Dividends just jumped the shark

If you're holding shares of a company that's borrowing to pay its dividend, make sure you know the real gamble you're taking.

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If you're a Happy Days fan — and why wouldn't you be — you may have seen the episode where Arthur 'Fonz' Fonzarelli rides his motorcyle over a jump… and a shark.

Critics and fans generally agree that episode was a pivot point for Happy Days — the point at which it went from a wonderful show to one that was reaching further and further for new storylines, and failing in the attempt.

And hence 'jumping the shark' became part of the lexicon. It's used to mark the point at which something — a television show, fashion, or concept — turns bad.

And BHP Billiton's announcement this morning that it would be happy to borrow to pay its dividend, should that be required, might just be the point at which dividends jumped the shark.

Here's the simple reality of what BHP is suggesting — it's the equivalent of taking a cash advance on your credit card to fund your kids' pocket money.

Mortgaging the future

It really is as silly as it sounds. But there are reasons a company like BHP — and it's certainly not on its own — gives for doing it.

So just why would a company want to pay dividends by charging them to the corporate credit card?

The first, and most logically defensible reason is that the company is going through a very short term cash squeeze. If the management has a very strong reason to believe that things will get back to normal in the space of a few months, that might justify a small amount of debt.

The second reason is that shareholders demand it. Though logically unsustainable, I get where management is coming from.

If the owners of the business say they want a dividend — and if they'd be mad with a falling share price if that dividend was cut — the top brass becomes suddenly predisposed to whip out the credit card.

Lastly, and least defensibly, is the 'well, we have the balance sheet to support it' argument. We all had our mothers or fathers say at least once in our childhoods 'just because you can, doesn't mean you should'.

At best, this is a way to justify one of the other reasons above. At worst, it's desperate spin.

Now, let's look at each in turn.

It just doesn't make sense

Very few companies have the required future certainty that profits will recover. Sure they might, but the debt is a must. Using a 'might' to pay for a 'must' seems particularly risky to me.

And doubly so when you're a commodities business, reliant on prices that are — by definition — outside your control. So even with the best intent and highest quality management, it's an unnecessary gamble on the future.

And yes, while shareholders may well demand a dividend be paid (and remember, BHP is considering borrowing not just to pay a dividend at current levels, but at even higher levels), unless the problem is genuinely short term in nature, those shareholders are asking the CEO to mortgage the future.

Sure, they might want the money, but if in doing so it weakens the business, they're robbing the future to pay for today. Which, again, sounds exactly like a credit card.

And those shareholders who want the dividend maintained to stop the share price falling are in exactly the same position — the company will simply be worth less in the future, because it'll have lower earnings and more debt. Meaning they're — perhaps unwittingly — choosing gain today and pain tomorrow.

Understanding the risks

Managers love to be able to trumpet a rising share price and rising dividends. Shareholders love both, too. But if it's all simply a case of ostriches sticking their heads in the sand, and hoping the future never comes, then they're all living in a fool's paradise.

Yes, maybe it all turns out okay — but if you're holding shares of a company that's borrowing to pay its dividend, make sure you know the real gamble you're taking.

Instead, look for companies whose dividends are well covered by their cash flows — it'll mean less chance of that dividend being cut at some time in the future, and likely also a business that's in better shape overall.

You won't be surprised that BHP is not a Motley Fool Share Advisor recommendation. We instead look for quality businesses with pricing power, and whose dividends — where they're paid — are covered by the company's earnings and cash flow.

We're looking for the best of the best.

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