Income investors should never take dividend income for granted. Payouts are always discretionary, and companies can reduce or eliminate them due to poor performance or just a change in strategy. A rate cut could put you in a difficult situation because it may also send a negative signal to the markets that leads to a sell-off, leaving you with not just a reduction in dividend income but also a dent in your overall investment.
The warning signs aren't always obvious that a stock is in trouble or that a possible reduction in its dividend is coming. But two income stocks that you should be wary of right now and pay close attention to are Merck (MRK 3.02%) and AT&T (T -1.28%).
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1. Merck
Healthcare company Merck pays a relatively high yield of 3.3% (the S&P 500 average hovers around 1.4% these days). And it has been increasing its dividend payments in recent years -- its latest hike was a 7% increase from $0.61 to $0.65 last year. However, while raising payouts is a good sign that the business is doing well, it doesn't mean that it will continue doing so.
One problem I see with Merck is that its free cash flow of $6.5 billion over the trailing 12 months has barely been enough to cover its dividend payments of $6.3 billion over the same period. A lack of strong, consistent free cash could make the company less generous with future rate hikes. And a shortage of it could eliminate increases entirely.
Another issue is that with the spinoff of Organon (which primarily focuses on women's health) now complete, Merck's business will be different and focused more on growth. While that could end up being a good thing if it translates into a stronger bottom line, it may drain more cash from the business to fund growth initiatives.
Although the company believes the split will ultimately be a good move for both businesses, it's something dividend investors will want to keep a close eye on. The more a company focuses on growth objectives, the less of a priority regular payouts can sometimes become.
Merck may prove to be a great growth stock to invest in as it gets leaner and focuses more on its pipeline. But if you are primarily focused on recurring income, then this a stock you'll want to watch closely, as its dividend policy could change over time.
2. AT&T
A change is coming to AT&T's dividend after the company announced earlier this year that it will be spinning off WarnerMedia into a separate business that will join forces with Discovery. AT&T projects that without WarnerMedia, its free cash will be around $20 billion annually. It will target a payout ratio of between 40% to 43%, meaning that it will spend roughly $8 billion on dividends -- close to half of the $16.9 billion it has spent over the past 12 months.
The business will be smaller, so that change might be OK for investors in the short term. But without the potential growth that WarnerMedia would provide, there is uncertainty as to how high of a yield the company may be able to offer its investors. Prior to the acquisition of WarnerMedia in 2018, AT&T was paying investors a yield of over 6% -- less than the 7% it pays today. And in prior years, its payout ratio was excessive, at times well over 100%. (In late 2017, the ratio fell significantly, but that was because of an abnormally high net income thanks to the Tax Cuts and Jobs Act, which gave AT&T and other businesses a big tax break that year.)
T Dividend Yield data by YCharts
While some investors may have been worried about WarnerMedia being too much of a drain on the company's cash, possibly leading to a reduction in dividends in the long term, AT&T's business without WarnerMedia isn't in great shape to support that high of a yield to begin with. Other telecom companies pay their investors far lower yields -- Verizon's payout is at just 4.5%.
Investors should keep a close eye on the business, as things haven't panned out exactly as management has hoped they would. As recently as March, CEO John Stankey told CNBC he was "very comfortable" with the dividend and believed that AT&T could provide investors with both recurring income and growth through its HBO Max streaming service.
While AT&T appears to be content that moving forward the business will be in better shape, investors shouldn't take that as a given. Without something to strengthen its financials, it could be back to where it was before the WarnerMedia acquisition -- a high-yielding dividend stock that was potentially at risk of cutting its payouts.
