The past week has led to a few developments with Canadian companies covered by 5i that provide great insight into how to manage a dividend. Constellation Software (CSU) is a great example that deserves particular attention.

Before looking at the specific development at CSU, it may be of value to walkthrough some dividend theory. Dividends are viewed as signals to the markets. When a dividend is initiated, it is meant to be a signal that displays managements’ confidence in the future of the company and stability of cash flows. If management were not confident in future cash flows, they would typically not start paying a dividend as cancelling or cutting the amount can create volatility and uncertainty. Management may also pay a dividend because it has less growth opportunities available and has decided to return cash to its shareholders as it reaches a mature stage in the lifecycle.  Cutting a dividend signals problems at a company as something, in theory, should have unexpectedly happened to create an inability to make a dividend payment. It is important to remember that dividends are not assured and can be cancelled at a moments notice. It is an easy thing to forget, especially when times are good because it only seems that dividends go up. This unfortunately makes it difficult for a company to reduce dividends even if there is a legitimate reason. Constellation Software realizes this and is making an effort to ‘let down’ investors as softly as possible.

CSU reported fourth quarter results on March 6^th and had some interesting notes in a press release regarding the dividend. We have included some of the release from Marketwired below with added emphasis:

Constellation's President, Mark Leonard, said, "With the acquisition of Total Specific Solutions in December 2013, Constellation is financing long-term assets with significant amounts of short-term debt. During the course of the next few months or quarters we plan to address this situation by raising longer-term capital.

We also anticipate making further acquisitions. If we are fortunate and gather up another 20-30 small vertical market software businesses during 2014, then it is likely that much of our free cash flow from operations will be consumed. A recession or regional economic crisis may also create investment opportunities for Constellation. Such opportunities tend to be larger and more infrequent than our average investment, but often occur when raising capital is difficult. Under either of the above scenarios, we would not hesitate to reduce or even eliminate the current quarterly dividend.                   

There are some noteworthy points in the above paragraphs.  First, CSU may be planning on doing a financing. What form it will take is anyone’s guess but we would not rule out a share offering for a company that was up 118% over a year, 896% over 5 years and has not issued any shares since 2006.  Secondly, Constellation may be looking at some sizable acquisitions over 2014. The third important point to glean from above is that Constellation will not hesitate to reduce the dividend if they go forward with a sizable acquisition.  This statement alone shows a strong management team that has the long-term in focus and is not concerned with short-term performance. While a dividend cut may surprise some and even lead to a short-term decline, the company is essentially saying that there are better investment opportunities where the money can earn better returns for investors than what a dividend pays. This is one of the few times where a dividend ‘cut’ may actually be a good thing and shows prudent management compared to a team that refuses to reduce the dividend even if it is at the expense of company solvency.

Others may point out that CSU should not be paying a dividend at all if they need to reduce or cancel it in the first place. Constellation easily addresses this critique by noting that sometimes there are simply ‘offers you can’t refuse’ and is preparing the market for what it might have to do in order to take advantage of these rare opportunities.  While we generally view this news as a positive development over the long term, it very well may create some volatility in the short term. Further, if a/many larger acquisitions materialize, there will be increased integration risks and less room for error, which are aspects that should be watched.  Not only was CSU’s release brave and not often seen but also it makes for a great case study for those who are interested in financial/dividend theory. This is a development that we felt needed special attention due to the interesting lesson it provides as well as a ‘heads-up’ to the happy long-term, set-it-and-forget-it, CSU holders that might be surprised at the news of a financing or dividend cut in the future.