An Update on Dividend Safety During the Coronavirus Crisis

Dear customer or prospective member,

Matt (my business partner) and I want to provide you with an update on how Simply Safe Dividends is responding to the impact of the coronavirus and the turmoil it has caused in financial markets. 

 

The past several weeks have been a trying time for the U.S. and the world. Our foremost wish is health and safety for you, your families, and the brave men and women serving on the frontlines. 

 

As we all continue grappling with what the future may hold, I wanted to address some of the investing questions you might have. 

Here's what we will cover in this email:

First, I want to emphasize that our Dividend Safety Scores have remained largely stable thus far due to the conservative, long-term view we take when assessing dividend cut risk.

Since the beginning of March, less than 62 of the approximately 1,350 scores we maintain have changed. And only 8 companies with Safe or Very Safe ratings have been downgraded to Borderline Safe or lower.

Big picture, we don't want to have any knee-jerk reactions to price volatility. We believe the market is generally quite efficient, but it's also known to have periodic overreactions in the short term.

Our goal is to provide you with solid, objective analysis that you can use to make informed decisions instead of blindly following recommendations. On that front, we've been busy.

During the past two weeks, we have worked double-time to review companies facing the most direct and immediate pressure caused by coronavirus shutdowns and the oil-price war. Think restaurants, apparel retailers, department stores, malls, hotels, airlines, theme parks, movie theaters, oil producers, etc.

While this effort is largely complete, we still have work to do. We plan to evaluate more businesses primarily in energy, banking, insurance, chemicals, and pockets of retail.

However, based on what we know today, we do not expect a significant number of scores to change.

Over 30 dividend cuts or suspensions were announced over the past two weeks. Virtually all of these companies were directly in the crosshairs of the unprecedented shockwave caused by coronavirus shutdowns and the oil-price war.

We expect more dividend reductions in the weeks ahead from many consumer-facing businesses and energy companies (more on that below).

Outside of the industries that are most directly and immediately impacted, which represent a minority of the dividend-paying stocks in the market, we think the broader outlook for dividends will depend on the depth and duration of this downturn, which no one knows.

If this drags out and governments are unable to adequately support consumers and businesses that have seen their income evaporate nearly overnight, then there's potential for a domino effect of financial problems to be triggered.

For example, real estate investment trusts may not be able to collect all of their rent. Mortgage payments could be missed. Banks, insurers, and other investors could face a wave of non-performing loans and other impaired investments. Credit could freeze up.

Depending on how dire the situation becomes, political pressure could rise for certain businesses to dial back their shareholder distributions or disrupt their traditional operations to provide more immediate support to the American people and economy.

Unintended consequences abound in this high-stakes effort to flatten the coronavirus’ curve, and visibility is minimal at best.

For now, we believe these concerns are only a tail risk, albeit one that the market seems to be getting a little worried about. A lot can change in the weeks and months ahead based on policy response and the virus itself, and we aren't going to speculate.

All we can do is continue monitoring the situation. If we feel the scale begins to tip in a way that could usher in an unusual wave of dividend cuts across other industries, we will let you know.

Until then, we are taking a wait-and-see approach and are eager to hear updates from management teams when earnings season kicks off next month. 

Let's take a closer look at the industries and companies facing the most imminent risk of dividend cuts.

For some perspective on the extraordinary pace of financial disruption taking place in certain industries, the chart below shows the year-over-year change in U.S. restaurant diners since March 7th. 

 

In less than two weeks, cash flow has virtually evaporated with no advance warning. For context, during the 2007-09 financial crisis the casual dining industry’s same-restaurant sales declined at a mid-single-digit pace.

Coronavirus-related shutdowns designed to prevent the transmission of the virus have brought a sudden perfect storm to other consumer-facing businesses too – apparel retailers, department stores, malls, hotels, airlines, theme parks, movie theaters, etc.

 
Analysts at Goldman Sachs believe the economy will contract 24% next quarter, far outpacing the largest quarterly drop in gross domestic product on record (-10% in 1958), according to the Wall Street Journal. A rebound is expected in the second half of the year, but that’s anyone’s guess. 

Given the demand vacuum created in these industries, which we expected to drive an unprecedented need to preserve capital (and pressure dividends), our first priority was to evaluate any companies with Safe or Very Safe Dividend Safety Scores in these sectors.

 

Most businesses in these industries did not score well heading into this mess due to their cyclicality, capital intensity, high leverage, and poor durability.

In fact, over three-quarters (82 out of 108) of the stocks in these industries already scored below our Safe threshold for Dividend Safety at the beginning of March.

 

In a normal recessionary environment, we would have expected the firms with healthy Dividend Safety Scores to have had a good shot at maintaining their dividends. Most of these businesses maintained low payout ratios, generated solid cash flow, and earned investment-grade credit ratings.

 

But in this extreme environment where liquidity is especially precious, all bets are off for dividends. Not only did many of these businesses suddenly lose most of their revenue, but a lot of them also have high fixed costs. In other words, a steep, prolonged drop in revenue burns through cash quickly.

 

We downgraded some of these previously Safe-rated companies to Unsafe, including Darden (DRI), Marriott (MAR), Cracker Barrel (CBRL), and Delta Airlines (DAL). 

 

Within a week or less, several of these companies announced dividend suspensions. Even Darden suspended its dividend after having made uninterrupted payouts for two decades.

 

That’s how fast some management teams are responding to this unprecedented crisis. If investors held these stocks for income, there was unusually little time to react. This is another example of the importance of keeping a diversified portfolio. Bad luck happens.

 

We expect more dividend cuts to come from these industries that are most directly in the crosshairs of the coronavirus. When evaluating companies in these areas, investors should tread very carefully, especially with firms that have Borderline Safe scores or worse.

 

We also believe a wave of dividend cuts will come from the energy sector, which is dealing with oil prices collapsing from about $45 per barrel in early March to below $30 today.

Once again, the theme was similar – 84% (76 out of 91) of energy producers and oilfield services providers, which are in the crosshairs of the collapse in oil prices, scored below our Safe threshold at the beginning of March.

 

Most energy stocks are rated especially conservatively for dividend safety due to their dependence on supportive oil & gas prices and rising production. The health of a business can change quickly, and we take a long-term view of dividend risk.

 

Score changes were rather minimal and driven by our take that oil prices could remain depressed for at least several quarters, if not for a year or longer. This lowers the balance sheet runway oil companies have to sustain both their production and dividends.

 

As a result of this shock, we downgraded Exxon (XOM) and Shell’s (RDS.B) Dividend Safety Scores to Borderline Safe, BP (BP) to Unsafe, and Chevron to Safe.

 

Oilfield service providers such as Halliburton (HAL), Helmerich & Payne (HP), and Schlumberger (SLB) are expected to be under the most pressure going forward as spending by exploration and production companies plunges. These are speculative income investments, in our view.

 

In the midstream space, it’s too soon to say what could happen. Throughput could fall as production slows in response to weak commodity prices and demand. Tariff rates may be challenged by financially struggling customers. And contract defaults are possible.

 

We shared our thoughts on Enterprise Products Partners (EPD) and Magellan Midstream Partners (MMP), which retain Safe ratings for now.  

 

We’ve yet to see a wave of cuts from energy companies, but we believe they are coming from weaker firms and again advise income investors to tread carefully, if at all, in this volatile sector.

As of March 1, investors who stuck with companies that scored above 60 (our Safe and Very Safe categories) would have avoided 336 of the 341 cuts since our scoring system’s inception.
 

Since the beginning of March, another 31 dividend cuts and suspensions have been declared. None of these companies had a Safe or Very Safe score at the time of their announcement, and all but a few had Unsafe or Very Unsafe ratings.

Our realtime track record is always available here. 

To be fair, our Dividend Safety Score system was conceived in late 2015 and has not experienced a recession.

Combined with the long-term view of dividend risk we try to take over a full economic cycle, it's difficult to read much into deeper statistics like the percentage of Borderline Safe companies that have cut their dividends (around 6%).

As conservative investors, we prefer to have most of our portfolios invested in companies with Safe or Very Safe scores.

 

As you may know, I don't like to sell unless I believe a company's dividend may no longer be safe or its long-term outlook has faded significantly. Recent events forced two trades across our three model dividend portfolios.

On March 10, I sold Boeing out of our Top 20 Dividend Stocks portfolio and downgraded its Dividend Safety Score from Borderline Safe to Unsafe. I felt the dividend may no longer be safe in light of financial challenges caused by the coronavirus outbreak (hurting airline customers) and a new wiring issue with the 737 MAX.

We bought our shares in July 2015 at a price of $144.48 per share and trimmed our position by a third in February 2018 at $342.30 after our position reached an uncomfortably large weight (about 8% of our portfolio).

We sold our shares near $200 on March 10. Less than two weeks later, Boeing suspended its dividend and trades below $100 today. That's how fast conditions have changed this month in certain industries.

We also plan to sell Sysco from our Conservative Retirees portfolio on March 23. The issue here is the company's core customer base (restaurants = 60% of sales, hotels = 9%, schools and governments = 9%) shutting down and straining its short-term cash flow.

Management appears motivated to maintain the dividend for now (Sysco has paid higher dividends for 51 consecutive years), but the firm's financial position has suddenly become shaky.

With many high-yielding stocks selling off, we believe we will have opportunity to own a different stock that generates similar income but has a safer customer base in this extreme environment.

No other trades are planned at this time. If we find replacement ideas for Boeing and Sysco prior to the next newsletter on April 3, we will send out an email. For now, the sale proceeds are sitting in cash.

It's also worth mentioning that we could encounter some bumps in parts of our portfolios. For example, we plan to continue holding restaurant chain Texas Roadhouse (TXRH) in our Long-term Dividend Growth portfolio.

Though the company's balance sheet is excellent and its long-term outlook arguably remains unchanged, it's possible management will follow some of its peers and temporarily suspend the dividend in this uncertain environment.

These are tough judgement calls to make, but for now we are content holding what we believe are great businesses with stable long-term outlooks. We expect the benefits of portfolio diversification to help smooth out any unexpected bumps in the road ahead.
 

Hope for the best, and prepare for the worst. We are in uncharted waters here. A number of great businesses are beginning to sport interesting valuations, but no one knows when the bottom will be in. This situation has a wide range of potential outcomes and timelines.

In the meantime, pockets of the market experiencing the most abrupt and severe drops in cash flow (e.g. the consumer-facing businesses previously discussed) could experience a jump in dividend cuts and suspensions.

There's really no visibility beyond that point. Stay diversified, own quality businesses with healthy financial profiles, and remain patient. While we've had to make a couple of tweaks in our portfolios, we have no plans on going to cash.

There are never any guarantees, especially with short-term performance. But we remain optimistic that this latest crisis, like every other shock before it, will not threaten the global economy's long-term outlook.

As we all anxiously await better times, I suggest heeding Warren Buffett's latest advice and finding your own version of Coca-Cola:

We will do our best to continue navigating this challenging environment alongside you and are always here if you ever have any questions.

Best regards,
Brian