The Next 3 Dividend Burnouts?

With the S&P 500 still down more than 30% 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, for example, domestic dividend-focused ETFs that invest in high-yielders experienced net inflows of $1 billion.

Buyer beware
While dividends provide a source of income that helps to smooth out market volatility, crises like the present one are leaving many companies with little choice but to reduce or omit payments. According to data from Capital IQ, some 370 companies cut their dividends last year, and their stock prices had an average return of negative 56% for the year.

Even though some companies -- including ExxonMobil (NYSE: XOM), Costco (Nasdaq: COST), and Procter & Gamble (NYSE: PG) -- have continued raising their payouts in 2009, we've already broken the record set in 2008 for most skipped payments in one year, at more than $46 billion. Black & Decker and KeyCorp (NYSE: KEY) are just some of the latest victims.

So how can you tell whether your company is about to make a cut? In January, I argued that Dow Chemical and Huaneng Power (NYSE: HNP) were risking dividend cuts. (Both have since made cuts.) Among the warning signs these companies exhibited:

• High yields.
• High payout ratios.
• Industry headwinds.

Extremely high yields signal investors' skepticism that the company will be able to maintain its dividend. When National City announced its first dividend cut last year, for example, the stock was "yielding"10%. Since then, the stock plunged, and the company was acquired by PNC. 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 its payouts.

But these factors don't necessarily imply that a cut is imminent. Many other companies have continued for years to pay dividends they cannot afford. All they've done is damage their own companies -- and the value of your shares.

I'll spare you all the details
A fascinating 2004 survey explains how and why. A team of four professors from Duke and Cornell, surveying more than 400 financial executives, discovered 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 -- because they wouldn't want lenders to think their company is struggling.

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 existing cash reserves.
• Borrow money.
• Issue shares.
• Sell assets.

And while some of these practices may be acceptable temporary fixes for a difficult year, none is sustainable over the long term. A company that pursues these strategies for too long will eventually burn itself out and damage its shareholders in the process. Even worse, it will probably end up having 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:

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

As a regulated investment company, American Capital is required to pay out 90% of its taxable income in the form of dividends. For the past few years, the company could afford to do so by diluting shareholders and issuing debt (and, last year, selling investments).

Annualizing the upcoming distribution shows the stock yielding more than 130%. But investors should be aware that it could become more difficult to support the dividend in the future. That's because the private equity firm's cost of capital is rising because of a recent credit downgrade and $2.3 billion of unsecured debt currently in default.

While Consolidated Edison and Linn Energy 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. Neither company has produced free cash flow in years, though both have continued to pay a hefty dividend -- for now.

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 that 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.

Already subscribe to Income Investor? Log in here.

Ilan Moscovitz is neither long nor short any companies mentioned in this article. Costco is both a Motley Fool Stock Advisor and Inside Value recommendation. Procter & Gamble and Huaneng Power are Income Investor selections. Huaneng Power is also a Rule Breakers pick. The Motley Fool owns shares of Costco and Procter & Gamble and has a disclosure policy.