Track the companies that matter to you. It's FREE! Click one of these fan favorites to get started: Apple; Google; Ford.



The Releveraging of American Business

Don't let it get away!

Keep track of the stocks that matter to you.

Help yourself with the Fool's FREE and easy new watchlist service today.

Even as investors sit on the edge of the fiscal cliff, dividend stocks have never been more popular. Yet while many investors see dividends as a sign of financial strength, the way that an increasingly large number of companies are coming up with the cash to pay dividends suggests that at least in some cases, the opposite is true.

Yesterday, I took a look at the wave of special dividends that millions of shareholders will receive this month. That article concluded that even for companies with billions of dollars in cash reserves, sending substantial chunks of money back to shareholders represents a failure of sorts in businesses' ability to come up with profitable investments.

What's more troubling, though, is the fact that many of the companies that are paying big dividends don't have massive hoards of cash. Instead, they're turning to the credit markets, which have been more than happy to allow corporations to finance huge amounts in recent years. The result is a steady increase in overall leverage that could eventually bring back some of the problems that led to the financial crisis four years ago.

Borrowing with one hand to pay with the other
When it comes to regular quarterly dividends, investors typically look closely at the sustainability of company payouts. If a company's dividend exceeds its earnings by too wide a margin -- or, in some industries, its free cash flow -- then it raises concerns among shareholders that the company will have to rein in on its payouts at some point in the future. As a result, investors, sometimes prefer stocks with lower yields over others that have higher yields, simply because over the long run, they expect the current lower-yielder to keep paying and even increasing its payouts over time.

Special dividends, however, are another story. Historically, companies tended to make special dividend payouts when their cash levels got too high or when they received big cash windfalls. One of the most prominent examples was in 2005, when Microsoft (NASDAQ: MSFT  ) paid a total of $32 billion in cash to its shareholders in the form of a $3-per-share special dividend as part of a broader plan to return $75 billion in capital to investors over a four-year period. No one expects special dividends to be sustainable -- that's what makes them special.

Many companies simply aren't waiting to have cash on hand in order to pay special dividends. An article in The Wall Street Journal last week detailed how a number of prominent companies have issued substantial amounts of debt in order to come up with the cash to make dividend payments. Here's just a sample:

  • Cruise-ship operator Carnival (NYSE: CCL  ) issued new bonds worth $500 million last week. That gave the company more than enough money to cover its $0.50-per-share special dividend, which should cost it about $390 million in total.
  • For oil and gas exploration company Murphy Oil (NYSE: MUR  ) , about a third of a $1.5 billion offering will go toward paying a $2.50-per-share special dividend to shareholders.

The problem, though, is that these special dividends pit shareholders against bond investors. When companies drain their cash reserves by making massive payouts, they leave bondholders with far less security that they'll get paid in full.

In response, therefore, bond ratings agencies have started to take action against special dividend payers. Fitch Ratings downgraded Costco (NASDAQ: COST  ) from AA- to A+ after the warehouse retailer announced its $7-per-share special dividend. Similarly, spirits producer Brown-Forman (NYSE: BF-B  ) incurred the wrath of S&P, which cut Brown-Forman's rating from A to A- and issued a negative outlook following the company's declaration of a $4-per-share special dividend.

Levering up
The saving grace for companies is that financing costs have never been cheaper. That makes going into the debt markets for just about any reason a relatively safe move right now.

The problem, though, will come down the road, when companies have gotten used to having a thick cushion of leverage helping to inflate their returns on equity. When rates move higher, companies will face the difficulty of either having to refinance at much higher interest costs, or paying down their debt. Neither eventual solution will be easy. Investors should look closely right now at what their companies are doing before jumping in on the special dividend frenzy.

It's been seven years since Microsoft paid that special dividend, and the business is still a cash cow. But recent efforts to go beyond its PC-based software haven't produced the blockbuster results investors had hoped for. Find out whether Microsoft is a buy in our premium research report on the stock, in which our top tech analyst parses through the big opportunity the company has as well as the many challenges it faces. He's also providing regular updates as key events occur, so make sure to claim a copy of this report now by clicking here.

Read/Post Comments (0) | Recommend This Article (2)

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.

Be the first one to comment on this article.

Compare Brokers

Fool Disclosure

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2138314, ~/Articles/ArticleHandler.aspx, 10/27/2016 6:51:20 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Today's Market

updated Moments ago Sponsored by:
DOW 18,169.68 -29.65 -0.16%
S&P 500 2,133.04 -6.39 -0.30%
NASD 5,215.97 -34.29 -0.65%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

10/27/2016 4:00 PM
BF-B $45.46 Down -0.01 -0.02%
Brown-Forman (B Sh… CAPS Rating: ****
CCL $46.53 Down -0.62 -1.31%
Carnival CAPS Rating: **
COST $150.86 Down -0.12 -0.08%
Costco Wholesale CAPS Rating: ****
MSFT $60.10 Down -0.53 -0.87%
Microsoft CAPS Rating: ****
MUR $27.60 Down -2.11 -7.10%
Murphy Oil CAPS Rating: ***