When Bad Things Happen to Good Dividends

Earnings have been particularly disappointing so far this season. Among the big-name companies missing their targets are Apple, Starbucks, and Ford, and S&P Capital IQ predicts that profits in the S&P 500 will drop by 0.5% from a year ago based on companies that have reported so far. Overall profits haven't dropped like that since 2009, and analysts are predicting another decline next quarter. Revenues have also been particularly underwhelming, with just 42% of companies beating estimates, as opposed to an average of 60%.

In times like these, it's Foolish to double-check your company's cash flow and take a look at how secure the dividend payout is, which is key for the stock to maintain its value in uncertain times like these. Let's look at some basic dividend ground rules and examine some companies whose payouts have blown up in the recent past.

All hail the payout ratio
The best numerical indicator for a company's ability to continue to pay a dividend is its payout ratio, which is the dividend per share divided by either earnings per share or free cash flow per share (DPS/EPS, or DPS/FCFPS).

Using free cash flow, a company's operating cash flow minus its capital expenditures, tends to be a better measure in the short term than earnings because FCF represents cash earnings, which go straight to dividends. Accounting adjustments like depreciation and amortization aren't going to protect your quarterly windfall. Payout ratios also indicate how much of a company's profits are being reinvested in operations and how much it's returning to shareholders, and they show how much room there is to increase the dividend. Stable, healthy businesses tend to have higher payout ratios. Let's look at Coca-Cola (NYSE: KO) as an example. Here are the figures for 2011; you can readily find figures like these from any company's cash-flow statement.

Source: Yahoo! Finance.

At percentages near 50%, Coke's payout ratio shouldn't ruffle any feathers, but investors should also be aware of money paid out through share buybacks. Repurchasing shares is the other way companies return value to shareholders, indirectly by artificially inflating EPS. Fellow Fool Sean Williams argues that dividends are better ways to return capital to shareholders than buybacks; I tend to agree. One advantage buybacks offer, however, is their flexibility over dividends and tax consequences. Companies can raise or lower their annual buybacks as they please, but if they cut or suspend their dividend, the market almost always punishes them for it.

The "R" word
Dividend investors keeping one eye on their stock's payout ratio may want to focus the other one on companies undergoing restructuring. When once-healthy companies that paid a steady dividend fall behind the competition, it's time for the "R" word, management's favorite way of telling shareholders "what we've been doing isn't working, but our consultants say this will." When businesses restructure, dividends often go out the window.

General Motors (NYSE: GM) suspended its dividend in 2008, as one of several cutbacks that included shrinking management costs by 20% and selling about $4 billion in assets. The catalyst for the financial turmoil was a spike in oil prices and the recession, which drove down demand for vehicles, especially gas-guzzling SUVs that the company had bet on. Its bloated pension-payment structure and legacy benefits also added fuel to the fire. Despite its current success and world leadership in automotive sales, the carmaker still looks far away from reinstating its dividend. Fixed payments like pension obligations and a cyclical business create a high-risk situation for dividends to be decreased.

Frontier Communications (Nasdaq: FTR) was forced to cut its dividend earlier this year because of mounting debt and an unsustainable payout ratio, slicing the quarterly payment nearly in half from 18.75 cents to 10 cents. A look back at 2011's financials shows the company had a payout ratio of about 500% of EPS and around 100% FCF. A whopping amount of depreciation, as is common among telecoms, caused the imbalance. At levels like that, it's easy to see why management dialed down the dividend, but still, the company pays a healthy 10.8% yield at today's share price. Since the announcement, shares have dropped about 15%, and there's still concern that another dividend cut is coming up, as payout ratios are still high and the company is loaded with debt.

Finally, SUPERVALU (NYSE: SVU) suspended what had been a 6.8% dividend yield earlier this month, chopping its share price in half in the process. The company has been struggling for years, since its acquisition of Albertson's in 2006, and the stock is worth just 5% of what it was at its height in 2007. Amid what seems to be a never-ending restructuring process, the company bit the bullet on its dividend, saying it needed to spend more money retiring debt. The company's payout ratio was actually not unreasonable compared with the high amounts of operating cash flow it spins out, but with a heavy debt burden, struggling operations, and a lack of profitability, it's no surprise the dividend disappeared. It's generally the first item on the chopping block when times are tough. In a further sign of SUPERVALU's troubles, the company jettisoned CEO Craig Herkert yesterday, replacing him with Chairman Wayne Sales. That move sent shares up 12%.

Foolish takeaway
Shareholders must remember that they're at the end of the long value-creating food chain known as the modern corporation. For them to reap benefits, the company must first create value for other stakeholders, namely customers. A business that prioritizes share buybacks and dividends over sustainable operations will ultimately fail, and a chronically unprofitable company that pumps cash back to investors should be a red flag. If the business is failing now and it doesn't have an idea worth investing in, there's no reason to think it will be around much longer.

We've looked at a few warning signs to watch out for with dividend cuts: High payout ratios, heavy debt burdens, and a lack of probability should all cause investors to think twice about a stock. Macro concerns are another issue to be aware of, as we saw with GM. Investors in stocks with heavy exposure to Europe these days, for instance, should mind their dividends carefully. As we saw with Ford, a dependence on that market could be an Achilles' heel, especially with the continually weakening euro. I would also caution against dividends from struggling big-box retailers such as J.C. Penney and Best Buy, as both have reported dismal financial numbers recently but continue to return cash to shareholders. That pattern is not sustainable.

Luckily, not all dividends are created equal. I touched on Frontier earlier and the uncertainty around its dividend. If you're a Frontier investor, we've created a new premium report that details not only steps the company is taking to secure its future, but also the threats that could derail its dividend. Best of all, the report comes with continuing updates as news strikes. Get a copy of this new premium report.