Why This Big Bank Slashed Its High-Yield Dividend

By Markets Fool.com

Two words no investor ever wants to hear are "dividend cut." That's especially true when the cutter reduces its payout by two-thirds in one fell swoop. That's what happened earlier this month when sprawling Europe-based financial group Banco Santander sliced its annual distribution to 20 euro cents ($0.23) per share from the previous 60 euro cents ($0.69). Let's take a closer look to see why, and what this might portend for the bank's future.

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The paper it's printed on
Banco Santander's previous dividend, compounded with a weakened share price, meant that its yield was high. But it wasn't particularly sustainable. While paying out 15 euro cents ($0.17) per quarter, the firm posted earnings per share of only 0.13 euro cents ($0.15) in Q3, and 0.12 euro cents ($0.14) in Q2.

The bank avoided financial evisceration by not paying most of those dividends in cash. Starting from 2009, it began offering the disbursement in "scrip" -- i.e., its own shares -- as an option for stockholders.

In 2013, nearly 88% of the dividend was handed out in this form. That level of uptake was due largely to a big tax advantage -- according to the laws of the bank's home country of Spain a stock dividend is not taxable as opposed to a cash payout, which is subject to withholding tax no matter where the shareholder is based.

The option may be popular but it hasn't helped inspire confidence in the firm -- since it was paying out in paper, it was diluting its shareholders. At the moment, Banco Santander's share price is almost 30% below where it was at the beginning of 2009, and at its lowest level since the summer of 2013.

Nobody likes a reduced dividend, but at least this skinny new one is relatively cash-heavy; scrip will comprise only one of the four quarterly distributions, with the rest being paid in cash.

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Capitalizing on a sale
In addition to the dividend cut, Banco Santander also announced a new round of capital raising. It effected this through a share placement with institutional investors to the tune of 7.5 billion euros ($8.7 billion), or nearly 10% of its existing share count. Apparently the issue was a popular one; the bank said it was completed in under four hours.

The dividend cut and the new stock issue are a one-two punch aimed at boosting the bank's capital base. For 2014 it missed its goal of reaching a capital ratio of 9% at the end of the year. One estimate from Citigroup calculates that the moves put Banco Santander on pace to hit a ratio of nearly 12% by 2017.

These moves appear to be meeting with cautious optimism from investors. In spite of the dividend cut and the dilutive effect of the share increase, the company's stock price has largely held steady since the measures were announced.

Holding on
What also helps is that Banco Santander's fundamentals haven't been too bad, considering that none of its key economies -- particularly its home country of Spain -- are doing particularly well.

Yet the bank manages to improve its results. In the first nine months of 2014, its net interest income was marginally higher on a year-over-year basis, while its net loan-loss provisions saw an admirable decline. As a result, attributable net profit saw a nice gain of 32% to 4.4 billion euros ($5.0 billion).

All this considered, Banco Santander's new focus on strengthening core capital is a sensible one, particularly since it's the top lender by market value in the still-struggling economy of the euro zone. Dividends are pleasant to receive, but they shouldn't come at the expense of a bank's capital foundation.

So it seems the company is moving in the right direction. Its investors will probably learn to live with the lower payout, but you can bet they'll be hoping the bank can use that stronger capital base to produce better returns.

The article Why This Big Bank Slashed Its High-Yield Dividend originally appeared on Fool.com.

Eric Volkman has no position in any stocks mentioned. The Motley Fool owns shares of Citigroup. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.