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.
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.