The dividend game

Cuts are not always bad news

The news that BCE Inc. (TSX: BCE) cut its dividend by 56%, to $1.75 a year, should not have come as a surprise. The market had been indicating for months that it did not believe the dividend, which represented a payout ratio of almost 150% of free cash flow, was sustainable. The share price had fallen by one third this year, and the dividend yield rose to over 13%.

As recently as six months ago, BCE’s management, led by CEO Mirko Bibic, insisted the dividend, while not growing any more, would be maintained. The cut was obviously a disappointment to investors, but the stock jumped 8% after the announcement, indicating that some purchasers believe the new level is realistic.

Readers with long memories may remember that another corporate giant, TC Energy (TransCanada Pipelines as it was known then) cut its dividend by over a third in late 1999 to outrage from investors. Yet within seven years, the dividend had risen back to above the level it was at before the cut, and the share price reflected the strong underlying performance that had led to the rising payout.

A number of companies cut their payouts during the Covid outbreak, but in almost all cases, the dividends have been raised since 2020, and in some cases are now above the pre-Covid level.

There were a couple of specific reasons for BCE’s cut. They included the high level of debt taken on to fund its 5G upgrade, the pressure on fees from the competition, including Quebecor’s Freedom Mobile, and the lower level of immigration.

BCE used the $4.7 billion raised from the sale of its 37.5% stake in Maple Leaf Sports and Entertainment (MLSE) to Rogers to buy Ziply Fiber in the U.S. Northwest in November rather than reduce its debt load. This occurred after Moody’s and S&P downgraded BCE’s debt in September, leading to the question of why management didn’t address its debt load sooner.

The conclusion has to be that dividend cuts are not necessarily all bad news. While some dividend cuts, such as BCE’s, are well anticipated in advance by the market, others come abruptly with no forewarning. These are probably the most damaging, as investors have had no chance to sell ahead of the cut. Such cuts also raise questions about management’s credibility. If they have been proclaiming their intention to maintain the dividend, without any indication that a cut is at least under consideration, investors can justifiably feel misled.

The dividend payout ratio and its problems

One metric that some investors look at is the dividend payout ratio, or dividends as a percentage of a company’s earnings. The obvious conclusion is that investors should avoid companies paying more than 100% of earnings. The difficulty with using this ratio is that company earnings have become increasingly difficult to rely on, as special one-off items or the exclusion of certain categories of expenses, such as stock options, make earnings much more of a judgement call by management than an accurate reflection of a company’s profits. As the old joke has it, a good accountant is one who, when asked what 2 + 2 equals, replies “What would you like it to be?”

Many companies these days will focus on earnings before interest, tax, depreciation, and amortization (EBITDA) – or earnings before bad stuff (EBBS) as it’s sometimes called – rather than GAAP earnings. But at least these ratios give some sense of the cash being generated by the business operations.

Income trusts and REITs use funds from operations (FFO) when calculating their payout ratios, or, more conservatively, adjusted funds from operations (AFFO). The latter includes such items as repairs and maintenance to keep up the properties they own.

Trade wars

The recent agreement between the U.S. and China to reduce American tariffs to 30% from 145% has seen an explosive rally in the U.S. major indexes. The S&P 500 and Nasdaq are well above their levels before the Liberation Day announcement of reciprocal tariffs in early April. But the new deal is not a final agreement but a pause lasting 90 days while the two sides come to terms.

The likely lower inflation due to reduced tariffs on Chinese imports has meant that Federal Reserve Chair Jerome Powell has been willing to stand pat, with the Fed Funds rate at 4.5%. The number of expected further cuts this year has been pared back to two rather than three or four. Meanwhile, the Bank of Canada and other central banks, such as the European Central bank and the Bank of England, reduced their short-term rates by 0.25% this month, and the direction of rates remains downwards.

The Bank of Canada has almost halved short-term rates in the last 12 months, to 2.75% from 5%. The weak job numbers for April, with the unemployment rate jumping to 6.9% from 6.7% and 75,000 private sector jobs lost in the last two months, makes more cuts probable later this year.

This makes dividends that are at least maintained or even increased more attractive, even before taking their tax-efficient treatment (67% of the top rate tax) into account.

Enghouse a solid dividend payer

One dividend-paying company that would be of interest to income investors is Markham, Ontario-based Enghouse Systems Ltd. (TSX: ENGH), a Canadian enterprise software company. Founded in 1984, it specializes in contact centres, video communication, healthcare, public safety, telecommunications, and the public transit markets.

Enghouse has recorded solid growth in its revenues and earnings over the last two years, despite it not being reflected in its share price. But revenues of $503 million for the year ended Oct. 31, 2024, are no higher than they were in 2020, as slow decline in the contact centre business offset growth in the safety, healthcare, and public transit areas. Revenues grew 10.6% for the year ended Oct. 31, 2024, up from $454 million in the prior year, and are ahead 20% from 2022. Annual Software as a Service (SaaS) and maintenance revenue grew 16.4%, to $346.6 million, and now represent 69% of total revenues. Net income grew 12.6%, to $81.3 million ($1.47 per share) from $72.2 million ($1.31 per share), although still below the $1.77 per share in 2020.

The company raised its quarterly dividend 18%, to $0.26, at the beginning of 2024, equivalent to a yield of 4.5%. It is 81% higher than four years ago. Enghouse also paid a one-off special dividend of $1.50 at the beginning of 2021 to reflect the exceptional profits from its Vidyo contact centre business during Covid.

Enghouse would be worth looking at as a long-established enterprise software company with an excellent track record and a reasonable and sustainable dividend. Consult with your financial advisor before investing to ensure the stock aligns with your financial objectives and risk-tolerance level.

Gavin Graham is a veteran financial analyst, money manager, formerly Chief Investment Officer of BMO Financial, and a specialist in international investing, with over 35 years’ experience in global investment management. He is currently Chief Investment Officer of Calgary-based Spire Wealth Management.

Notes and Disclaimer

The commentaries contained herein are provided as a general source of information, and should not be considered as investment advice or an offer or solicitations to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however, accuracy cannot be guaranteed. Investors are expected to obtain professional investment advice.

The views expressed in this post are those of the author. Equity investments are subject to risk, including risk of loss. No guarantee of performance is made or implied. The foregoing is for general information purposes only. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.

Image: iStock.com/Bob Lord