Consumer staples companies with high dividend payout ratios may have found a solution for their dividend problems.
Last week, AB InBev, the Belgian beverage giant, announced that it was “rebasing” – i.e. “cutting” – its dividend to “release approximately $4 billion of additional cash annually to accelerate deleveraging.”
AB InBev argued that by taking its leverage down to 2x net debt/EBITDA, it will reduce its cost of capital and “maximize total enterprise value.” All else equal, a lower cost of debt would in theory increase enterprise value, yet AB InBev already has solidly investment-grade credit ratings (e.g., A- from S&P). A ratings upgrade within the investment-grade space would likely only have a marginal impact on lowering cost of debt. Deleveraging could even increase its cost of capital, as more expensive equity takes a greater share of the capital structure.
So, what might really be behind the dividend cut…er, rebase? AB InBev is paying down debt following its huge 2016 acquisition of SABMiller. Despite annual free cash flow around $11 billion, AB InBev spent about $9 billion on dividends, leaving just $2 billion to reduce debt.
In short, the dividend was a handcuff. AB InBev had little financial flexibility to do more M&A, react to changes in the competitive landscape, or opportunistically buyback stock at attractive prices. These strategies could, if done prudently, benefit long-term shareholders.
Indeed, one of the reasons we believe HBO fell behind Netflix on streaming content was Time Warner’s stubbornness around its dividend. Rather than increase content investment, it protected its $1.3 billion dividend payout. The fact that AT&T, which recently completed its Time Warner acquisition, said it will ramp HBO content spending seems to validate this viewpoint.
What’s to come
At first glance, AB InBev’s decision makes sense. In fact, I think some other consumer staples companies may follow suit in the coming years.
Consider these blue-chip consumer staples companies’ high earnings payout ratios:
||Dividend Payout Ratio – Earnings (LTM)
||1-Year Dividend Growth
|Procter & Gamble
Source: Bloomberg, as of October 26, 2018
While these blue chips could likely sustain their current dividends for years to come, like AB InBev, their generous payout commitments limit their ability to further raise the dividend, opportunistically buyback stock, engage in M&A, or reduce debt.
There’s also little room for error. And at a time when many blue chip brands are facing a new wave of competition, consumer staples companies may need to pivot their current strategies to adapt to changing industry dynamics. Further, if interest rates continue to rise, it will be more expensive for these companies to roll over their debt. The prospect of holding back some cash flow may become increasingly appealing.
Still, optics matter, and the blue chips will resist cutting without a catalyst. As such, I expect future merger activity in the sector to include dividend adjustments at the remaining company. This is what Pfizer did, for example, when it acquired Wyeth in 2009. And, with hindsight, it’s what AB InBev should have done when it initially acquired SABMiller.
Ultimately, a company’s dividend should be affordable, reflect the growth in shareholder value creation, and help management more prudently select high-return projects rather than pursue wasteful “empire building” deals. Dividends can be a problem, however, when they become too generous and handcuff management’s ability to invest in high-return projects and defend or widen the firm’s economic moat. When this happens, a dividend “rebasing” or “cut” would benefit long-term shareholders.
As of the date of the post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Netflix (NFLX). This company represents only a percentage of the full strategy. As a result of client-specific circumstances, individual clients may hold positions that are not part of Ensemble Capital’s core equity strategy. Ensemble is a fully discretionary advisor and may exit a portfolio position at any time without notice, in its own discretion.
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