Income investors and retirees love stocks that pay high dividends. However, it's not quite as simple as running a screener to identify the stocks with the best dividend yields. Investors need to understand how much cash flow they should expect in the future and whether or not a company's distributions are sustainable.
Here are three stocks that have recently cut their dividends while dealing with a challenging operating environment. That action actually ended up making their trailing dividend yields rise and, as a result, created the misleading idea that these companies have great dividends. Let's explore why these deceptively high dividend yields may be tricking investors.
1. Energy Transfer LP
Energy Transfer LP (ET 2.22%) a master limited partnership (MLP) that owns and operates a large and diversified set of midstream energy assets related to the transportation, storage, refinement, and production of crude oil and natural gas. MLPs are structured as a tax-advantaged business that provides high amounts of cash flow to shareholders. They're popular in midstream energy companies because of the relatively predictable and stable nature of midstream operations, compared to other companies in this sector.
The energy sector has been rocked by turmoil this year. First, a steep drop in crude prices led production companies to reduce capacity as the economics of oil extraction and processing quickly became unprofitable. Oil prices have recovered somewhat, but continued weak demand due to the coronavirus pandemic has prevented a full rebound.
Investors may be excited by Energy Transfer's 17.5% trailing dividend yield, but the number is misleading when you look closer. Energy Transfer's quarterly dividend was reduced in November 2020, so the trailing yield is calculated using distributions that are higher than investors should expect to receive. To payout the reduced dividend, Energy Transfer needed 230% of its free cash flow. That rate is not sustainable over a longer time frame. Energy Transfer's forward yield is 9.8%.
There's a good chance that the forward yield is sustainable, especially if oil prices rise and the sector recovers. However, investors should recognize the risks related to uncertainty and the discrepancy between forward and trailing yields.
Macerich (MAC 7.06%) is a real estate investment trust (REIT) that owns and manages nearly 50 top-tier malls and open-air shopping centers. The coronavirus pandemic has been disastrous for brick-and-mortar retailers, with government shutdowns and consumer health concerns keeping many people away from stores.
The resulting economic recession (which is likely to extend into 2021) is also an issue, as luxury and big-ticket items tend to experience cyclical demand. As a result, Macerich's tenants have experienced significant trouble staying afloat, with some becoming delinquent on their lease payments and some shutting down their stores. Lease revenue was down 18% year over year for the REIT in its most recent quarterly report.
Macerich management responded to the current crisis aggressively, slashing its quarterly dividend from $0.75 a share in February to $0.10 a share in April. The two subsequent quarters saw the dividend actually move higher to $0.15 a share as conditions began to improve. This up and down movement in the dividend has created a case of a deceptive trailing yield.
The stock's 10.46% trailing yield is far less enticing when investors recognize that the forward yield is only 5.61%. The forward yield is not necessarily in jeopardy, as its most recent quarterly funds from operations (an equivalent of earnings for REITs) were more than triple the dividend, so the REIT is producing ample cash to support its distribution. However, investors should strongly consider the acceleration of e-commerce in 2020 and consider the risks of exposure to the brick-and-mortar retail market in the medium term.
3. Wells Fargo
Wells Fargo (WFC 2.95%) is a major consumer and corporate banking operation with heavy exposure to the residential mortgage market. The events of 2020 resulted in a very challenging environment for most banks. The economic impacts of the global pandemic have forced unemployment and underemployment rates higher, leading to mortgage delinquency rates above 7.5% and forbearance rates around 5.5%.
The bank has also been forced to write-off or restructure loans with distressed enterprise and small business clients. Falling interest rates, instigated by responsive monetary policy, also create a challenging environment in which loan income falls and fixed expenses, such as personnel and technology, remain the same.
Wells Fargo slashed its quarterly per-share dividend from $0.51 to $0.10 in August. The trailing 4.08% dividend yield is therefore much higher than the 1.33% forward yield that investors should anticipate. Wells Fargo's top-line revenue is expected to fall 15% for the full year 2020, and analysts are expecting a further decline in 2021. The bank's forecast earnings are likely to fall short of the current dividend, so higher profits will be necessary to keep even the reduced dividend in a sustainable place.