Keppel Corporation Limited Shows Investors What Danger Signs To Look Out For In Dividend Stocks

Last week, Keppel Corporation Limited (SGX: BN4) released its earnings for the fourth quarter of 2016 and declared a final dividend of S$0.12 per share, which is 45.5% lower than the final dividend seen in the fourth quarter of 2015.

All told, Keppel Corp’s total dividend for 2016 is S$0.20 per share, a 41.1% decline compared to the company’s total dividend of S$0.34 in 2015.

Thing is, there were early signs that the company’s dividend for 2016 was at risk of being slashed from the level seen in 2015. In an article I published a year ago on 1 February 2016 titled 3 Key Charts Investors Must See About The Dividends Of Keppel Corporation Limited, I shared the following chart on Keppel Corp’s free cash flow numbers from 2005 to 2015:

Chart 2 - Keppel Corp's free cash flow per share since 2005
Source: S&P Global Market Intelligence

You can see that the company’s free cash flow had declined drastically over the years and went deep into negative territory in 2015. Here’s how I described the problem with Keppel Corp’s free cash flow picture in my earlier article:

“Dividends are ultimately paid using cash and a company can obtain its cash from a few sources. A company can (1) take on debt, (2) issue new shares, (3) sell assets, and (4) generate cash from its business activities.

There are always exceptions, but it’s generally more sustainable for a company to be paying dividends with the cash it has generated from its business. This is why it’s important to keep a close watch on a firm’s free cash flow.

Free cash flow is the actual cash flow from operations that’s left after the firm has spent the necessary capital needed to maintain its businesses at their current state. The higher a company’s free cash flow can be in the future, the greater the potential there is for growing dividends.

What we can observe in Chart 2 is troubling – Keppel Corp hasn’t been able to generate positive free cash flow for a number of years now and the situation only seems to be worsening. This seriously erodes the margin of safety that the firm has in maintaining or growing its payouts in the future.”

The chart you see below is also one I showed in 3 Key Charts Investors Must See About The Dividends Of Keppel Corporation Limited; it’s about how Keppel Corp’s net debt to equity ratio had evolved from 2005 to 2015.

Two key observations from the chart are that the company’s net debt to equity ratio in 2015 had increased sharply in more recent years and it was at a peak for the timeframe under study. (Generally speaking, a low net debt to equity ratio is preferred over a high one.)

Chart 3 - Keppel Corp's net debt to equity ratio
Source: S&P Global Market Intelligence

I described the risks that came with Keppel Corp’s increasingly shaky balance sheet in the article with the following passage:

“This brings me to something important about dividends that investors need to note: There are no guarantees when it comes to a company paying dividends. When a firm has a weak balance sheet that’s bloated with debt, its dividends run the risk of being reduced or removed – either due to pressure from creditors or a simple lack of cash – even at the slightest hiccup in its business.”

Toward the end of my aforementioned February 2016 article, I wrapped it up with the following:

“From what we’ve seen, Keppel Corp has had a commendable long-term history of dividend increases. But, for investors who are attracted to the firm’s yield and dividend track record, there are important risks to note regarding the troubling lack of free cash flow and the severe weakening of the balance sheet.”

And as we’ve observed from Keppel Corp’s dividend for the whole of 2016, an inability to produce free cash flow and a balance sheet that has seen significant growth in debt can lead to painful cuts in a company’s dividend pay-out. The appearance of the two danger signs do not always mean that a company’s dividend is facing a sharp and imminent reduction. But when the signs show up, there better be good reasons why that’s so.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any company mentioned.