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.
— Roger Conrad, Big Yield Hunting
I’m always on the lookout for a high-yield investment, so a few days ago I decided to “do it myself” by using one of the stock screens I discuss in Best Stock Screening Tools on the Web. Stock screens are easy, especially when you don’t spend much time or thought on the filtering criteria. I felt lazy that day so my only criterion was high yield. The screen results spit out many of the usual suspects, namely mortgage REITs which I know are high risk.
But there was one stock listed I hadn’t seen before called IncrediMail (NasdaqGM: MAIL). I checked it out on Yahoo! Finance and, sure enough, this stock with the incredible-sounding name appeared to pay an 11.4% dividend. In the low-interest rate environment we currently live in, any double-digit yield is beyond attractive – it’s almost miraculous.
Stock screens, as I am wont to say, are just the first step in the investment process. The second step is to perform due diligence research on the screen results, making sure that the fundamentals of the underlying business support the high yield (or whatever other filtering criteria produced the screen results).
IncrediMail Business Description
So I set out to learn more about IncrediMail. It turns out that it is an Israeli software company that has a market cap of only $75 million. Normally, I only consider stocks that have at least a $250 million market cap to avoid illiquidity issues, but I had been lazy setting up my screen, remember? Anyway, I found it odd that a microcap company could sport such a huge dividend yield. Normally, small companies need to retain all of their cash to pay off debts and grow their business. But IncrediMail has no debt and virtually no cost of goods sold. The company’s products are intellectual property, so the only real production-related costs are the salaries paid to the computer programmers who develop new software applications.
IncrediMail focuses on the consumer personal computer market. It has three primary software applications: (1) email (IncrediMail); (2) instant messaging (HiYo); and (3) digital photography (PhotoJoy). Virtually all of their products are offered for free. The email application is a knock-off of Microsoft Outlook, which retails for $139.99, so a free clone is attractive to many people. HiYo isn’t an instant messaging (IM) application itself, but enhances the experience of third-party IM services. So if you are an AOL, MSN or Yahoo! IM user, downloading HiYo will provide you with extra emoticons, winks, animations, and sounds. PhotoJoy enables you to create personalized desktop wallpaper and 3D screen savers based on your own photographs.
Search Revenue is IncrediMail’s Business Model
Since these products are offered to consumers for free, how does the company make money? One word: search. The products are not web-based but downloaded software. Consequently, when a consumer downloads the software, a search bar is included in the download. Every time the consumer makes a search query using IncrediMail’s search bar, the company gets paid two cents per search by the search engine the query goes to. Since roughly 110 million search queries are made per month on IncrediMail’s search bar, the company receives around $2.2 million in monthly search revenue.
Dividend Red Flags
Search revenue from Google alone comprises 65% of the company’s entire revenue. Whoa, that’s a red flag for me. Overdependence on one customer is dangerous for any company’s business model and does not provide conditions conducive to a sustainable dividend. What if Google were to cease working with IncrediMail? IncrediMail’s stock would plunge, that’s what. Back in January 2008, Google temporarily broke off its relationship with IncrediMail and IncrediMail’s stock plunged 45 percent!
Fortunately for IncrediMail, Google just recently agreed to a two-year extension of their search partnership. Strangely, however, IncrediMail issued a “corrected” press release that deleted the following paragraph which had been in the original press release:
This agreement also marks the beginning of a new era of transparency for consumers. As we previously announced, part of our new strategy is to create products that are simple, safe and useful and it starts with building trust with our consumer. As such we fully embrace and support Google’s effort to enhance and protect the user’s experience
Why did IncrediMail delete this paragraph? Is the company telling us that, in fact, it doesn’t plan on being transparent with consumers? Definitely weird and qualifies as red flag number two.
A third red flag is the company’s short history of paying a dividend. IncrediMail has existed only since 1999 and has been a public company only since 2006. It didn’t start paying a regular dividend until 2009 when it announced that it would pay out at least 50% of net income each year:
The Board and management have determined that the Company’s interest for enhancing shareholder value is best served by instituting a dividend policy whereby at least 50% of annual net income will be paid out as a dividend.
The company said in a June 2010 investor presentation that its dividend policy was intended to “excite” new shareholders. Red flag number four is using dividends as a short-term bribe rather than as a long-term capital allocation decision.
All of these red flags came to fruition this past November when the company announced that it was eliminating its dividend altogether:
As part of our repositioning the Company towards growth, we will be discontinuing our dividend distribution in 2011. As a growth-oriented company, cash that we had paid out in the form of a dividend will in 2011 be used to increase shareholder value by growing our business by way of investment in organic and non-organic growth.
From 11.4% to zero. That hurts, especially if you relied on IncrediMail’s dividend for living expenses.
Dividend Time Bomb Summary
To sum up, don’t buy high-yield stocks that exhibit any of the following red flags:
1. Micro-cap stock that pays dividends to “excite” potential shareholders
2. Short operating history as a public company with no long-term record of paying dividends
3. Company revenue relies on one customer
4. Chaotic investor relations that issues press releases and then re-releases “corrected” versions with deleted text.
For more on the warning signs of dangerous high-yield stocks, read my article entitled Dividend Time Bombs.
Tuesday Morning’s Dividend Nightmare
A fifth red flag — not present in IncrediMail’s case but pertinent nonetheless – is a policy of paying dividends not from operating cash flow but from debt. A good example of this “dividend disaster waiting to happen” occurred back in May 2005. Tuesday Morning (NasdaqGS: TUES), a closeout retailer of home accessories, announced that it would start paying a dividend “funded from available working capital and revolving debt.” Debt was needed because the dividend exceeded the company’s free cash flow.
The company also said in that 2005 press release:
With zero debt and a favorable tax environment for dividends, we felt the time was appropriate to reward our dedicated stockholders for the success Tuesday Morning has provided over the last four years.
In other words, Tuesday Morning was touting its strength as a company with no debt and yet then decided to eliminate this strength by incurring debt to pay a dividend. Weird and incoherent.
Big Yield Hunting Has an “Income Plus” Investment Philosophy
Big Yield Hunting, the high-yield investment service from Roger Conrad and
High yields without strong businesses behind them will be at perpetual risk of devastating dividend cuts. And they have no chance of growing either, so they’re guaranteed losers if inflation emerges.
In contrast, only growing and healthy companies will continue to pay their distributions. If we see more inflation, growth is our best chance of keeping pace. Adopting an “income-plus” strategy won’t save your portfolio from all volatility if credit or inflation conditions worsen. But it remains the best approach.
Dividend investors need to avoid dividend time bombs like IncrediMail and Tuesday Morning. Either spend the significant amount of time it takes to vet the fundamentals of a company completely or seek the advice of investment experts that are willing to do the work for you.
Roger and David devote their entire working lives to uncovering only the best high-yield stocks. So far, Big Yield Hunting has recommended two Canadian income stocks, two telecommunications carriers, and a shipping company. All of their recommendations sport very high yields that are stable and sustainable.
Give Big Yield Hunting a try today!