Dividend yields are often calculated using historical data, but
when considering investing in a security for income purposes, it's
much more important to consider what the future might look
like.
In other words, it is important to be more concerned about the
ability of a stock to keep on paying its dividend going forward.
Below are six potential warning signs that a current dividend
payout rate might prove unsustainable.
1. High Payout Ratio
Generally, a stock that sports a dividend yield higher than the
market or its peer group represents an appealing opportunity for
income-minded investors. However, be wary of a payout that differs
significantly from the crowd because it might not be sustainable.
Such a high yield could indicate that investors expect a drastic
cut or that the fundamentals don't support such a high payout going
forward.
Take grocery store chain Supervalu (
SVU
), for example. Back in early July 2012, the stock seemingly
offered an eye-popping dividend yield of over 15%, based on an
annualized payout of $0.35 per share divided by its then-current
stock price of about $2.40 per share. However, on July 11, the
company announced that it was suspending its quarterly dividend
entirely. This move was due to continued struggles in growing sales
and profits at its existing stores, as well as high debt levels due
to an ill-timed acquisition right before the financial crisis. That
the yield was well above the industry average of 2.4% represented a
clear warning sign.
2. Big Debt Burdens
Upcoming debt repayment obligations can make it tough to keep up
with dividend payout obligations.
In the case of natural gas provider Chesapeake Energy (
CHK
), its 1.7% dividend yield doesn't really makes sense given its
debt levels and historical track record of allocating more funds on
capital spending than its operations generate in terms of operating
cash flow. Last year, the company paid dividends of nearly $200
million, but generated negative free cash flow of $3.5 billion.
Debt as of the end of its most recent quarter at the end of June
2012 also stood at $14 billion. Chesapeake only had $1 billion in
cash on the balance sheet at the time and still had billions in
capex commitments for the year. There is little capacity for the
firm to be paying a dividend. Low gas prices have hit its cash flow
generating capabilities and the survival of the firm could really
be called into question in a rising interest rate environments.
3. Layoffs
A company cutting its workforce significantly is a sign of
trouble, and could eventually translate into cash conservation
through reduced dividends. Embattled technology giant
Hewlett-Packard (
HPQ
) has been struggling with turnover in upper management as well as
computer and printing businesses that are seeing sales and profits
decline. The company recently increased its estimates of employee
layoffs by a couple of thousand of workers to 29,000 individuals in
total.
One news source
recently estimated that HP has now laid off around 120,000 workers
over the past decade. The stated dividend yield currently stands
around 3.6%, but could likely be cut if growth fails to return, or
if the PC and printer operations continue to experience cutthroat
competition from tablet computers and smart phones.
4. Earnings Misses
Lower-than-expected earnings or reported cash flow can diminish
a company's ability to pay a dividend going over time. Avon
Products (
AVP
), which sells cosmetics, related beauty products and other
consumer goods directly to individuals, has steadily seen its cash
flow decline in recent years. Back in 2005, the firm generated
$1.45 in free cash flow per share and easily covered its annual
dividend payout of $0.66 per share. Last year, free cash flow was
$0.88 per share but the firm paid out $0.92 in per-share dividends.
The stated dividend yield of 5.3% certainly looks tempting, but is
unsustainable based on current cash flow production and the
worrying direction its fundamentals are heading.
5. Reduced Guidance/Estimates
If analysts become increasingly pessimistic on a company's
outlook, it could be a sign of struggles ahead. Pro wrestling
promoter and movie producer World Wrestling Entertainment (
WWE
) slashed its dividend by 50% in 2011 to $0.72 per share. The
warning signs for the stock were apparent, as the dividend payout
exceeded reported earnings for the five previous years (and free
cash flow levels in three out of five of those years). Analysts
were likely fully aware of the slowing profit growth and tried to
ramp down their profit expectations. Over the past three months,
they have reduced both their quarterly and annual earnings
projections. As it stands right now, the annual profit outlook of
$0.39 will fall below the current annual dividend obligation of
$0.48 per share. There is a chance that free cash flow will cover
the dividend payout, but the current trend suggests the stated
dividend yield of 5.4% is still too generous.
6. General Industry Softness
Weakness among competitors, discouraging market data statistics,
and other general industry weakness could serve as warning signs
that dividend payouts are unsustainable. In the technology
industry, personal computer weakness has been prevalent and could
be a warning sign that H-P's profit levels continue to dip and that
its dividend will at best stay flat. Ironically, archrival Dell (
DELL
) just announced the payment of its first quarterly dividend, but
its current cash flow trends are far from encouraging. Struggles in
the natural gas industry and rapid drop in gas prices are worrying
for industry participants. Indeed, any firm with an above average
dividend payout in this space could be forced to cut the annual
payout.
The Bottom Line
Companies with deteriorating fundamentals will hold out as long
as they can to support their dividend payouts. But eventually, if
reported earnings and cash flow levels fail to cover the dividend,
cutbacks are inevitable. Declines in profits or forward projections
are some red flags to track, as are more challenging industry
conditions.
At the time of writing, Ryan C. Fuhrmann was long shares of
HPQ but did not own shares in any other company mentioned in this
article.
Be sure to visit our complete recommended list of the
Best Dividend Stocks
, as well as a detailed explanation of
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.