4 Must-Know Secrets to Income Investing

Dividends are wonderful, yet odd things. While it's often great to hold stocks that pay you handsomely for keeping them around, many are like your old friend from the neighborhood who only comes around when he needs money. Of course, he promises to pay you back, with interest, once he "hits a big score." But you know it won't happen. You just hand over the cash because, well, that's what buddies do.

A lousy dividend payer is exactly like your old pal. It'll entice you with high yields, but underneath it lacks the cash to pay you what's promised. And so its stock and your portfolio both get deep-sixed. Fortunately, it's pretty easy to find these greaseballs. Take StarTek (NYSE: SRT  ) , a company that provides supply chain management services. At 8.7%, its yield is incredibly tempting, but a quick check of Yahoo! Finance suggests the payout can't be funded through existing free cash flow (FCF). No wonder the shares are down more than 50% over the past 52 weeks.

Four ways to find the good ones
A little work will help you avoid this scenario. And I do mean a little. Mathew Emmert, chief analyst of Motley Fool Income Investor, has come up with four criteria for picking dividend winners that you should steal for your own investing. They are:

  1. Enough size and financial strength to create growth and pay a substantial dividend. Alternatively, a company offering a deep value.
  2. A market capitalization of $1 billion or more and debt less than 60% of capital.
  3. Return on equity in excess of 10% and return on assets approaching 2% for financials, 5% for property real estate investment trusts (REITs), and 7% for others.
  4. A dividend yield approaching 3% that's fully funded through free cash flow.

Now, ready to do this for yourself? Good. I've chosen United Online (Nasdaq: UNTD  ) , a second-tier Internet access provider, as our guinea pig. Let's see if it passes Mathew's tests, starting at the bottom:

4. A dividend yield approaching 3% that's fully funded through free cash flow: United Online is, plain and simple, an Internet service provider (ISP). Its leading brands, NetZero and Juno, are relatively well-known, but its BlueLight Internet is eerily reminiscent of Kmart's infamous in-store bargain bin pitches. Moreover, competition is everywhere -- from AOL, Earthlink (Nasdaq: ELNK  ) , and Microsoft's (Nasdaq: MSFT  ) MSN to pretty much any provider of broadband Internet access. Despite that, United Online generates substantial free cash flow (FCF). Check out the numbers:

Quarter Income before tax** Depreciation Amortization Net capex Adjusted FCF
Q1 '05 $20.985 $3.474 $5.978 $3.455 $26.982
Q4 '04 $19.036 $2.768 $7.651 $1.112 $28.343
Q3 '04 $20.516 $1.957 $4.395 $1.449 $25.419
Q2 '04 $20.011 $1.680 $4.393 $2.534 $23.550
12-MONTH TOTAL: $104.294
* Amounts in millions
** Operating income used to offset unsustainable tax gains. Stock-based compensation was expensed. Data provided by earnings press releases.

Not bad for a company with an enterprise value of barely $550 million, eh? It's also more than enough to cover the cost of United Online's meaty 7% dividend yield, which is likely to eat up $37 million this year and $50 million thereafter.

But don't let the high price of the company's payout worry you. United Online should generate plenty of moola during 2005. Guidance calls for adjusted cash from operations to be from $117.4 million to $122.4 million. If capital expenditures remain steady at $8.75 million -- and there's no reason to expect otherwise -- then adjusted FCF would be at least $108.65 million. Dividends, loan payments, and capital leases should account for no more than $53 million. That's more than $50 million left over for continued share buybacks and debt retirement.

Grade: Pass.

3. Generous returns on equity and assets: Mathew says he likes to see management that deploys capital effectively. There are several ways to measure this, but he prefers to focus on return on equity (ROE) and return on assets (ROA) in his initial assessment. (ROE measures the effectiveness of reinvesting stockholder money to generate higher profits. ROA is similar, except that it measures the effectiveness of investing in capital assets such as property.)

Fortunately, United Online does well in both. A check of Yahoo! Finance pegs ROE at 45.92% and ROA at 13.03% over the trailing 12 months. Debt financing has probably skewed ROE somewhat, but it's still probably safe to assume that even without it, Mathew's minimum requirement of 10% would have been easily satisfied. Let's move on.

Grade: Pass.

2. A market cap of $1 billion or more and debt equaling less than 60% of capital: Can I plead no contest? There certainly isn't one in this category. United Online is a small cap with a total market capitalization of a little less than $700 million. Debt, however, is less than 20% of total capitalization as of the latest quarter. We still need to meet the market-cap minimum to net a passing grade, but I'd still count this as a good sign.

Grade: Fail.

Two out of three isn't bad, but the most important element is still to come. How will United Online do? Find out by taking a free trial to Motley Fool Income Investor. We'll show you the rest of the story and give you unlimited access to our best stock ideas -- free -- for 30 days. Best of all, there's never an obligation to buy. Ever.

Find out more about United Online with this related Foolishness:

  • The company first agreed to share the wealth in May.
  • It's moves like this by broadband providers that ought to have investors worried.
  • AOL is becoming more like United Online every day. Is that a good thing?

Fool contributorTim Beyersdoesn't want to get off on a rant or anything, but he really liked the NetZero commercials featuring Dennis Miller. Tim didn't own stock in any of the companies mentioned in this story at the time of publication. To see what's in Tim's portfolio, check out his Fool profile, which ishere. The Motley Fool isinvestors writing for investors.


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