Often, when a stock has a high and rising dividend yield, it's a red flag that the dividend may not be sustainable. That's because the yield is based on the share price, so when the yield shoots higher, it could be due to the fact that the share price has plummeted -- making the yield a larger percentage of the share price by default.
And when the share price goes down, that typically means the company may be struggling or that earnings or other performance metrics are down. Now, this is not always the case with rising yields, but it is something to monitor. But if a rising yield does reflect trouble, then it could signal that a dividend cut may be coming.
This is exactly what happened recently with two popular dividend stocks, Intel (INTC 1.77%) and Annaly Capital Management (NLY 0.59%). Both announced that they are reducing their dividends, with cuts coming in the second quarter.
Intel slashes dividend by two-thirds
Intel, the semiconductor chipmaker, slashed its quarterly dividend in late February to $0.125 per share, down from $0.365 the previous quarter -- a 66% cut. The new dividend will be paid to investors on June 1.
The cut is part of a reset of the company's dividend policy, as the former payout, at a yield that was about 5.9% at the time of the reduction announcement, had become unsustainable. A flashing sign that the dividend had become unsustainable was the payout ratio, which had risen to about 75%. The payout ratio is the percentage of quarterly net income that goes toward the dividend. Anything over 50% is often viewed as elevated, but 75% is clearly in the danger zone.
The payout ratio to sustain that high dividend spiked as the chipmaker struggled to generate earnings. In the fourth quarter, revenue fell 32% year over year, while the company posted a $700 million loss, or $0.16 per share.
A dividend reset such as this is tough on income investors, but it is clearly the right move for the company, which needs to focus on investments that will help it shift into a new growth phase.
Annaly's inflated dividend yield
Annaly Capital Management is a different animal from Intel: It's a mortgage real estate investment trust (REIT), and it is built to deliver high-yielding dividends. That's because, as a REIT, Annaly is required to pay out 90% of its taxable income in dividends in exchange for certain tax advantages that come with being a REIT. As a result, payout ratios for REITs are typically much higher than for other companies.
Because this has been a difficult time for the housing market, with mortgage rates rising, home buying shrinking, and refinancing virtually non-existent, Annaly's earnings have suffered. In the fourth quarter, Annaly reported significant declines in earnings and net interest income due to the tough macroeconomic conditions. But it maintained its $0.88-per-share quarterly dividend at a yield of almost 18%. Other than last September, when the yield was over 19%, the 18% yield was as high as it has been during the past decade.
With declining earnings and a housing market that doesn't appear to be improving anytime soon, Annaly officials realized that the dividend was not sustainable, as Chief Executive Officer David Finkelstein indicated back on the company's Feb. 9 fourth-quarter earnings call:
"While we generated EAD (earnings after distribution) that covered our dividend this quarter, we witnessed the moderation discussed in recent quarters, and we anticipate some further pressure on EAD going forward," Finkelstein said. "As a result and subject to determination by our board, we expect to reduce our quarterly dividend in the first quarter of 2023 to a level closer to Annaly's historical yield on book value of 11% to 12%, which compares to the approximately 16% yield on book we are paying today."
Subsequently, Annaly slashed its dividend 26% to $0.65 on March 14, payable April 28. That brings the yield down to about 14%, which is still high, but closer to Annaly's historical range.
In both of these cases, the companies made the right move in cutting their dividends because of their financial condition. But given that these are popular dividend stocks, it is a major blow to many investors. Of the two, Annaly remains the better dividend stock because it still has a high yield and is built to generate high-yielding dividends. Investors that own it should still hold it. However, there are other REITs out there that generate good dividends and deliver them more consistently.
Finally, investors who want to avoid the trap of investing in stocks with yields that are too high to sustain should watch for rapidly rising yields and high payout ratios.
