Banks running out of wiggle room on dividend hikes

In Canada, dividend increases at big banks have become like presents at Christmas. We expect them every year and if we don't get them, we'd be pretty upset.

And like Christmas, those bestowing the gifts can feel the pressure in a tight financial year. The banks are heading into one of those now – and the dividend generosity of some of them might become more strained as the year unfolds.

This week, those worries look pretty far away. Several of the country's biggest banks unveiled annual dividend increases in conjunction with their fiscal first-quarter financial results. Toronto-Dominion Bank and Royal Bank of Canada delivered 5-per-cent increases; Bank of Montreal came through with a 3-per-cent hike.

In most years, profit growth has more than paid for dividend increases, keeping everyone happy. Over the past decade, the median annual income growth for the country's Big Six banks, collectively, was 16 per cent. Average growth since the financial crisis was 21 per cent.

But not this year. Canada's weak economic outlook – led by a downturn in housing (a big business for the banks) – is poised to choke off profit growth at the banks. Bloomberg's analysts' consensus forecast is for earnings per share at the Big Six to grow 4 per cent in their 2013 fiscal year. "Modest" would be putting it too kindly.

Bank of Nova Scotia, which reports its first-quarter results next week and hasn't yet declared its dividend plans, is actually expected to show a 5-per-cent decline in profit for the fiscal year. Bank of Montreal is forecast to report just 1-per-cent profit growth.

These are based, in part, on current economic expectations for Canada. With the country's growth this year looking weaker with each economic release, there's a chance analysts may have to lower their forecasts for bank-earnings growth even further.

All six banks have a policy of maintaining their dividend payout ratio (dividends as a proportion of earnings per share) at between 40 and 50 per cent. That gives them some flexibility from year to year, and plenty of wiggle room in very tough years to maintain their dividend levels. Cuts are really not a serious danger.

But the combination of higher dividend commitments and slim profit growth should push the banks closer to the top end of their payout-ratio band. (See the accompanying table below.)

For some, this could become an issue when it next comes time to decide on a dividend increase. If growth prospects get much worse, they may have little or no room for comfort.

Projected 2013 dividend payout ratios of Big Six vs. 2012