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Income investors sure love dividends, which can build incredible wealth over time thanks to compounding with a side of patience. But some dividend stocks can be a lot riskier than others, either because of the underlying business or inconsistent dividend policies.
Let's look at three names in particular -- Sunoco (SUN -1.22%), Barnes & Noble (BKS), and Nokia (NOK) -- that are probably worth passing on.
Something doesn't look quite right
Tyler Crowe (Sunoco LP): There is a difference between a stable business model and a stable dividend paying stock. While Sunoco LP has all of the characteristics of what should be a relatively stable business, there are a lot of concerns that make this dividend stock look suspect.
Sunoco's business is pretty simple to understand, it owns and operates retail filling stations as well as a wholesale fuel distribution business for non-Sunoco branded and franchise retail stores. The retail filling station and wholesale fuel business are pretty stable ones considering the volatility of gasoline and diesel prices. The reason it is able to generate relatively consistent cash flow is because the margin for retail and wholesale fuel is pretty consistent regardless of the price of the fuel itself. On top of that, the company generates strong retail margins for non-fuel merchandise at its retail stations, and have been generating consistent and growing traffic.
Despite all of these traits that would scream stable dividend potential, Sunoco's management of its finances has been a bit wanting. Management has been a little overly aggressive with its acquisition strategy as of late, and it has resulted in a pretty bloated balance sheet that puts the company's payout in question. As a result, the market is pricing in a pretty decent sized payout cut as its current distribution is 13.6%.
To top it all off, Sunoco's parent companies -- Energy Transfer Partners (ETP) and Energy Transfer Equity (ET -0.03%) -- are facing their own issues as they are undergoing some significant structural changes. With so much going on at the parent company, it's very possible that Sunoco isn't getting the attention that it probably needs right now.
A company on the wrong side of a huge consumer shift
Jason Hall (Barnes & Noble, Inc.): This past weekend, my wife and I were out shopping for Christmas presents for our nieces and nephews, and one of our traditions has been to spend a few hours in our local Barnes & Noble. Not only do we get each kid a book, but we also pick out a few educational toys, and enjoy a hot seasonal coffee beverage from the in-store coffee shop. At some point, I decided to look up an item on Amazon.com, and this single moment completely changed the shopping experience for us.
The particular item I checked on cost half as much on Amazon. I decided to check a few more items, and I found that essentially every single item I compared was either significantly cheaper on Amazon, or the same price. Factor in that every single person we were shopping for lived in another state, and free shipping and cheap gift options simply made it a no-brainer to put everything back on the shelves and order with Amazon -- and that's before considering the 20 minute line to check out at Barnes & Noble.
From a financial perspective, this kind of consumer activity is a major reason why Barnes & Noble's sales continue to decline. Sales fell 4% last quarter, and comps, or same-store-sales, were down 3.2% on lower traffic, even with the release of the latest Harry Potter book. Furthermore, the company continues to report losses, and it's hard to imagine a scenario where those losses don't compound as sales decline further. And this puts the company's dividend, currently $0.15 per quarter, worth a 4.8% yield at recent share prices, at risk.
Yes, the company did generate positive cash from operations and enough free cash flow to pay the dividend over the past year, but I'm not willing to bet on that continuing in the future. Retail operations are very expensive, with thin margins, and positive cash flows can get erased faster than you can say, "where's the fantasy book section?"
Bottom line: Barnes & Noble doesn't have a competitive advantage, and more consumers are choosing its competitors. That makes it -- and its dividend -- too risky to count on down the road.
A high-yield dividend you can't count on
Evan Niu, CFA (Nokia): If you were to run a screener for high-yield dividend stocks within tech, Finnish network equipment maker Nokia would show up near the top of your list with a current yield around 6.3%. That's the kind of payout that would have most income investors licking their chops, but sometimes things are too good to be true.
The vast majority of income investors highly prefer consistent and reliable payouts that are funded by strong operating cash flows. That's why most companies set dividend policies that can accommodate future increases, slowly but steadily increasing the payout over time. It's extremely rare these days for companies to implement dividend policies that pay out a specified payout ratio relative to earnings, since investors don't like that type of volatility. It's for this reason why income investors should avoid Nokia. Generally, Nokia's goal is to distribute retained earnings, subject to a handful of other variables, which is why its dividend history is so volatile.
It's worth noting here that last year's payout of 0.26 euros per share included an ordinary dividend of 0.16 euros per share in addition to a special dividend 0.10 euros per share. That distribution is why Nokia's yield appears so high. Exchange rates also come into play here. When that dividend was paid in June, it was valued at just $0.203 in U.S. dollars. Financial databases now show the payout at $0.29, due entirely to foreign exchange rate fluctuations that are artificially inflating that yield. Shares are also lower than in June, further boosting the reported yield.
If you're looking for a high-yield dividend stock that you can trust to pay out a predictable amount on a regular basis, Nokia is decidedly not for you.
