Good dividend stocks can create long-term wealth through solid earnings growth, consistent dividend hikes, and the "magic" of compounding. Meanwhile, bad dividend stocks lure in investors with big yields, then cut their payouts as their stocks stumble.
Investors can spot high-yield traps with three red flags -- an oversized yield, deteriorating earnings growth, and payout ratios (the percentage of a company's earnings or free cash flow spent on dividends) exceeding 100%. Here are three bad dividend stocks that tick those boxes: CenturyLink (LUMN), National CineMedia (NCMI 2.22%), and Abercrombie & Fitch (ANF 2.83%).
CenturyLink provides communications and data services to residential, business, government, and wholesale customers. It recently acquired Level 3 Communications in a $30 billion deal, and is currently the third-largest US telco in terms of lines served behind AT&T and Verizon.
The Level 3 merger is expected to boost CenturyLink's revenue by 34% next year, but its earnings could fall 31% on acquisition-related expenses. That's bad news for its whopping forward dividend yield of 16%, which used up 373% of its earnings and 254% of its free cash flow over the past 12 months.
CenturyLink already slashed its dividend once in 2013, and it hasn't raised its payout since then. This makes it an unappealing and dangerous dividend stock for income investors. CenturyLink believes that the Level 3 takeover will strengthen its free cash flow and reduce its payout ratios through $975 million in cost-saving synergies, but it's unlikely to make its dividend much safer. Therefore, investors looking for a dependable telco dividend stock should stick with AT&T and Verizon.
National CineMedia owns 49.5% of National CineMedia, LLC, the largest in-theater digital network in North America. National CineMedia's services include cinema ads and pre-show entertainment on movie screens, as well as ads in theater lobbies. But over the past year, National CineMedia tumbled with other US theater stocks as theater attendance rates dropped to a two-decade low.
Analysts expect National CineMedia's revenue and earnings to respectively slide 4% and 32% this year. Yet the company still pays a whopping forward dividend yield of 13%, which was inflated by the stock's near-60% decline for the year. It spent 268% of its earnings and 42% of its free cash flow on that dividend over the past year.
The optimists might believe that its lower cash payout ratio makes that dividend more sustainable, but the company hasn't raised its quarterly dividend since 2011 (excluding a special $0.50 dividend it paid in 2014). Moreover, the company's core business of cinema and lobby ads seems destined to be rendered obsolete as theater attendance rates keep dropping -- making it a poor long-term income play.
Abercrombie & Fitch
Apparel retailer Abercrombie & Fitch recently rebounded after it posted its first quarter of positive comparable store sales in six years. Analysts expect its revenue to rise 2% this year and for its bottom line to return to profitability. Those estimates indicate that A&F might be finally turning a corner amid tough competition from fast fashion retailers and e-tailers.
However, A&F's 4.9% forward dividend yield still doesn't look sustainable. That payout gobbled up 222% of its earnings and 112% of its free cash flow over the past 12 months. The dividend also hasn't been raised since 2013, when the stock traded more than 200% above its current levels.
A&F's gross margin is still declining, and much of its earnings growth is driven by reductions in operating expenses. But if A&F is serious about preserving its free cash flow, it will likely need to cut its dividend. For now, investors looking for turnaround apparel plays with sustainable dividends should stick with Gap and American Eagle Outfitters instead.