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:

Company

Net Income Payout Ratio

Free Cash Flow Payout Ratio

Total 3-Year Shortfall*

Funding Method

American Capital

N/A

161%

$434 million

Stock, debt, sell assets

Consolidated Edison (NYSE: ED  )

58%

N/A

$460 million

Debt, stock

Linn Energy (Nasdaq: LINE  )

21%

N/A

$3.6 billion

Stock

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.


Read/Post Comments (12) | Recommend This Article (37)

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 August 02, 2009, at 11:26 AM, BlazeTime wrote:

    Linn Energy is an MLP so it's not like the others. You should look at Distributable Cash Flow (DCF). Linn Energy has maintained its payout by hedging in the energy market when prices were high.

    I'm not saying LINE is totally safe, but it doesn't belong with the others in the list because the situation is much different.

  • Report this Comment On August 02, 2009, at 3:24 PM, mickeyd1943 wrote:

    I agree with BlazeTime. These guys are smart, have hedged 100% of their production level portfolio for 2009, 2010, 2011; replaced 3x their production capacity by drilling; and, get this, self fund capital expansion - the dividend should be safe for a while in my opinion - I look to this as a major holding in my portfolio.

  • Report this Comment On August 02, 2009, at 4:20 PM, lucidmaze wrote:

    Author made a mistake in analyzing Linn. For most companies that would be correct, but for a Master Limited Partnership you need to look at distributable cashflow. Even still, if you looked at Linn’s payout ratio, it’s listed at 24%. Therefore, even using the author’s analysis, this would not fall into the “burnout” category. So I don’t understand how arrived at that, except through mathematical error.

    Regardless, 24% is well within a margin of safety, if Linn had not hedged its oil production. The fact that it did, means that the payout should stay consistent. In the end, the proof is in the pudding. They just announced the dividend payment for shareholders of record next week at no change! You can’t pay out money you don’t have, so it’s unlikely that there are any accounting shenanigans going on. Also if you run a 360 on Linn, there are few law suits filed for a company with this amount of market cap, which is extraordinary. After doing the analysis myself, I simply can’t much downside risk at all, although no investment is perfectly safe.

  • Report this Comment On August 02, 2009, at 5:19 PM, lucidmaze wrote:

    I also have to agree with mickey....after hedging, free cash flow has not been an issue going forward. Also Linn has had significantly lower capital expenditures going forward last quarter, albeit not on an annual basis. The results of hedging will not be fully realized until the next annual report, and realized as reports come in on a quarterly basis.

  • Report this Comment On August 03, 2009, at 9:14 AM, rtaliano wrote:

    Ditto the comments on DCF. Articles like this are good to introduce folks to the various metrics but for goodness sake MF needs to have a mechanism to make sure that the information printed is a generally fair characterization of the company. Evaluating an MLP in this fashion is inappropriate.

  • Report this Comment On August 03, 2009, at 7:08 PM, Fool wrote:

    These comments are spot on. Author either isn't qualified to analyze in this way or has an ax to grind. Either way, MF should do better job of peer reviewing/quality control on articles before they go out.

  • Report this Comment On August 04, 2009, at 12:51 PM, sblax2000 wrote:

    Either Motley Fool or the author needs to do more research on Linn, or explain where they sourced this information. Linn used stock issue to finance acquisitions a few years ago and recently to pay down some debt, however, they are generating cash flow from hedges and from sales of production.

    Please review this content again, it's misleading. Or explain why they will stop paying the dividend at least before their hedges run out in 2012.

  • Report this Comment On August 04, 2009, at 10:33 PM, mcl61mcl61 wrote:

    Sorry if this is a duplicate post, but MF does make mistakes ... fortunately people catch them.

    My guess is they will amend the article.

  • Report this Comment On August 05, 2009, at 11:59 AM, mrex27 wrote:

    By the time I read this article, the rebuttals about LINE had already been made by others. Good job fools! We know this company better than the author, and maybe he can learn something from this site like the rest of us sometimes do. Linn is one of my favorite picks, and I'm not backing down.

  • Report this Comment On August 05, 2009, at 5:34 PM, TMFDiogenes wrote:

    Hi everyone,

    Thanks for the great comments. I reviewed LINE, and I think you are right to notice that it appears out of place in this article. I had been working off free cash flow, but if you use adjusted EBITDA, the company's metric for distributable cash flow, the payments are indeed covered.

    That said, this doesn't appear to be a company that is (or at the very least, wasn't until very recently) rolling in liquidity, as indicated by the recent equity offering (5.5M shares at $16.25 + with options for underwriters to purchase 825,000 shares below the issue price) and the debt issuance at near-usurious rates (11.75%, sold for 5% below par).

    http://phx.corporate-ir.net/phoenix.zhtml?c=179523&p=iro...

    http://phx.corporate-ir.net/phoenix.zhtml?c=179523&p=iro...

    If this weren't an MLP, you would expect them to cut the dividend before raising capital in these ways.

    Thanks everyone for posting,

    Ilan

  • Report this Comment On August 05, 2009, at 6:25 PM, lucidmaze wrote:

    Dear Ilan,

    You bring up some excellent points, however cash flow has not been an issue going forward after hedging.

    As far as the cost of borrowing is concerned, you need to consider the timing. Warren Buffet wrote in his shareholder letter, just a month and a half prior,

    “Though Berkshire’s credit is pristine – we are one of only seven AAA corporations in the country – our

    cost of borrowing is now far higher than competitors with shaky balance sheets but government backing.

    At the moment, it is much better to be a financial cripple with a government guarantee than a Gibraltar without one.”

    The fact that they could obtain credit at all, at the height of the worst liquidity crisis since the Great Depression, when creditors where the least likely to toss out $250 million or risk floating new issues, speaks volumes for Linn.

    However the proof is in the pudding, and we will see on Friday, how they are holding up.

    Regards,

    Lucid

  • Report this Comment On August 05, 2009, at 6:27 PM, lucidmaze wrote:

    Sorry... should use my name.

    Aaron Horvitz

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