The Next 3 Dividend Burnouts?

With the S&P 500 down some 45% since the start of 2008, many wary investors have been turning to the safety of dividend-paying stocks. In just the last three months of '08, domestic dividend-focused ETFs that invest in high-yielders like AT&T (NYSE: T  ) and Chevron experienced net inflows of $1 billion.

Dividends help to smooth out volatility, and as Jeremy Siegel notes, they're especially attractive during down markets, when their yields rise. Research by Professors Fuller and Goldstein supports his findings: the duo calculated that from 1970-2000, dividend-paying stocks outperformed non-dividend-paying stocks during market declines by an average of 1% to 1.5% per month.

But there's a catch
Even the most careful income-seeking investors were probably burned by the Great Dividend Implosion of 2008. According to data from Capital IQ, some 370 companies cut their dividends last year, for an average return of negative 56%. And we're not just talking dividend upstarts like Whole Foods (Nasdaq: WFMI  ) , which first instituted a dividend policy in 2004. Many cutters were stalwarts -- Dow Chemical had consistently raised or maintained its dividend since 1912, before reducing its payout in February of this year.

So how can you tell if your company is about to make a cut? In an article last month, I called out General Electric (NYSE: GE  ) and Calumet Energy as risking dividend cuts. (GE announced a cut the following week, while Calumet has yet to do so.) Among the warning signs I pointed out:

  • High yields
  • High payout ratios
  • Industry headwinds

Extremely high yields signal investors' skepticism that the company will be able to maintain its dividend. A high payout ratio -- particularly when combined with a difficult operating environment -- suggests that the company doesn't have enough free cash flow to support the payouts.

But these factors don't necessarily imply that a cut is imminent. While GE made the right call in an effort to preserve capital, many other companies have continued to pay dividends they cannot afford for years, damaging their own firms -- and the value of your shares -- in the process.

I'll spare you all the details
A fascinating 2004 survey explains how and why. A team of four professors from Duke and Cornell surveyed more than 400 financial executives, discovering that 94% of executives "strongly ... or very strongly ... agree that they try to avoid reducing dividends." Many admitted to selling assets, laying off employees, borrowing heavily, or omitting important projects before cutting dividends.

See, these managers know that the market reacts negatively to dividend cuts. Several executives noted that Wall Street's response is an especially important consideration during liquidity crises -- such as the present one, which has hurt even strong banks such as Wells Fargo (NYSE: WFC  ) -- because they wouldn't want lenders to think their company is struggling. Such a fear may be one of the reasons why Citigroup (NYSE: C  ) reluctantly slashed its dividend three times, apparently hoping each time that a small cut would do the trick. It may also explain why Morgan Stanley could refrain from cutting its payouts, even after JPMorgan's (NYSE: JPM  ) recent cut opened the door for it to do so.

But let's get back to payout ratios. Unfortunately, if a company isn't generating enough free cash flow to support its payout, the extra cash has to come from someplace else. Aside from raising revenue or cutting expenditures, there are four basic ways a company can collect the cash it needs to make such payouts:

  • Burn cash
  • Borrow money
  • Issue shares
  • Sell assets

And while some of these practices may be acceptable band-aids for a difficult year, none are sustainable over the long term. A company that pursues these strategies for too long will eventually burn itself out, damaging its shareholders in the process. Even worse, it's likely that the company will ultimately have to cut its dividend anyway.

So which companies might fit that description today?

Three companies risking a burnout
These three companies have paid out more in dividends than they took in as free cash flow (or were free cash flow negative) over the past three years:

Company

Net Income Payout Ratio, 2008

Free Cash Flow Payout Ratio, 2008

Total 3-Year Shortfall*

Primary Funding Method

FPL Group

44%

N/A

$8.8 billion

Debt

Dominion Resources

50%

N/A

$8.0 billion

Sell Assets

Nordic American Tanker (NYSE: NAT  )

135%

265%

$524 million

Issue shares

Data from Yahoo! Finance and Capital IQ, a division of Standard & Poor's.
*Calculated as total dividends paid minus free cash flow.

While FPL and Dominion may appear to have adequate net income to cover their dividends, it's important to remember that net income is an accounting construction that doesn't always reflect how much cash a company actually has left over to cut your check. Free cash flow payout ratios often provide a more accurate picture. In recent years, both companies have operated with free cash flow deficits.

FPL needed to borrow heavily to fund an increased dividend, even as it spent billions on new wind power plants. Dominion Resources has recently sold off billions in assets; it's been largely free cash flow negative, yet it has continued to pay its large dividend.

Nordic American doesn't pay a set dividend -- it distributes cash to shareholders based on its net operating cash flow -- but over the past five years, the company hasn't had a single year in which free cash flow outstripped the amount of cash paid to shareholders.

To his credit, Nordic American's CEO is honest about his company's strategy of supporting large dividend payouts with massive share issuances. As he recently told my colleague Mike Pienciak, "Given that Nordic American pays out all earnings as dividends, a growth model that relies on retained earnings is not right. Rather, Nordic American will continue to go to the capital markets." But that seems a little like the company is paying the left hand with the right hand, and the right hand with its foot.

The silver lining ...
Dividend stocks have a history of putting money in investors' pockets, but choosing the right dividend stocks for a down market is critical to protecting your portfolio. Paying close attention to how your company funds its dividend will help you achieve the golden returns dividends offer.

If you'd like to see the stocks our team at Motley Fool Income Investor likes, including their six "Buy First" dividend payers, you can try the service free for 30 days. Click here for all the details -- there's no obligation to subscribe.

Ilan Moscovitz owns shares of Whole Foods, a Motley Fool Stock Advisor recommendation. The Motley Fool has a disclosure policy.


Read/Post Comments (17) | Recommend This Article (79)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 26, 2009, at 6:00 PM, teejk wrote:

    a factor not mentioned in this article...some company's shares are so beaten down that they may cut dividends in spite of cash-flow. Absent utilities, I think "normal" yields were around 2%. For the Jim C "accidental high yields", they may cut also. For them a dividend cut will hurt but not that much...what else can you do to them if they are already mis-priced?

  • Report this Comment On March 26, 2009, at 6:45 PM, rgperrin wrote:

    Roger Conrad's Utility Forecaster has highly recommend FPL Group and Dominion Resources for years and years. Both have very right ratings for likelihood of dividend safety. It's hard to believe that Mr. Conrad has missed the problem reported in this article. And yet. . . .

  • Report this Comment On March 26, 2009, at 7:38 PM, Morfax wrote:

    Nordic Tankers has rewarded me well over the past 5 years. Yes, there is risk in that the dividend basically "floats" but the US and Europe will always need imported oil.

  • Report this Comment On March 26, 2009, at 8:04 PM, growsmartmaine wrote:

    Yes but.....

    NAT issues stock to finance new tanker purchases not to pay dividends.

    The new tankers provide the additional income.

  • Report this Comment On March 26, 2009, at 11:08 PM, harleybull wrote:

    so llan, is your point to look out for NAT to reduce it's dividend? sell the stock? double down?

    the CEO has said publicly more than once that the dividend is pegged to profits & would be reduced if profits drop & raised if profits increase, so i'm not quite so sure what you're trying to say.

  • Report this Comment On March 27, 2009, at 3:04 AM, TMFDiogenes wrote:

    Hey growsmart and harleybull,

    Both of you are right, as I mentioned in the article, NAT's dividend payout varies depending on its operating cash flow. I suspect that's something they will continue doing so long as possible. Whether their model is sustainable and how long it can last are questions worth asking, in my opinion.

    The main problem, as I see it, is that the company has paid out more in dividends than it's earned in free cash flow every year for the past decade. Whether they can continue issuing new shares to make up the shortfall depends on the willingness of investors to buy new shares at prices attractive to NAT.

    Let's take last year as an example. NAT produced about $130 million in operating cash flow, spent $10 million on capital expenditures, and spent another $165 on dividends (we'll ignore some adjustments that went into the payout ratio in the article above and the $115 million spent repaying debt.) So there's a shortfall that has to be accounted for -- this isn't free money. NAT issued another $160 million of new shares last year (at an average price of about $36 per share), diluting shareholders some 15%. That means, your stake in the company is now reduced by 15%. Just be aware of that.

    I'm not saying this to knock NAT's integrity -- as far as I can tell, their CEO has been very transparent about their strategy.

    Regarding your question of whether you should sell or double down, I can't answer that one for you. But shareholders should be aware that issuing shares is a major part of how the company makes the money it needs to pay dividends. I think it's just a fascinating situation that may or may not be sustainable.

    Thanks everyone for reading,

    Ilan

  • Report this Comment On March 27, 2009, at 3:49 AM, paultaut wrote:

    Cramer has been pushing Nordic for ages.

    Need I say more.

    Ordinarily, I would dismiss NAT out of hand just becuase of Cramer. But Nordic's CEO was on the show and expressed "new shares will not be issued" this year, except maybe if an extrordinary opportunity arose which would be accretive to earnings. Accretive, is my keyword.

    As long as the issuance of stock does not dilute, I may not like the Onus JC brings to the table but I can berate the company itself.

  • Report this Comment On March 27, 2009, at 8:45 AM, Doris411 wrote:

    Hmmm, $130M less $115M less $10M leaves $5M available; add $160M, and pay out $165 M.

    How is paying dividends with money from new investors not a Ponzi scheme?

  • Report this Comment On March 27, 2009, at 11:25 AM, rob053 wrote:

    Isn't net profit reduced by depreciation? If you have capital assets such as ships doesn't it make sense that you might depreciate those assets. If you add the depreciation back into the net proits you will find the "mystery" money. The NAT CEO in my opinion is one of the only CEO's out there who is simply honest. He will buy three ships with the proceeds from the stock offering. Lets do the math, lets see he will add 3 more ships to the fleet of 12 or increase the fleet by 25%, yet he only deluted my equity by 15% to get there? Sounds like sound business to me. His model is simple and transparent, if he retained capital, and amassed debt and paid out huge bonuses then his company would look like the rest and be highly recommended until the proceeds could no longer cover the debt. The "story by the motley fool above was a great spoof to allow the shorts to cover. It should be prosecuted as the fraud it is. I feel sorry for any who might be decieved by its content.

    Thanks.

  • Report this Comment On March 27, 2009, at 7:24 PM, ETFJunky wrote:

    Hey rob053 you hit the nail right on the head. If any you don't like the way the company is run then stay away and let the rest of us take the risk and collect the rewards. I guess a lot of you on here have forgotten that anytime you invest you are taking a risk

  • Report this Comment On March 30, 2009, at 12:37 PM, jts187 wrote:

    I am a newer investor, so I might be anywhere from misguided, to totally wrong. However, it was my understanding that NAT distributed dividends based on its earnings and not its cash flow, is that not correct?

    Also, is it not possible that cash flow totals are lower than payouts because some of that money was invested/spent on something other than dividend distribution?

    Im not claiming either side of the story is right or wrong, I just find it odd, that a company with a pretty good balance sheet, a miniscule amount of debt, with a CEO who is widely considered to be honest and transparent, as well, the companies break even rate is well below the spot rate, would have any kind of trouble with its payouts.

    Again, im new, so I might be way off course here, so feel free to correct me if thats the case.

  • Report this Comment On March 30, 2009, at 7:26 PM, TMFDiogenes wrote:

    Hi jts,

    Yup, that's basically right. NAT has a variable dividend, but it's based on operating cash flow:

    "Our policy is to declare quarterly dividends to shareholders, substantially equal to our net operating cash flow during the previous quarter after reserves as the Board of Directors may from time to time determine are required."

    http://www.nat.bm/IR/dividends.html

    It sounds like you have a good understand of NAT. They have minimal debt, the CEO is widely considered to be transparent, and forth. My point is just that from a cash flows perspective, it appears that they're paying out far for money than they're making and issuing shares to make up the difference. They could keep this up forever so long as investors are willing to buy newly issued shares at an attractive price for NAT.

    Thanks for reading and posting,

    Ilan

  • Report this Comment On March 31, 2009, at 10:31 AM, rob053 wrote:

    Most folks understand net operating cash from the use of their own wallet you pay a bill and the money goes. Unfortunetly depreciation does not enter into our wallet model. Depreciation is a for lack of a simpler term a "magic" bill. It is "magic" because it is a bill which reduces your net operating capital, BUT it does not reduce the amount of money in your wallet. NAT pays its dividends from its excess operating capital which includes the funds from the "magic bill" depreciation. This is why NAT will pay dividends Qtr after Qtr and the rest of the "quickey" analysts will be mystified by its ability to do so. If you look at NAT's balance sheet and expect it to look like other companies which do not have the same capital assets you will become confused and assume the same things the author wrote in the original article. NAT will always pay a dividend as long as it follows the its financial model. Its dividend will include the interest others are paying for interest on borrowed money. If you have NAT stick with it if you don't buy it if you can.

  • Report this Comment On March 31, 2009, at 6:09 PM, goldseth wrote:

    The article is interesting, but there's a flaw in the inclusion of Nordic American Tanker Shipping Ltd. (NAT).

    If, as the asterisk says, the author is using the Yahoo finance 3 year records as a cash flow indicator, then the indicator here is extremely backward looking...$600 million in capex was spent in 2005/2006, which skews the numbers. 2007 capexwas a pittance and to top it off, NAT still used cash to pay off debt.

    Now they have possibly the best balance sheet in the industry which means they are in a great position to deal with short term dayrates while competitors, due to high debt loads and cap requirements, cant afford to...choosing to sell ships or dock em!

    I think NAT clearly states that if it averages $10K dayrates it will pay a dividend and if you loo at the fleet, things look good with almost all set to move up in dayrates on spot market.

    NAT likely won't pay the gaudy 18% shown on Yahoo finance, but its more likely than most to give shareholders a nice yield!

  • Report this Comment On April 03, 2009, at 12:48 AM, mmcmillanii wrote:

    The day rates are in the $30k to $40k range. It is NAT's per ship, per day COST which is $10k. So you can clearly see the profit margin. And I don't understand all the talk about debt. They have NO debt. The description of the last stock issuance by rob053 is a good one. The stock was diluted by 15% to increase income by 25%. The only negative was the lag time waiting for the ships to be delivered.

    This is the type of company that two years ago would have been ridiculed for having NO DEBT, because their return on capital would have been low compared to other highly leveraged companies.

    The NO DEBT - ALL DIVIDEND model means a stockholder actually gets to feel like an owner and participate in the profits. What do Microsoft stockholders get? Not even a coupon...

  • Report this Comment On April 03, 2009, at 4:44 PM, Richh100 wrote:

    If Free Cash Flow is so important, why don't you, Yahoo Finance and other financial web sites (who display Cash Flow statements), include it in the statements they show?

    There are 3 sections to a Cash Flow Statement and not one shows FREE CASH FLOW. Why is that?

  • Report this Comment On April 03, 2009, at 5:16 PM, chipm wrote:

    I have been combining the options argument TNO makes above with a high dividend paying ETF in investing in IGD, which uses an option strategy to generate steady divs.

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