All too many investors get lured into the trap of buying high-yield dividend stocks. Those monstrous yields tend to make us throw caution to the wind despite clear signs to stay away. It only takes a short amount of time -- or an abrupt dividend cut -- to make us realize the error in our thinking.
So we asked three of our contributors to highlight stocks they consider high-yield traps to avoid. Here's why they picked gasoline retailer Sunoco LP (NYSE:SUN), Fifth Street Finance (NASDAQ: FSC), and Lenovo Group (OTC:LNVG.F).
Tyler Crowe (Sunoco LP): If a 13.4% yield sounds suspiciously high, you're right. That is where Sunoco LP's current distribution yield stands, and it's getting increasingly harder for the company to justify paying out that much cash on a quarterly basis considering the issues it is facing today. Not only is it not generating enough cash to cover its current payout -- its distribution coverage ratio for the most recent quarter was a ghastly 0.68 times -- but the company has been put on notice by its creditors that it needs to lower its debt metrics.
To meet its debt reduction diet, Sunoco will have to make drastic moves. It estimates that it will be able to use asset sales and at-the-market equity issuances to cover some of those capital needs. The trouble with equity issuance is that it is a short-term solution that compounds a longer-term problem: At a distribution this high, it is prohibitively expensive to issue new equity because each new share means more cash out the door each quarter for distributions.
On the company's most recent conference call, veiled language seemed to suggest that they are considering cutting the payout. Statements like "nothing is off the table" and "debt reduction is our primary focus" appear to indicate that something isn't quite right at Sunoco, and investors looking at the sky-high yield should be aware that there is a very good chance it will be lowered relatively soon.
Cheap for a reason
Jordan Wathen (Fifth Street Finance): In an industry where the average company trades at a 5% discount to book value, Fifth Street Finance trades at a 36% discount. It also promises a yield of 11%, based on dividends it expects to pay starting in September 2017.
Fifth Street Finance is a classic case of how statistical cheapness can lead investors astray. Its portfolio of loans and equity investments in private businesses has seen better days. The company noted in its most recent financial results that it isn't recognizing income on more than 7% of its portfolio by fair value. At its original cost, it isn't recognizing income on more than 18% of its portfolio.
And when it comes to pleasing disappointed investors, Fifth Street Finance apparently cares more about looking the part than making real changes. It modified a management fee agreement so that incentive fees could be reduced by only 25% if performance is poor. Are they really incentive fees if management is guaranteed to receive at least 75% of the anticipated haul, regardless of performance?
Wrong place, wrong time
Tim Brugger (Lenovo Group): Unlike primary rival HP, China-based Lenovo is heading in the wrong direction despite its industry-leading PC sales. With its 6.7% dividend yield, investors in search of income will be hard-pressed to find a better payout. Problem is, Lenovo demonstrated yet again last quarter that market share doesn't translate to revenue growth.
With management citing "sizeable challenges in its three main lines of business, namely data center, mobile devices, and PCs and smart devices," Lenovo's fiscal third-quarter revenue dropped 6% year over year to $12.2 billion. Unfortunately, the bad news doesn't end with Lenovo's revenue declines across every geographic region on the planet.
Thanks largely to slumping gross margins, which sank to 13.1% from 14.6% a year ago, and little to any decline in overhead, Lenovo's operating profit nosedived 64% to $138 million. Not surprisingly given its drop in margins and revenue, Lenovo's earnings per share sunk 67% compared to last year, to $0.90.
CEO Yang Yuanqing is quick to point out that Lenovo is the world's PC sales leader -- except that Lenovo's PC sales climbed an anemic 1.7% in 2016's calendar fourth quarter while HP shipments jumped 6.6% and privately held Dell's increased 8.2% year over year. In other words, Lenovo's competitors are closing in on its primary source of revenue.
What makes Lenovo's situation even more precarious are that its efforts to garner market share in the highly competitive mobile space are woefully underperforming. A nearly 7% dividend yield may look enticing, but after poor financial results and expectations for more trouble ahead, it's best to avoid Lenovo.