National-Oilwell Varco, Inc. (NOV): A Lesson on Dividend Safety

National-Oilwell Varco, Inc. (NYSE:NOV) surprised many dividend investors with its decision to slash its dividend by 90% on April 11. Income investors could have avoided the cut by paying closer attention to the company’s main risk factors.

The dividend cut announcement came shortly after the company’s CEO gave an investor presentation on March 22.

In the slide deck, the company was noted to have a “strong balance sheet” and “resilient free cash flow generation,” perhaps giving dividend investors a false sense of security.

While business trends weren’t great (sales fell by 52% last quarter), the company still had over $5 billion in cash and undrawn credit capacity compared to $3.9 billion of debt and just $710 million in dividend payments made last year.

National Oilwell Varco’s free cash flow payout ratio over the last twelve months was also still somewhat reasonable at 81%.

Simply put, most companies that end up cutting their dividends are usually in far worse shape by the time they opt for a reduction.

Among hedge funds and other institutional investors tracked by Insider Monkey, National Oilwell Varco’s popularity remained basically unchanged with the number of funds long the stock falling by two to 26 during the fourth quarter. These funds amassed 10.10% of the company’s outstanding stock at the end of 2015, with notable shareholders including First Eagle Investment Management and Mason Hawkins’ Southeastern Asset Management, which held 20.77 million shares and 10.80 million shares, respectively.

How could conservative income investors have known to avoid buying National Oilwell Varco for its dividends?

At Simply Safe Dividends, we do our best to help dividend investors avoid companies that cut their dividends before the dividend is actually reduced.

Analyzing the main factors that support a company’s ability to pay a dividend allows us to assess the dividend’s safety and find safer dividend stocks.

We review a company’s debt levels, payout ratios, recession performance, cash flow generation, industry cyclicality, profitability trends, and more to generate Dividend Safety Scores.

Scores range from 0 to 100 with scores of 50 being average, 25 or lower considered weak, and 75 or higher considered excellent.

Using this process, Kinder Morgan Inc (NYSE:KMI), ConocoPhillips (NYSE:COP), BHP Billiton Limited (ADR) (NYSE:BHP), and other major dividend-payers were each flagged as being in the riskiest 10-20% of stocks out there for dividend safety well before they ultimately cut their dividends.

Let’s take a closer look at National Oilwell Varco, which scored in the bottom 10% for dividend safety prior to announcing its dividend cut.

One of the first safety factors we consider is the industry that the company is in. A company’s industry has a large influence on the stability of the cash flows a business generates.

For example, an industry selling construction equipment will experience a high level of cyclicality, whereas beverage companies enjoy steadier demand.

National-Oilwell Varco, Inc. (NYSE:NOV) operates in the oil field machinery industry and essentially supports oil wells across their entire lifecycle – from the time they are drilled through their production and maintenance.

When oil prices are high, oil producers have incentive to drill more wells and increase their production, driving demand higher for National Oilwell Varco’s products and services.

However, the opposite is also true – low oil prices cause producers to pull back on their investments, hurting demand for oil field machinery.

Commodity prices are inherently unpredictable. Surprises happen, and companies that depend on commodity prices are not always prepared.

As a result, cyclical industries that rely on commodities receive lower marks for dividend safety. Furthermore, we pay especially close attention to near-term trends for these sensitive businesses.

Since commodity prices are unpredictable, a small cut can quickly turn into a gaping wound. If business trends begin to deteriorate, a company’s Dividend Safety Score will quickly start to drop.

The chart below shows National Oilwell Varco’s quarterly sales growth. We can see that growth turned negative in the first quarter of 2015 and quickly plummeted from there. The company’s Dividend Safety Score began to fall quickly after the second quarter of 2015, and business trends only worsened from there.

On a somewhat related note, our Dividend Safety Scores take into consideration how a company performed during the last recession.

Companies with the safest dividend payments typically sell essential products and services that can power through periods of economic weakness. Many of these businesses held sales stable during the financial crisis.

As seen below, National Oilwell Varco’s diluted earnings per share fell by nearly 30% in fiscal year 2009. While its performance was better than many other energy companies, this is clearly a business that is sensitive to the broader economy. NOV’s stock also plunged by nearly 70% in 2008.

Energy is not one of the best stock sectors for dividend income.

Besides a company’s industry, near-term business trends, and recession performance, its balance sheet is incredibly important.

Businesses will always meet their debt obligations before they pay dividends. If times get tough and cash flows dry up, unprepared companies with too much debt can be forced to make very difficult decisions.

National Oilwell Varco’s balance sheet was actually in decent shape at the time of its dividend cut. The company had just over $2 billion in cash on hand compared to $3.9 billion of debt and $710 million in dividend payments made last year.

However, the company’s dependence on commodity markets once again compromised the safety of its dividend.

With fears that low oil prices could keep demand lower for longer, National Oilwell Varco made a reasonable decision to do whatever it takes to preserve cash flow and keep its balance sheet healthy.

Cutting the dividend by 90% will improve the company’s cash flow by over $600 million per year. Until there are clearer signs that the industry has bottomed, National Oilwell Varco will remain conservative.

Our Dividend Safety Score had also noted that the company had only been paying dividends since 2009. While National Oilwell Varco had increased its dividend for over five straight years, management had shown less of a commitment to the dividend than many other companies, such as those in the dividend aristocrats list.

While oil companies such as Exxon Mobil Corporation (NYSE:XOM) and Chevron Corporation (NYSE:CVX) have taken on more debt and sold off assets to keep their dividend growth streaks alive, this was presumably less of a concern for National Oilwell Varco.

Finally, we pay attention to trends in a company’s dividend payout ratio. A rising payout ratio means that a company’s dividend has increased relative to its earnings.

This can happen because of strong dividend growth, falling earnings, or some combination of the two.

If earnings are falling fast, a payout ratio that looked safe last quarter can quickly become dangerous.

In the case of National Oilwell Varco and other stocks, we like to evaluate long-term trends in payout ratios. As seen below, the company’s free cash flow payout ratio increased from 14% in 2013 to 81% in 2015. Its payout ratio also doubled from 2014 to 2015.

Source: Simply Safe Dividends

While a payout ratio of 81% is not ideal, it could also be much worse. However, investors need to remain aware that payout ratios can quickly deteriorate.

Given the cyclical nature of National Oilwell Varco’s business, our Dividend Safety Scores flagged the company’s rising payout ratio and reduced its safety score accordingly.

If business trends continued declining in 2016 (anything can happen in one year in commodity markets), there’s not much stopping the payout ratio from doubling again to an unsustainable level.

Closing Remarks

Dividend investors can improve the safety profile of their portfolio’s income by doing their homework. Simply monitoring a company’s payout ratio is not enough to evaluate the safety of its dividend.

Our Dividend Safety Scores to size up all of the key risk factors impacting a company’s ability to continue paying dividends, and we use our scores to avoid risky income stocks.

Checking a stock’s Dividend Safety Score prior to making an investment decision can help income investors can steer clear of many risky income stocks such as National-Oilwell Varco, Inc. (NYSE:NOV).

By sticking with companies that score well for Dividend Safety, we sleep better at night with the holdings in our Top 20 Dividend Stocks and Conservative Retirees dividend portfolios.

While the market’s direction can always surprise us, we expect our portfolios’ dividends to continue being paid in almost any environment and continue growing over the long run.

Disclosure: None