Ian Wyatt has another “special dividend” presentation that’s currently being heavily promoted to lure new subscribers for one of his newsletters… and like the one we looked at last year, this is a pitch for Steve Mauzy’s Dividend Confidential.
If you don’t know what “special dividends” are, they’re essentially one-time dividends that don’t imply any promise of future continuing dividend payments. Companies occasionally get into a pattern of recurring special dividends, offering a special extra dividend each quarter or each year but not calling it a “regular” dividend, mostly because that makes it easier to adjust the amount without angering investors (people expect special dividends to be irregular, they expect regular dividends to either stay flat or steadily increase, and almost always punish stocks when a regular dividend is reduced)… but mostly, they’re one-time payouts for some specific reason.
In theory, special dividends are used as a way to disburse excess capital to shareholders while regular dividends are used to disburse a portion of ongoing earnings to shareholders — some folks anticipate that if companies are allowed to bring back their overseas profits at a low tax rate, they might pay out a lot of that cash as special dividends, for example, but they’re often caused either by investors demanding that a company do something with all its extra cash, or by some sort of corporate action that leads them to have excess capital (like selling a division, for example).
Wyatt and Mauzy refer to these special dividends as providing “quick profit opportunities”, mostly because of the tendency of the stock to recover back to close to the price it traded at before the dividend payment… though that, of course, does not happen every single time. Nothing is certain in the stock market.
Stocks always adjust in price for dividend payments, and this process is both automatic and unrelated to investor sentiment — if your $40 stock is going to pay a regular 30 cent dividend to shareholders who hold it through November 9, for example, and the stock closes at exactly $40 on November 9 today, then the stock tomorrow will open without the right to claim that dividend payment, and it will open at a price of $39.70. It could immediately shift higher or lower after the open, but that dividend adjustment is automatic.
The same is true for special dividends — if that same stock declared a special dividend of $10, it would open $10 lower on the day after the dividend payment is made (large special dividends, unlike regular dividends, typically have ex-dividend dates after the actual dividend disbursement date, to make sure there’s no confusion about who gets the dividend… and before you ask, don’t waste any time trying to “game the system” with those, everyone trading around that date either gets $10 plus a $30 stock or a $40 stock, there is no secret backdoor that lets you get $10 in cash plus a $40 stock through some crafty trading scheme).
Wyatt thinks that investors are missing out on special dividends because they don’t know that (in many cases, at least), the stock is likely to recover after the drop on the ex-dividend date. So he and Mauzy recommend stocks that are paying a special dividend, which they recommend that you buy after the dividend is announced, hold through the payment and the drop in the share price, and wait until the share price recovers back to the pre-dividend price to sell.
I don’t know how often it works, but there are certainly times when it doesn’t work (like the last teaser of theirs we looked at, in 2016, for example), so this is certainly not guaranteed — you need to both have a reasonable strategy and to choose the right companies.
So what makes a company the right choice for this strategy? Here are the criteria Steve Mauzy suggests in the presentation:
- “Dividend has to be high — at least 4%
- They have to have cash available to pay dividend and have cash flow for the future as well, so the business won’t suffer
- Has to have positive free cash flow
- A financially sound capital structure
- Insiders have to have “skin in the game”
- Growing business and a bright outlook — they’re not doing this to weaken the company
And the dividend is paid from strength, not weakness”
He also suggests that Dividend Confidential will try to jump on these ideas and recommend them within 24 hours of the dividend being announced, because investors often get excited about special dividends and the stock often goes up until the ex-dividend date.
His strategy then is to hold the stock for 3-12 months after that in anticipation of the stock price recovering — he sets the “target sell” price at the level the stock traded at immediately before the dividend was paid.
They claim a strong record over the past year or two, which is not terribly surprising — the market has been going up, so the stronger companies have had a solid chance of recovering in price after the dividend payments.
As I noted above, the last teaser pitch we covered from them (“Can You Really Collect a 35% Dividend In October 2016?“) happened to have been one of their three failures that they include in their portfolio performance — so at least they do acknowledge their failed picks.
That was Syntel (SYNT), which paid a huge special dividend in the Fall of 2016 and never recovered (it also, for some reason, is a stock they didn’t hold for long — they did not wait for it to recover. I’m not sure what their “it’s not working out, sell at a loss” strategy is — it could just be a stop loss, since Syntel did have another big leg down in the weeks immediately after their special dividend payment (the special dividend was $15, so the shares dropped immediately from $42 to $27, but then a few days later they dropped again down to $20).
So what’s the 41% dividend stock they’re pitching this time? That’s almost certainly Warrior Met Coal (HCC), a company that mines metallurgical coal in Alabama. They announced that they would be issuing debt in order to pay out this special dividend a few weeks ago, and it is now official — and the dividend will be $11.21 per share, to be paid on November 22 with an ex-dividend date of the next trading day, November 24 (the markets are closed for Thanksgiving on the 23rd). So yes, if you sell the stock before the dividend is paid, the dividend gets sold with it. And the share price will drop by precisely $11.21 between the close of trading on November 22 and the first trade on November 24.
The details of the dividend, including the dates, are detailed in their press release here.
So what is this company that’s borrowing a bunch of money and using all their cash to pay a special dividend? It’s a recent IPO — private equity companies Apollo, KKR and a few others were lenders to Walter Energy, the previous owner of those mines, and as Walter Energy was on the verge of bankruptcy about two years ago, with no one else really interested in coal mines in early 2016, the lenders essentially took control with a stalking horse bid that turned the $1+ billion they had lent to Walter into a controlling equity stake.
Then coal surged back into favor this year, with metallurgical coal rising several hundred percent in the first half of 2017 following the election of President Trump and the recovery of the steel industry in China (and the closing of some Chinese met coal mines — metallurgical or coking coal is used by steel furnaces, and is more valuable than thermal coal used in coal-fired power plants). That was enough to make the IPO of Warrior Met Coal attractive to investors (and to rejuvenate a bunch of other moribund coal stocks), and HCC went public back in April.
The company is still controlled by those private equity lenders, who got most of the cash from the IPO by selling some of their stake, and presumably the special dividend is being paid because these companies want to extract more of their cash from the company now that things are going pretty well (and, since it’s a dividend and not a sale of stock, they get to extract roughly 40% of their equity as cash without losing any voting control). The combination of the $320 million IPO and the $600 million special dividend, then, gets those private equity companies back close to even on the $1.2 billion or so in debt they extended to Walter Energy and they will still retain controlling stakes in what will be, after the dividend is paid, still roughly a billion-dollar company.
So this special dividend clearly is designed to benefit those initial backers — does that mean it’s terrible for individual investors who buy in now for the dividend? Not necessarily… that all depends on how the company does going forward. It would make me nervous as a long-term investor, because this is essentially a single-asset coal miner that got into trouble and went into bankruptcy less than two years ago… and now, after having reset their debt and fixed their balance sheet, they’re again borrowing a big chunk of cash at junk-bond rates to give their investors some liquidity.
It might work out OK if metallurgical coal prices remain strong, they do have some good things going for them — principally, the fact that they got a generous-sounding ruling on tax loss carry-forwards from the IRS, and are being allowed to use their old tax losses despite the fact that they have effectively been recapitalized as a different company… so if you want to think of it as an asset that they’re “monetizing” here by borrowing money and paying it out as a dividend, it’s that backlog of losses that they can use to offset most of their taxes for the foreseeable future.
I haven’t scoured through the books, but if anything is supportive of the stock price recovering after the $11.21 drop it will take after the special dividend it’s presumably their ability to restate and improve earnings and forecasted earnings because of that much lower tax rate. And if anything is fighting against that recovery of the stock price, it’s the fact that it will again become a leveraged company that will again have to put creditors ahead of shareholders if anything bad happens to their mines or to the price of coal.
It’s also worth noting that we don’t know what the tax treatment of the special dividend will be — sometimes investors are attracted to special dividends but they end up being nothing more than a way to force you to take taxable gains, but probably more often special dividends are classified as “return of capital”, which would seemingly make the most sense in this case (if it’s “return of capital,” the dividend essentially just resets your cost basis lower, so it will change the capital gains taxes you ultimately owe when you sell the shares).
If that’s the case, then, what you’re looking for to provide your gains is not the actual dividend — it’s the run-up in the stock price going into the special dividend, and any recovery in the stock price to above the ex-dividend price in the coming year. The special dividend itself is not terribly relevant — if the stock stays where it is now through November 22, then there’s no point in owning it for those next ten days and getting the dividend, you could just as easily buy it on the 24th at $11.21 less per share and have the same total return.
So that’s how to think about this one — and, really, about any other big special dividend. You have two questions:
- Is it going to run up in price before the special dividend is paid? (They often do, but not every single time… and it depends on the broad market sentiment as well as the specific stock). And…
- Will the stock recover after the dividend is paid? Again, much of the time it does… but not every single time. If you count on the price recovering all of the special dividend payment, you’re essentially saying that the market is inefficient in valuing the company’s assets, and undervalues either the cash or the balance sheet flexibility the company has, so it will consider the company to be roughly as valuable in the future as it was before they paid out that “excess” or unappreciated cash or tapped that access to credit.
As with most things, the tendency is probably for it to work out — after all, the tendency is for the market to go up, most companies probably don’t get enough credit from investors for their cash balances or clean balance sheets or more esoteric assets like “net operating loss carryforwards”, and most things work most of the time when the market goes up.
Personally, I look at the company and see big private equity lenders looking to get their cash back out in both the IPO and this special dividend, which will leave the company with some high-yield debt and without a cash cushion, and it doesn’t look like a company I’d want to own given the fact that this same management team set the company up for bankruptcy by doing much the same thing (overleveraging, not the special dividend part) before coal prices collapsed a couple years ago.
But that doesn’t mean it can’t work to trade around the special dividend over the next few months, as this newsletter pitch recommends, particularly if coal prices do well… it’s just not a trade I’m particularly interested in as a one-off. If you want to follow this kind of special dividend trading strategy, it’s probably better to set aside a portion of a portfolio and make sure you’re pretty well diversified across these trades — you don’t want to overcommit to just one super-aggressive one like this, since, as we saw with Syntel last year, sometimes they don’t work out.
And, well, that’s all I’ve got for you today — yes, there’s a 41% dividend coming… yes, it might be possible to trade around that dividend for a good gain over the relatively short term (though it’s probably safer to shoot for a return of less than 41%). And no, I won’t be making this trade myself because I don’t particularly like the company’s prospects and it looks to me like they’re taking unnecessary balance sheet risk just to help their large investors cash out.
So I’ll pass it back to you, dear readers — do you like these kinds of trades? Interested in seeking or trading around special dividends? Any experience with that kind of strategy in the past you’d like to share, good or bad… or, for that matter, any interest in (or reason we should avoid) Warrior Met Coal? Let us know with a comment below.