Dividend stocks can be a great way to generate some passive income. However, unlike fixed-income options such as bonds, dividend payments aren't guaranteed. If a company runs into financial trouble, its dividend is usually the first thing it cuts.
One warning sign that a dividend is at a higher risk of hitting the chopping block is a high dividend yield. That's especially true when the company operates in an industry currently facing significant headwinds. That's why the dividends of oil giant ExxonMobil (XOM 1.64%) and prison-focused real estate investment trust (REIT) GEO Group (GEO -0.54%) seem to be on a shaky long-term foundation.
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Holding firm for now
ExxonMobil pays a big-time dividend. That payout currently yields more than 6%, significantly higher than the S&P 500's 1.5% dividend yield.
On one hand, Exxon has made it clear that preserving its payout is a priority. The oil giant plans to focus its investments over the next few years on its highest-return capital projects. That should enable it to generate an increasing supply of free cash flow to fund its dividend and repay debt.
However, even in an environment of sustained higher oil prices in the $60- to $65-per-barrel range, Exxon's strategy won't deliver much balance-sheet improvement. According to an analysis from credit-rating agency Moody's, Exxon's debt will remain well above 2019's level by 2022 under its current plan. If oil prices weaken over the next couple of years, Exxon might need to reduce its dividend and use that cash to repay debt.
Another longer-term headwind facing Exxon's dividend is the energy transition to cleaner fuel sources. While Exxon has started to slowly shift gears by earmarking more capital toward low-carbon solutions, at 3% of the total, it's investing much less than European rivals Royal Dutch Shell and Total, which are spending more than 10% of their capital on cleaner fuel sources. Exxon could fall behind, which might put its dividend at risk of a reduction.
Already on the chopping block
Prison REIT GEO Group has already reduced its dividend by 26.5% this year. However, even with that reduction, it yields more than 12%, suggesting that investors don't believe in its long-term sustainability.
The company faces significant headwinds. Many view private prisons as part of the criminal justice system's problem and not part of the solution, since they're profiting from incarceration. That perception has made it harder for private prison operators to borrow money, as an increasing number of banks are refusing to lend to them. It has similarly led fellow prison operator CoreCivic (CXW) to suspend its dividend so it can use that cash to reduce debt. It also exited the REIT sector.
The industry's headwinds could grow even stronger in the future. The Biden administration wants to reduce the federal government's use of private prisons by not renewing contracts as they expire. That could put significant pressure on GEO Group's cash flow.
The company has already experienced some renewal issues because of the overall decline in the prison population as a result of the COVID-19 outbreak. In January, GEO Group said the U.S. Federal Bureau of Prisons wouldn't exercise its renewal option for the Moshannon Valley Correctional facility in Pennsylvania, which supplied the company with $42 million in annualized revenue. Meanwhile, the U.S. Marshals Service didn't renew its contract for the Queens Detention Facility in New York, costing the company another $19 million in annualized revenue. If GEO Group continues to lose contracts, its dividend could take another hit.
High-risk, high-yield dividend stocks
ExxonMobil and GEO Group are at high risk for a dividend reduction in the future. Both face significant headwinds as political changes are affecting their core businesses. They might not be able to sustain their cash flows in the future, which could force them to reduce or suspend their dividends to free up that cash for debt reduction. Given that risk, income investors should turn their attention elsewhere.
