It's natural for income investors to be attracted to stocks that offer big payouts. However, a high yield can often indicate that a stock is too risky.
Staples: Make more happen, please
Anders Bylund (Staples): At 5.3%, Staples offers one of the most generous dividend yields in the S&P 500 today. That doesn't make it a great stock for income investors, though. In fact, the huge yield is more of a red flag, signaling deep trouble within the office-supplies retailer.
Great dividend stocks power their payouts via stable or rising free cash flows. Ideally, the quarterly payout per share should receive annual increases -- preferably large ones. In short, the sky-high dividend payouts you see should rest on a great financial foundation. That's not what you get from Staples.
The company hasn't raised its payout since 2013, leaving the quarterly policy sputtering at $0.12 per share for 16 straight payments. Meanwhile, earnings and free cash flow have been cut in half over the last five years.
To Staples' credit, the dividend is still fully funded by cash flows. In fact, the company is only funneling 53% of its free cash into the payout program. But the rising yield in recent years did not come from higher payouts. Instead, it was the result of plunging share prices.
A Staples investment is a bet on a turnaround that might never come. Even worse, the stalled dividend growth could evolve into dividend cuts, or an outright cancellation at any moment unless the company manages to halt the cash-flow drought.
You should be able to buy great dividend stocks, put them under your pillow, and enjoy peaceful dreams for decades. Staples is potential nightmare fuel for income investors.
Don't toy around with this stock
Brian Feroldi (Mattel): Considering Mattel's yield of 5.9% and a stable of well-known brands like Barbie, Hot Wheels, American Girl, and Fisher-Price, you might be tempted to buy this toymaker's stock while it's on sale. But that isn't a good idea. Let's start with its recent results.
The company reported a net sales decline of 8% in the all-important fourth quarter on the back of losing exclusive rights to Disney Princess and Frozen characters to Hasbro. Even when adjusting for that move, gross sales were flat. However, the company's gross margin took a serious nosedive, hinting that the company had to offer huge discounts to help move its merchandise. Add it all up, and net income dropped by 19%.
All of this might be OK if it was a one-time blip, but this has been the story for a few years now:
This weakness has caused Mattel's payout ratio to skyrocket well past 100%. Last year, Mattel paid out $1.52 per share in dividends, but its earnings per share (EPS) was only $0.93. That's not a trend that can persist indefinitely.
Mattel just hired a new CEO to right the ship, so changes are on their way. It's possible that one swift action right out of the gate could be to cut the dividend. If so, shareholders could be in for even more pain ahead.
GNC Holdings: Crisis ahead?
Cory Renauer (GNC Holdings): At first glance, it looks like this stock's dividend has been eating the supplements that made the company famous. At recent prices, the $0.20 quarterly payment offers a tempting 9.4% yield. Unfortunately, the huge yield is the unintended consequence of a prolonged market beatdown. Shareholders have lost about two-thirds of their principal over the past year, while the quarterly dividend remained at $0.20 per share.
You can blame dismal results for the persistent market thrashing. When GNC Holdings reported third-quarter earnings, it noted that same-store sales fell 8.5% compared to the previous-year period. Sagging comps are troubling, but the 29.3% drop in net income in the third quarter was downright terrifying. The company needed just 29.1% of profits over the past 12 months to make dividend payments, but the next few years are going to be real nail-biters.
GNC finished September with $1.54 billion in long-term debt and faces a massive $1.16 billion principal payment in 2019. Over the past 12 months, operations generated a profit of just $358.9 million, and there was only $37.2 million in cash on the balance sheet at the end of September.
If its bottom line continues to slide, GNC may have trouble refinancing that debt. If the company is forced into raising equity to avoid a default, the share count will soar while your slice of the profits dwindles.