Avoid This Dividend While You Still Can

We all know about investors' current preoccupation with dividend stocks. This, of course, is quite justified compared with other alternatives (like bonds or cash, which promise essentially no return). Stocks that actively pay their owners provide a pretty attractive option in today's low-yield environment.

However, investors need to look past the hype and realize that, although lovely in many ways, these investments do carry certain risks, some much greater than others. Today I'll detail one specific dividend investment that certainly alarms me.

Caveat emptor
The dividend universe is a diverse place.  Opportunities run the gamut from stable companies that pay dividends like clockwork, such as Johnson & Johnson (NYSE: JNJ  ) and Intel (NYSE: INTC  ) , to companies with payouts well into the double digits. The stocks I have in mind exist on the higher-yielding end of the spectrum.

Even in assessing high yield stocks, it's important to avoid equating all companies as dangerous as the next stock. REITs, or real estate investment trusts, serve as a fair example of an industry known for its dividend prowess. Home to dividend powerhouses Annaly Capital Management and Chimera Investment that yield 14.8% and 19.5%, respectively, these companies couldn't be more different from J&J and Intel. Their dividend policies have certain characteristics you might not find elsewhere in the investment world. You see, REITs are a special corporate structure (formed as an investment fund) that receives unique tax benefits on its income so long as it pays out a high percentage of its income every year. The point here is that sometimes large payouts occur for good reason.

Sizing 'em up
The telecom industry also makes for about as fertile a hunting ground for exorbitant dividends as you'll find. The average company that pays a dividend in the sector --  not all do -- yields a robust 7.1%. Contrast that against the 2% yield of the S&P 500 (INDEX: ^GSPC  ) and 2.9% of the Dow Jones Industrial Average (INDEX: ^DJI  ) and you get the picture. Telecom stocks often take returning cold, hard cash to their shareholders quite seriously.

On the riskier end of the spectrum, payout behemoth Alaska Communications Systems (Nasdaq: ALSK  ) should send investors running. Its siren song, a 16.1% dividend yield, could blow up in your face, making it exactly the kind of dividends investors should avoid. On the surface, the company appears a model of consistency. It's paid dividends out like clockwork since 2004 (the company was only founded in 1998), despite reporting losses sporadically throughout the period. Losses appearing intermittently should probably raise a red flag for most investors.

However, investors interested in investing in telecom stocks will fare better if they frame their analysis around cash flow versus reported income, even more so than investors in other sectors (one of those industry norms again). Telecom firms are renowned cash cows, much more so than merely looking at their income statements might indicate. Since surviving in the industry requires heavy capital investment, telecom companies often have extremely high depreciation costs that erode substantial portions of their recorded profits.

As a result, using tools like the earnings payout ratio fail to really accurately capture a telecom company's ability to make payments to its shareholders. However, turning to the cash flow statement will give investors a much better sense of the relative health of companies in this industry. You can see this distinctly in rural telecom Frontier (NYSE: FTR  ) as well.

In Alaska's case, it generates much more consistent, albeit not wholly unblemished, cash flow that it uses to pay shareholders. Over the last 12 months, Alaska generated $27 million in free cash flow versus a net income loss of $3.1 million during the same period. And while that seems great, Alaska's cash dividend payments still comfortably outstripped its cash flow over the period, to the tune of $38.6 million in dividend payments, well above the $27.6 million in cash that came in the door.

The company's most recent conference left shareholders even more rattled. Although management couldn't specifically comment on the dividend going forward (the board of directors sets such policies), it did reveal several key points that paint an ugly picture for the future. First, CEO Anand Vadapalli admitted to investors during the call that "our board has been reviewing our dividend policy ... we expect this matter will receive additional scrutiny." The stock dropped 28% in reaction to this ominous news about the safety of the firm's beloved payout.

Worse yet, the firm sees mounting competition on the horizon. Telecom heavyweight Verizon Wireless (NYSE: VZ  ) announced this year that it intends on entering the Alaskan market. The telecom notoriously favors the big fish that have the resources to make key investments and offer popular phones at attractive prices. Verizon will clearly loom large as it challenges Alaska for share of this remote market. Put all this together and Alaska, and its prodigious payout, looks poised for a rough patch.

Foolish bottom line
As I hope you learned here today, investors need to approach dividend investing with a healthy dose of skepticism. Although a great way to help drive a portfolio's overall returns, these payouts also carry their own set of risks investors need to fully understand before investing. Unfortunately, a higher yield doesn't necessarily guarantee a happier portfolio. In the end, investors need to fully understand the sector norms and the individual circumstances surrounding each company in which they invest. As I said above, buyer beware.

And if you want more ideas on other dividend opportunities, The Motley Fool recently compiled a research report detailing 11 Rock-Solid Dividend Stocks. Best of all, it's absolutely free for our readers. I invite you to pick up your free copy today.

Andrew Tonner owns no position in any of the companies mentioned in this article. The Motley Fool owns shares of Chimera Investment, Intel, Annaly Capital Management, and Johnson & Johnson. The Fool owns shares of and has bought calls on Intel. Motley Fool newsletter services have recommended buying shares of Intel and Johnson & Johnson; creating a bull call spread position in Intel; and creating a diagonal call position in Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (13) | Recommend This Article (89)

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 December 07, 2011, at 6:06 PM, Darwood11 wrote:

    "There is no free ride."

  • Report this Comment On December 07, 2011, at 6:10 PM, Darwood11 wrote:

    "If it's too good to be true, it probably is."

    I'd suggest those who are chasing dividend performing stocks consider looking at "S&P 500 Dividend Aristocrats."

  • Report this Comment On December 07, 2011, at 6:19 PM, Synchronism wrote:

    Since Alaska's been paying dividends since 2004, given that we have about... 7 (or 8) years' worth of data, how often has the company been paying dividends straight out of debt? How much of its OCF's are generally put into its business?

    And if its profits (cash and accounting) are set for a big, biiiiig decrease from the looming competition, what's the dividend yield it is more capable of affording?

    Moreover, what competitive advantages and strategies does Alaska have under its belt to keep the telecom Goliath from completely displacing it from its business? Is there even a possibility for Alaska to prostitute its assets to Verizon?

    Now, I'm not expecting any answers for these (for all I know, your analysis could be rudimentary rather than intensive), but the point I'm trying to put across here is that no dividend-paying stock should be dropped as if it was a profit-less value trap just because people are expecting a challenge to crop up.

    ...and in retrospect, this comment seems to supplement the bottom line of your article.

  • Report this Comment On December 07, 2011, at 6:39 PM, mikecart1 wrote:

    "You either die a hero or live long enough to see yourself become the villain"

  • Report this Comment On December 07, 2011, at 7:21 PM, Regarded49 wrote:

    Does the author believe that mREITs are not stocks to own in a well diversified portfolio? I have held NLY for quite some time and even though it has had its ups and downs, the shares have been more than paid for themselves and the company continues to make very strong profits.

    Clarification on mREITs would be appreciated.

  • Report this Comment On December 07, 2011, at 8:34 PM, bytre wrote:

    How does a fund like GABUX pay out .07 per $6 share every month, mostly as return of capital, without impacting its price?

  • Report this Comment On December 07, 2011, at 9:11 PM, TMFBreakerRob wrote:

    Until Andrew responds....

    @AlanLee49: "Does the author believe that mREITs are not stocks to own in a well diversified portfolio?"

    He neither said that nor did he imply that. In fact, the only thumbs up/down related statement he made concerning the two cited companies and the asset class was "The point here is that sometimes large payouts occur for good reason.", which is more of a positive statement than anything else.

    I also own NLY, by the way.

  • Report this Comment On December 07, 2011, at 10:19 PM, yardomd wrote:

    Excellent article.

    John.

  • Report this Comment On December 08, 2011, at 10:50 AM, OpenEyes1 wrote:

    While it doesn't look great for the dividend rate for ALSK to hold at its current levels, there is always the possibility that VZ may buyout ALSK rather than build their own network in America's biggest state. VZ is currently contracted to use ALSK network, and is building a facility next to ALSK in Anchorage (reported on another message board).

    There's no question that ALSK is a high risk play, so investors should use caution.

  • Report this Comment On December 08, 2011, at 8:28 PM, servererror1 wrote:

    Kept waiting for the author to analyze NLY & CIM, but he never did.

    I think most seasoned investors know enough to look at outlandishly high dividend payouts with a jaundiced eye.

  • Report this Comment On December 09, 2011, at 1:30 PM, fool425 wrote:

    " investors know enough to look at outlandishly high dividend payouts with a jaundiced eye."

    This could be said of treasuries right at this moment as well. In fact, I would argue that there is not a less rewarding investment for the risk at hand than treasuries going forward, yet you won't hear this from your local financial advisor.

  • Report this Comment On December 11, 2011, at 1:46 AM, Lokihome wrote:

    Hello -- read this article twice! For those who are not that old do some research on old line companies and the dividends they paid. OMG -- what ever happen to Armstrong Crown & Cork, Otis, GM and many more. While these companies were giving you dividend the executives of all of these companies were reaping huge salaries, running the companies into the ground and were safe from "The Boards" rath! Wake up - do your research!

  • Report this Comment On December 12, 2011, at 2:29 PM, GeorgeAJH wrote:

    Only a month ago there circulated a story that Verizon was going to enter the Alaskan market by purchasing Alaskan Communications.

    George

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