Debt Funded Dividends?

A recent research report by India Ratings and Research, a Fitch group of companies has shown that though the quantum of debt funded dividends have come down still many of the corporates are paying dividends out of borrowed funds.

The study is based on the study of the top 500 corporate borrowers. Of these 500 corporates 65 companies account for 85-88% of the total dividends paid since FY 2010, and hence these 65 companies have been studied.

The 65 companies are classified into three categories:

1. Category A: Free Cash Flows (FCF) are positive and greater than the dividends paid (FCF +ve & > Dividend)
2. Category B: Free Cash Flows (FCF) are positive but less than the dividends paid (FCF +ve but < Dividend)
3. Category C: Free Cash Flows (FCF) are negative and the entire dividends paid id funded by debt (FCF -ve & entirely funded by debt)

The summary of the research report reveals:

Debt Funding of Dividends (DFDs) Shows Downward Trend:

From a level of 22% of the total dividend in the financial years 2010-16, DFDs will decline to an estimated 13%. 

In absolute terms too the DFDs are estimated to come down from an absolute figure of Indian Rupees 90 billion to 58 billion.

Capital Intensive Sectors to be the Main Culprits:

Capital intensive sectors like infrastructure, telecom and power are the main contributors. The reason being the profits are fully absorbed for creation of capital assets and therefore are forced to borrow to pay dividends.

DFDs of capital intensive sectors which contributed 42% of the total in FY 2010-16 are likely to steeply climb to 77% in FY2017-18.

Healthy Corporates to Pay Higher Dividend

Ind-Ra expects the Category A companies to pay higher dividends than focus on growth (at the cost of dividends).

The CAGR in dividends grew at 21% compared to the CAGR growth of 6% in free cash flows.

Unwarranted Dividends by Riskier, Category C Companies

The riskier, Category C companies, wherein dividends are 100% financed by debt, the dividend payout grew at a 11% CAGR between FY 2016 and FY 2010.

Ind-Ra predicts that the possible reason for growth in debt funded dividends is to defend the market capitalisation. It is observed that the market capitalisation of the Category C companies increased 2% despite their free cash flows being negative since the financial year 2012.

In conclusion, debt funded dividends is a horrendous practice and value investors should shun investing in such companies.