Dividend Time Bombs

Everyone wants to buy into a big yield. The trouble is most people aren’t willing to put in the time to tell the good from the bad and ugly. No matter what high-yielding investment you own, knowing the health of its underlying business is critical. You should always sell if the underlying business of your stock deteriorates.

Roger Conrad – Utility Forecaster

What do Capstead Mortgage (NYSE: CMO), Blackstone Group (NYSE: BX), and Valero Energy (NYSE: VLO) all have in common? They’ve all cut their dividends at least once during 2010. It’s every dividend investor’s nightmare, especially for those who rely on dividends to meet their living expenses. The key to avoiding dividend cuts is to invest only in companies with strong fundamentals and cash-generating businesses that can support their dividend payouts over the long term.

Dividend Cut Warning Signs

Before buying a dividend-paying stock, I try to weed out companies that show any of the following warning signs:

1. Heavy debt load

Cash flow is uncertain but the interest due on debt is a mandatory certainty. If a company doesn’t have enough cash flow to pay both a dividend and make interest payments, the dividend gets chopped first. A good example is SuperMedia (NasdaqGM: SPMD), which changed its name from Idearc after filing for bankruptcy in 2009. The company was the yellow pages business of Verizon (NYSE: VZ) before Verizon spun it off in 2006 along with a huge chunk of debt. At the time, many analysts recommended the stock based on its high dividend, dismissing the high debt load as easily covered by current cash flow. When cash flow declined more than expected as advertisers switched to Internet platforms, the $9.1 billion in debt overwhelmed the company, the dividend was eliminated and bankruptcy followed.

2. Change in Business Conditions

In 2008, Fairpoint Communications (Other OTC: FRCMQ.PK), a North Carolina-based telephone company, agreed to buy Verizon’s telephone businesses in northern New England (Maine, New Hampshire and Vermont) for $2.8 billion. Fairpoint incurred a lot of high-cost debt to pay for the deal and agreed to pay for expensive capital improvements in order to get regulatory approval. Many analysts recommended the stock, arguing that the increased cash flow from the Verizon businesses was more than enough to cover the increased debt expense. When more-than-expected telephone customers canceled their landline telephone service and switched to wireless and cable alternatives, cash flow disappeared and Fairpoint couldn’t service its debt load. Bankruptcy followed in 2009.

3. Verizon Involvement

Based on the previous two examples, be wary of any dividend-paying stock that is the result of a transaction involving Verizon. It almost makes me want to buy Verizon stock, given how the company has an uncanny ability to unload its garbage onto other parties. Did I mention the bankruptcy of Hawaiian Telcom in 2008 after Verizon sold it to the Carlyle Group for $1.6 billion in 2005?

4. Not Enough Cash

Bottom line, a company can only pay its dividend if it generates enough cash to do so. Any company that pays more out in dividends than it generates in normalized cash flow is high-risk and I’d run – not walk – away.

5. Recent Dividend Cut

Companies in trouble rarely stop at one dividend cut. Just look at the aforementioned Capstead Mortgage, which has cut its dividend in each of the last four quarters. At the time of its first cut, it was trading at $15 and now it is trading for about $11. Investors who sold after the first dividend cut did better than those who held on. Other examples of serial cutters include Bank of America (NYSE: BAC) and K-Sea Transportation Partners (NYSE: KSP).  

Some Dividend Cuts are OK

Of course, not all dividend cuts are warning signs. Some cuts are due to one-time events that do not signify deterioration of the business. For example, Frontier Communications (NYSE: FTR) cut its dividend to pay for the acquisition of telephone lines in 14 states from Verizon (Uh oh!) and Penn West Energy Trust (NYSE: PWE) cut its dividend to take into account the conversion to a corporation in 2011. Roger Conrad of Utility Forecaster still likes both companies despite their dividend cuts.

Stock Screen of Potential Dividend Time Bombs

Predicting the future is difficult, but that never sways me from trying. Below is a stock screen that looks for companies with suspect dividends that may be vulnerable to cuts in the future.  I looked for companies with dividend yields of at least 5% that were paying out more in dividends than they generate in earnings or cash flow. I also required that the dividend had not been increased for at least two years.

Source: Morningstar