit their position simply due to a token or smaller than usual raise. An increase is an increase after all, and shareholders are still receiving a bigger dividend than they did before.

But a dividend freeze means shareholders will see the same level of income (assuming dividends are not reinvested). For shareholders accustomed to seeing that annual raise, this can cause concern.

While not as bad as a dividend cut, a dividend freeze means that company management does not have the confidence or ability to increase the dividend payment.

Each dividend freeze is different, as no two companies are exactly the same. A dividend freeze can mean that the business is facing worse than expected business prospects. On the other hand, the dividend freeze can be for an actual positive reason, though this is much rarer.

While many income investors believe a pause or a cut is an automatic reason to sell, we believe that it is crucial to understand why the dividend was paused before making an investment decision.

When is a Dividend Freeze a Sign of Trouble?

To most, a dividend cut is the worst-case scenario. Reducing dividend payments is seen as taking money away from shareholders, and is typically met with steep declines in the share price.

Related: Dividend Trap: What Income Investors Need To Know

Consider the bank stocks during the 2007 to 2009 time periods. Some of the U.S. and Canadian banks paused their dividend growth during this time.

Eventually, nearly every one of the large financial institutions in the U.S. slashed their dividends to the bone, partially because they were forced to by Federal Reserve, but also because their businesses were in dire straits and they needed the capital to stay afloat.

In almost every case, the share price plummeted.

Of course, a good portion of the decline was due to the current business environment and the threat of financial market collapse.

If the banks had managed to maintain their dividends or even raised them, then investors would have the sense that company management believed that the current headwinds would eventually subside.

A dividend cut, coupled with market conditions, drove down the prices of some banks that were formerly considered to be well-run.

Can a Dividend Freeze Be a Good Thing?

More times than not, a dividend freeze is likely an omen of trouble ahead, and also that perhaps a dividend cut is possible.

There are times when a dividend pause could actually be a positive development for the long-term.

Take CVS Health Corp (CVS) for example. Up until 2018, the health care services provider had 14 years of dividend growth and the dividend had more than doubled over the previous five years.

That changed when the company purchased health insurance company Aetna.

The acquisition, competed in November of 2018, cost the company $77 billion, including the assumption of Aetna’s long-term debt. This added $45 billion in new debt to CVS Health Corp’s balance sheet.

As a result, leadership announced its intention to freeze its dividend until its leverage ratio declined to more manageable levels, ideally to the low 3x range.

Shareholders have received the same $0.50 per quarter dividend for 20 consecutive quarters, including the most recent payment distributed November 1, 2021.

Even though the company was fairly transparent with the reason behind the pause, the market did punish the stock, both for the cost of the Aetna purchase as well as the dividend pause.

It took the stock several years to recover.

Five years without a dividend raise might be a deal breaker for many dividend growth investors, but the acquisition of Aetna has paid off for the company.

Aetna had a membership of nearly 40 million people at the time of purchase, which added a substantial number of potential customers to CVS Health Corp’s business.

The acquisition has also provided a boast to revenue and earnings while also generating cash flow that the company could use to pay down debt.

Source: Investor Presentation

Powered by the Aetna acquisition, adjusted earnings-per-share are expected to reach a new high in 2021. And this is after the company had to issue a massive amount of equity to complete the deal.

CVS Health Corp has also taken steps to reduce its debt burden, often spending its extra cash flow to retire outstanding debt.

For example, CVS Health Corp repaid more than $2 billion in debt last quarter, bringing its year-to-date debt repayment to $5.4 billion.

In total, the company has repaid more than $17 billion of debt since the acquisition closed. As a result, the company remains on track to hit its target leverage ratio in the low 3x range.

The dividend is likely to remain paused for some time, but CVS Health Corp is an example of a solid reason for pausing growth.

The company pursued an acquisition that looked expensive on the face of it, one we were actually skeptical of when announced, but has provided CVS Health Corp with an influx of customers, a growing bottom-line and strong free cash flow.

Initially, the market did not care for the purchase or dividend pause, but shares are up nearly 50% since the lows.

Not a bad return for the investor who was able to understand that the company was freezing its dividend to help pay for a purchase that would aid in future results.

Final Thoughts

Other than a dividend cut, a dividend freeze might be the last thing income investors wants to encounter. It is often the case that a dividend pause is foreshadowing trouble for a business. This was the case during the last recession for many of the major banks.

AT&T is a more recent case, as the dividend pause is a direct result of spinning off previously acquired assets. This was essentially a “white flag” by management, declaring to the market that its previous strategy of making high-priced acquisitions was a mistake.

But a pause doesn’t always mean investors should sell the stock.

In the case of CVS, the dividend was frozen because the company acquired another business that would supplement its current business.

The dividend has remained constant for some time, but the stock has rallied in the ensuing years due to the enhanced growth prospects of the acquisition.

AT&T and CVS Health Corp are two companies that paused their dividends for very different reasons.

In our view, pausing the dividend because of failed business adventure is much different from doing so because of an acquisition that will strengthen the parent company.

For this reason, it is our opinion that investors should make sure they understand why a certain company has frozen its dividend before selling the stock.

You can see more high-quality dividend stocks in the following Sure Dividend databases, each based on long streaks of steadily rising dividend payments:

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