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Dividend investing is more complicated than simply choosing stocks with high dividend yields. The sustainability of those dividends is equally important. There's nothing worse for a dividend investor than seeing a company slash its dividend, a move which often sends the stock tumbling, adding salt to the wound.
We asked three of our contributors to discuss a stock that could prove to be a dividend trap, luring investors with an attractive yield only to cut the payout down the road. Here's what they had to say.
Don't fall for this double-digit yield
Matt DiLallo: MLP Martin Midstream Partners (MMLP 1.19%) currently yields an eye-popping 16.6%. That yield, however, is nothing but a trap, because the company is not generating enough cash flow to support the payout at its current level. That is causing a growing number of analysts to warn that it needs to face reality and cut the payout.
Operating conditions are challenging across several of Martin Midstream Partners' operating segments. As a result, distributable cash flow fell 12.3% in the first quarter to $32.5 million. However, because the company maintained its distribution, it only generated enough cash flow to cover 98% of what it paid investors. Unfortunately, operating conditions grew even worse last quarter, and when combined with higher maintenance capital expenditures, resulted in distributable cash flow slumping 20.4% to $25.4 million. Because the company again choose to maintain its distribution, the coverage ratio sank to even more worrisome 0.76 times last quarter.
Clearly, the company's payout is currently unsustainable, which has its management team "focused on multiple initiatives to improve our leverage profile and distribution coverage ratio both near and long term." Analysts believe that the easiest solution to both problems would be to cut the payout to a more sustainable level. Baird, for example, has Martin Midstream Partners on its list of 14 MLPs that could see their unit prices pop by cutting their distribution given the market's response to rivals that recently cut their payout. Meanwhile, FBR Capital sees Martin Midstream Partners as a potential outperformer once it cuts the distribution, which is what it is forecasting will happen.
Bottom line: Don't fall for Martin Midstream's eye-catching yield because barring a significant market change or strategic catalyst, it likely will not last much longer.
Hard drive blues
Tim Green: Hard disk drive manufacturer Seagate Technology (STX +0.00%), one of just three major players in the industry, sports a dividend yield just shy of 7%. That may seem enticing to investors, but there's a good chance that Seagate ends up being nothing more than a dividend trap.
Seagate managed to produce exceptional profits from fiscal 2012 all the way through fiscal 2015. But fiscal 2016, which ended in June, was a different story. Revenue plunged to just $11.2 billion, about the same as in fiscal 2007, and the company's operating margin slumped to just 4%, down from 15% in fiscal 2015.
Hard drive shipments are in decline, hurt by both a weak PC market and rapidly falling prices for solid-state drives. This fact has finally caught up with Seagate, and its profitability dropped accordingly. The company still produces plenty of cash, with about $1.1 billion of free cash flow in fiscal 2016, which covers the annual dividend payments of about $750 million. But the future is clouded with uncertainty.
Unless Seagate can boost its profitability in a sustainable way, a dividend cut could be in the cards. Don't be fooled by the sky-high yield.
Slowing profit could mean fewer dividends
Todd Campbell: A high dividend yield only matters if dividends continue to be paid and unfortunately, I think that Computer Programs and Systems (CPSI 0.19%), a healthcare IT company, isn't on solid enough financial ground to keep paying the dividend for long.
Computer Programs and Systems sells healthcare software to small and midsize hospitals, and while there's a lot of demand for healthcare IT solutions, this market is highly competitive and that's keeping a lid on the company's growth.
In August, Computer Programs and Systems reported second-quarter sales of $68.4 million and EPS of $0.48, which were $5 million and $0.31 below what industry watchers estimated, respectively. The company cited longer-than-anticipated decision timelines and fewer add-on sales as the reasons behind its sluggish performance.
The anemic results have already prompted management to cut its dividend payout by 47% to $0.34 and frankly, I'm not sure if that's the end to its dividend cuts. Computer Programs and Systems' board adopted a variable dividend policy earlier this year that limits dividends to 70% of the preceding quarter's non-GAAP earnings per share.
Since Computer Programs and Systems' cash position has been weakened by past acquisitions -- the company has $155 million in short- and long-term debt and only $3.8 million in short-term cash as of June -- and business headwinds could crimp non-GAAP EPS in foreseeable future, this company's dividend payout appears to be anything but safe to me.
