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How to Avoid Dividend Time Bombs

By Jim Fink on May 25, 2018

What do General Electric (NYSE: GE), Teva Pharmaceuticals (NSDQ: TEVA)Mattel (NYSE: MAT), NuStar Energy (NYSE: NS) and Mosaic Company (NYSE: MOS) all have in common? They’ve all cut their dividends at least once over the past year.

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 was SuperMedia, 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, 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.

Other historical examples of dividend cut disasters include General Motors (NYSE: GM) in 2006, Eastman Kodak (NYSE: KODK) in 2009, American International Group (NYSE: AIG) in 2008, J.C. Penney (NYSE: JCP) in 2012, and RadioShack in 2012. All except J.C. Penney subsequently went bankrupt after the dividend cuts started.

3. Verizon Involvement

Based on the SuperMedia and Fairpoint 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?

How about the slow-motion and relentless stock-price collapse of Frontier Communications (NSDQ: FTR) after it cut its dividend several times to pay for various disastrous telephone-line acquisitions, including the 2010 acquisition of Verizon telephone lines in 14 states, the 2014 acquisition of AT&T telephone lines in Connecticut and the 2016 acquisition of Verizon telephone lines in California, Texas, and Florida?  

4. Not Enough Cash and Declining Return on Equity (ROE)

Bottom line, a company can only pay its dividend if it generates enough cash to do so. Return on equity (ROE) is considered a key profitability metric when comparing companies against their peers and is used by many of the world’s top investors, including Warren Buffett. Any company with a declining ROE and 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

Just as you almost never find only one cockroach, companies in trouble rarely stop at only one dividend cut. Just look at Capstead Mortgage (NYSE: CMO), which has cut its dividend six times since 2014. At the time of its first cut, it was trading at $12 and now it is trading for about $9.20. Investors who sold after the first dividend cut did better than those who held on.

Other examples of serial dividend cutters include CYS Investments (NYSE: CYS) and AGNC Investment Corp. (Nasdaq: AGNC).

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 I created, compiled with data from Bloomberg. My screen looks for companies with suspect cash distributions that may be vulnerable to cuts in the future

I looked for companies with dividend yields of at least 4% that were paying out more in dividends than they generate in earnings or free cash flow. I also required that the dividend had not increased for at least two years and the company’s return on equity (ROE) had fallen for at least two years.

 

Company

Cash Distribution Yield

Dividends Per
Share

Earnings Per Share

Free Cash Flow Per Share

Return on Equity (ROE) Current Year

ROE
Year Ago

DCP Midstream (NYSE: DCP)

7.6%

$3.12

$0.10

$2.95

0.92%

3.92%

RLJ Lodging Trust (NYSE: RLJ)

5.8%

$1.32

$0.45

$1.02

2.48%

9.10%

Healthcare Realty Trust (NYSE: HR)

4.5%

$1.20

$0.18

-$0.73

1.34%

5.91%

Washington REIT (NYSE: WRE)

4.2%

$1.20

$0.21

-$2.45

1.83%

12.65%

NuStar Energy L.P. (NYSE: NS)

10.1%

$2.40

$1.35

$0.31

3.69%

6.62%

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, Royal Caribbean Cruises (NYSE: RCL) suspended its dividend in November 2008 in order to fund the delivery of new ships and pay for product improvements and the stock has increased more than ten-fold since then.

Similarly, ConocoPhillips (NYSE: COP) cut its dividend in February 2016 to conserve cash during a period of low oil prices and the stock price subsequently more than doubled. 

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