Williams Companies Inc.'s Dividend Reduction is Surprisingly Smart

By Markets Fool.com

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Williams Companies (NYSE: WMB) warned investors that it would need to reduce its dividend by a material amount if its merger with rival Energy Transfer Equity (NYSE: ETE) fell through. That's why it is no surprise to see the company announce that it chopped its quarterly dividend by a whopping 68.8% now that the deal is dead.

That said, the companyis not just slashing its payout and calling it a day. Instead, it is pursuing this path to prop up its master limited partnershipWilliams Partners (NYSE: WPZ), which needs the cash to fund growth projects, while also setting its investors up for a bigger payout down the road.

The new payout plan

Williams Companies' strategy is unique. While it is reducing its quarterly dividend from $0.64 per share to $0.20 per share, that reduction is not the result of a similar payout cut at Williams Partners, which would have resulted in less cash flowing up to the parent. Instead, the MLP's payout is not going anywhere.

What Williams Companies plans to do is reinvest a substantial portion of the cash it is entitled to receive from its MLP back into that entity, by participating in Williams Partners' new distribution reinvestment program (DRIP). As a result, it will reinvest roughly $1.3 billion into Williams Partners over the next year and a half by receiving units in its MLP instead of cash. In addition, Williams Companies anticipates investing another $400 million in its MLP, primarily withcash received from asset sale proceeds, which would bring its total investment up to $1.7 billion through the end of next year.

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Williams Companies intends to maintain its new quarterly dividend through 2017, and plans to begin increasing the payout in 2018. Williams Partners, meanwhile, plans to maintain its current distribution rate through 2017, and likewise resume growth in 2018.

Why this path forward?

Williams Companies' decision to cut its dividend to preserve the payout at its MLP is an interesting choice. Williams Companies could have just opted to cut the payout at Williams Partners, which would have forced it to cut its payout as well, because it derives the bulk of its cash flow from Williams Partners. That option would have accomplished the same goal of providing Williams Partners with retained cash flow to fund growth and reduce debt.

However, the path it has chosen comes with a potentially higher payout for its investors. It is trading spendable cash today for the promise of more money in the future by acquiring additional Williams Partners units. Those units not only have the potential to appreciate in value, but are poised to generate a growing stream of cash flow for the company for years to come.

Here's a purely hypothetical projection, just to put this plan into perspective. Let's assume Williams Partners' units do not budge over the next year, enabling Williams Companies to reinvest the entire $1.7 billion at the current unit price. That would net the company more than 45.3 million units. At the moment, those units would throw off roughly $150 million of cash flow each year.

Then let's assume Williams Partners increases its payout by 5% per year starting in 2018. At that projection, Williams Companies stands to collect a cool $1 billion in cash by the end of 2022.

Furthermore, if units appreciate in value by a mere 7% annually, Williams Companies' initial $1.7 billion investment would be worth $2.4 billion after five years.

Add it up and Williams Companies' dividend reduction could turn into a $3.4 billion windfall:

Chart by author. (Note: Assumes Williams Companies acquires additional units at the current price, and that Williams Partners increases its distribution by 5% annually starting in 2018, while units appreciate by 7% annually starting in 2018.)

Investor takeaway

Williams Companies warned its investors that its payout could be cut by a meaningful amount if its merger fell through, and that is just what happened. However, in an effort to turn that lemon into lemonade, the company has developed a plan that could lead to a really sweet payoff down the road.

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Matt DiLallo has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.