The Next 2 Dividend Burnouts?

With the economy still shaky, many wary investors have been turning to the safety of dividend-paying stocks.

Just last month, investors poured $440 million into the Vanguard Dividend Appreciation ETF alone.

Buyer beware
While dividends provide a source of income that helps to smooth out market volatility, crises like the recent 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 in 2008, and their stock prices had an average return of negative 56% for the year.

While companies such as Altria (NYSE: MO), ExxonMobil (NYSE: XOM), and Boeing (NYSE: BA) continued raising their payouts in 2009, Standard & Poor's reports it was "the worst year ever" for dividends. Pfizer (NYSE: PFE) and US Bancorp (NYSE: USB) were just two high-profile victims.

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

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

Extremely high yields indicate 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 its payouts.

But these factors don't necessarily imply that a cut is imminent. Many companies have continued to pay dividends they cannot afford for years, damaging their own companies -- 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 -- because they wouldn't want lenders to think their company is struggling. Such a fear may explain why KeyCorp (NYSE: KEY) reluctantly cut its dividend three times over the past two years, apparently hoping each time that a limited cut would do the trick.

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.

While some of these practices may be acceptable bandages 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, damaging its shareholders in the process. Even worse, it's likely that the business will ultimately have to cut its dividend anyway.

So which companies might fit that description today?

Two companies risking a burnout
These two stocks 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.

NL's sales of things like ball bearings, security products, and ergonomics products are down considerably over the past 12 months because of lower order rates. The company has not been free cash flow-positive for nearly three years. Still, it continues to pay a substantial dividend.

While Navios Maritime's net income payout ratio may look secure, and it pays a fairly modest dividend relative to its capital requirements, the company hasn't been free cash flow-positive since 2004.

The silver lining ...
Dividend stocks have a history of putting money in investors' pockets. However, 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.

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This article was originally published March 26, 2009 under the headline "The Next 3 Dividend Burnouts?" It has been updated.

Ilan Moscovitz is owns shares of US Bancorp but is neither long nor short any other companies mentioned in this article. Pfizer is a Motley Fool Inside Value recommendation. The Motley Fool has a disclosure policy.