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One of the reasons investors regard the 30 stocks in the Dow Jones Industrials (DJINDICES: ^DJI ) as blue-chip giants is that all 30 of them pay dividends. With an overall dividend yield of about 2.5%, just buying a Dow-tracking ETF can get you a significantly larger amount of income than you'll get from the broader market.
But Dow components have had to cut their dividends in the past, and so it makes sense to ask the question of whether each of the 30 Dow companies pays a sustainable dividend that isn't in danger of getting cut. With that in mind, let's take a look at companies that pay relatively rich dividends compared to their earnings.
The common problem of telecom payouts
Inevitably, when you look at payout ratios -- the amount a company pays out in dividends compared to its earnings -- two companies pop up with potential warning signs: Verizon (NYSE: VZ ) and AT&T (NYSE: T ) . Verizon in particular looks the most problematic, with trailing dividends equal to five times stated trailing earnings, according to figures from Yahoo! Finance. AT&T weighs in at "only" 137% of net income paid out in dividends.
But there's a trick to understanding why these two telecom companies are able to pay out more than they get in net income, and it has to do with accounting rules. The massive networks that AT&T and Verizon have involved large amounts of capital expenditures, but unlike money spent on ordinary expenses, the two telecom giants have had to amortize the costs of those capital improvements over long periods of time. For accounting purposes, the capital amortization reduces reported net earnings. But because the cash was already spent on those networks -- often long ago -- actual cash flow is a great deal higher, and that frees up money not just to pay the lucrative 4% to 5% dividends that Verizon and AT&T offer investors but also to fund share buybacks and other capital needs.
Dealing with drug pipelines
The third highest payout ratio belongs to Merck (NYSE: MRK ) , which pays out about 85% of its earnings as dividends. Here, concerns are arguably more justified, as the company has seen net income stagnate in recent years. Although reported earnings bounce around sharply because of restructuring costs, asset writedowns, and one-time gains or losses from sales of business units, Merck's earnings overall have remained largely flat from 2005 until now. The company hasn't raised its dividends frequently, but last year, a roughly 10% increase started pushing payout ratios higher.
For Merck, the secret to sustainable dividends will be to produce new blockbuster drugs to generate profitable revenue to replace what's been lost from previous drugs that are now off-patent. With plenty of lucrative candidates, that's not an impossible task, but it is one that will likely take some time. Don't expect to see Merck's payout ratio fall in the near future.
The big but hopefully short-term problem
Of course, the worst payout ratio to have is a negative one, and that's the situation that Hewlett-Packard (NYSE: HPQ ) finds itself in. But those losses largely come from one-time impairments that slashed about $9 per share from earnings last year. Once the negative impact of those writedowns disappears from the income statement, payout ratios should revert to their more traditional levels, which have typically ranged from 10% to 15% since 2006.
A recovery counts on CEO Meg Whitman's ability to execute a successful turnaround at the tech giant. But assuming even the current base level of core earnings is sustainable, HP should have enough income to sustain its dividend.
Don't stop watching
The Dow's dividends might look secure right now, but things can change quickly. Dividend investors have to stay on top of what's going on with their companies' businesses, or else you might be unable to avoid suffering from surprise dividend cuts that fortunately occur only infrequently among Dow stocks.