Acting Intelligently After A Dividend Cut

The Viacom dividend cut in September, which resulted in the annual payout declining in half from $1.60 to $0.80 per share, is one of the more unnecessary cuts to payouts I have studied based on a fundamental profile analysis.

Despite the circus surrounding Viacom right now, it is still making over $5 per share in profits, or a little over $2 billion per year. Even before the dividend cut, the company was only returning to shareholders $1.60 per share, or about $600 million per year. This Viacom dividend cut meant that the Board of Directors saw wisdom in paying out to shareholders $300 million rather than $600 million of its $2 billion profit stream, or 15% rather than 30% of overall annual profits. Off the top of my head, I cannot recall any other firm cutting its dividend from such a low initial dividend payout ratio amount.

The stated reason for the Viacom dividend cut is that Viacom needs to address its $12.5 billion debt load that has over $1 billion due within the next twelve months. Given the existence of $1.4 billion in retainable profits available at the prior dividend rate, it seems that this is a decision the board made by placing a low priority on the dividend in relation to financing rates and other project initiatives (rather than, as is often the case, a decision born of necessity.)

A point that I grow to lengths to belabor is that dividend payments only demonstrate the cash returned to shareholders at a given point in time, and should not be presumed to mean that mediocre compounding lies ahead. In fact, it is often the opposite–the valuation that exists at the time of the dividend cut means that there is significant P/E recovery ahead coupled with future business performance that is probably not going to be as bad as believed at the time of the cut.

It is my contention that, from a valuation perspective, Viacom is one of the cheapest large-cap stocks in the market. A stock trading at $36 per share while earning $5 per share in profits that aren’t cyclical or expected to taper off gives you a lot of room for error when the P/E ratio is only at 7.

Trading in the years prior to controversy put Viacom stock in the range of 11x earnings to 18x earnings. Even a return to the lower bound of normalcy at 11x earnings implies capital appreciation of 57%.

The amount of the expected valuation shift might sound high, but it is exactly what happens as people come to realize “It’s not the end of the world, and there is still a pretty solid base here.” Conoco traded in the low $30s around the time of its February dividend cut, and now it is up to $44 per share for a 37.5% gain in the same year of the dividend cut. BHP Billiton, which saw its price collapse to the teens, has roughly doubled its price to the $35 range in the months since its dividend cut announcement. The emotions and pessimism that exist at the time of the cut lead to valuations that are well below historically average and are almost destined for mean reversion.

The management turmoil involving Sumner Redstone (perhaps through his daughter) flexing the control over management personnel that comes with the territory of owning 79% of the Class A Viacom stock (if you purchase Viacom yourself, the liquid market is the B shares which do not carry the magnitude of voting rights that you find in the A shares) will eventually settle. Once there is a stable management structure mixed with a few quarters of normalized earnings, the valuation of this stock will rise rapidly because it is trading at way too cheap of a valuation right now considering it is not showing any indication of deteriorating profits. Even though Viacom has cut its dividend in the past month, it still offers an eight out of ten chance of beating the S&P 500 over the next five years because its valuation is so dramatically low. At a minimum, you don’t want to sell a business when it is trading for sixty cents on the dollar. At the maximum, you want to initiate investment positions in large corporations when these unfashionable conditions arise.