Dodging Dangerous Dividends

Why do junk bonds have such an unattractive name? They can be great investments, after all. Even Motley Fool Champion Funds analyst Shannon Zimmerman has sung their praises. So why pick on them?

You might say they, um, deserve it. Fellow Fool Selena Maranjian defined junk bonds best in The Motley Fool Money Guide: "A bond issued by a company with relatively high chances of defaulting." Exactly.

So, for instance, who cares if Visteon's (NYSE: VC  ) 2010 bonds offer a 9.6% yield? The troubled auto-parts maker may need a bailout from equally troubledFord (NYSE: F  ) . There may soon be nothing left to pay investors lured by the Siren call of what seems like market-beating returns jammed into a meaty payout.

Junky dividends
The same thinking goes for stocks. Let's say that in your desire to get paid to invest you go spelunking for stocks that pay a dividend yield of 3% or higher. You figure that with the market's average annual return of between 9% and 11%, you'll have a head start by getting paid almost one-third of your expected return in cold, hard moola. Which sounds great, right? Not so fast.

Let's take a look at some of the best-paying income stocks on the market. My favorite quick-and-dirty stock screener at Yahoo! Finance finds 859 stocks that yield at least 3%. Let's narrow it further, bumping the expected payout to at least 5%. That leaves 340 stocks. Still not enough yield for you? OK, let's go for broke. There are 63 companies that have more than $250 million in annual sales that also pay out 7% or more of their earnings in dividends.

Some of these yields look positively mouthwatering. Don't fall for it. You'd have to think dodging highway traffic is cheap entertainment to want to invest in stocks like these:

Company

Stock price

Yield

Payout ratio

Alaska Communications Systems (Nasdaq: ALSK  )

$10.63

7.7%

1,569%

Fairpoint Communications (NYSE: FRP  )

$11.30

14.0%

235%

Suburban Propane (NYSE: SPH  )

$24.15

10.0%

1,957%



When free cash flow isn't free
Everything looks good until you get to the payout ratio. What is it? The payout ratio shows what portion of net income is used for dividends, although Fools tend to substitute owner earnings for net income, as I have in the table above. A lower ratio is better. Above 100% means the company isn't generating enough cash to pay shareholders their due.

Remember: Any company that pays more in dividends than its trailing-12-month free cash flow has no free cash flow.

Small stocks, big payouts?
Of course, there are dozens of good companies that practice good fiscal management and still pay sizable dividends. In fact, some of them can be downright tiny. But finding such companies is no easy task, and even when you do find one that looks attractive, there's still likely to be a few gotchas. Consider the case of StarTek (NYSE: SRT  ) , a call center and telecom outsourcing company based not far from me in Denver.

The company's meaty 8.7% dividend yield is remarkably alluring, as is its price-to-earnings-to-growth ratio of 1.22, which suggests that the stock could be trading at a discount to its future earnings and cash flows. And there's more to like. According to Yahoo! Finance, StarTek's most recent balance sheet shows $49.83 million in cash and investments versus $6.29 million in debt. That equates to $2.98 per stub in the bank, which means ongoing operations are, as of this writing, valued at $14.38 per share. That's only 13.8 times next year's earnings. If only we could end the story there.

But we can't. That's because StarTek has a history of declining earnings. From 2003 to 2004, for example, net income declined 5.5%. And its year-to-date net income of $8.46 million substantially lags its 2004 total of $20.97 million, with only one quarter left in the fiscal year. StarTek booked $4.4 million in earnings during last year's fourth quarter, according to Yahoo! Finance.

Still, the Street expects StarTek's income to expand by an average of 16% over the next five years. Its after-cash multiple of this year's expected earnings is only 16.9, and it yields more than 8% in payouts, to boot. Contrast that with the S&P 500, which, as of this writing, trades for 18.5 times earnings and yields 1.62%.

Follow Foolish guidelines
StarTek may sound more attractive than it really is. Sure, it could be a winner. But it's important to note that the research I used for analyzing StarTek was acquired in 15 minutes of browsing at Fool.com and Yahoo! Finance. If you really want to scour for growth possibilities among the list of big income producers, you'll have to do some additional homework. Fortunately, Motley Fool Income Investor chief analyst Mathew Emmert has some guidelines for what to look for. Let's see how StarTek stacks up:

  • Show me the money. Dividends should be paid through cash flow. But StarTek's $22.63 million in dividend payments easily eclipses its owner earnings of $11.97 million over the trailing 12 months, according to Yahoo! Finance. That's -- gulp -- a payout ratio of 189%. Income Investor subscribers can't be surprised, though. In April, Mathew singled out StarTek as one of his "dividend time bombs" (available with free trial) for its propensity to pay more than it can afford.
  • Proven management team. Oh boy. Three of StarTek's board members joined last year and the CEO was appointed in May. New leadership may be a good sign, because the company has been ailing. But I'd prefer to leave such faith to priests, pastors, and rabbis. Strike two.
  • A noticeable yield. Yeah, better than 11% is noticeable. Very noticeable. But is it sustainable? That's an open question. Ball one.
  • Reliable dividend track record.Whiff! StarTek had raised its dividend every quarter from the inception of its dividend policy in third quarter of 2003 to the first quarter of this year. The good times ended in June, when the company cut its dividend back to $0.36 per stub, or equal to what it began paying two years prior. The trend continued into September and there's no sign that there will be any change before the end of the year. Which means, sadly, that StarTek's payout is as reliable as a 1973 AMC Pacer. Steeeeerrrrrrike three! Yer out!

The Foolish bottom line
Most dividend stocks aren't this simple. Many are deceptively alluring. Don't be small-"f" fooled. Apply Mathew's tests, and pay attention to that pesky payout ratio. And, most of all, remember: You may be able to profit from junk when it comes to bonds, but garbage rarely pays when it comes to stocks.

Go on, take the money and run. Take a risk-free trial to Motley Fool Income Investor today and you'll get access to all of the picks and research that have helped chief analyst Mathew Emmert beat the market since the inception of the service. And there's never, ever an obligation to buy. (Though if you do, you'll get Stocks 2006, our analysts' best picks for the year ahead, free. And the service is backed by our money-back guarantee, no questions asked.)

This article was originally published on July 16, 2004. It has been updated.

Fool contributor Tim Beyers equates sitting outside during a thunderstorm with thrill-seeking. Maybe that's why he avoids dangerous dividends. Tim didn't own stock in any of the companies mentioned in this story at the time of publication. You can find out what is in his portfolio by checking Tim's Fool profile. The Motley Fool has an ironclad disclosure policy.


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