Advance Auto Parts (AAP 0.58%) cut its dividend by 80% when it reported first-quarter 2023 earnings. Annaly Capital Management's (NLY 1.02%) dividend has been falling for a decade and was just slashed again. Simon Property Group (SPG -0.26%) cut its dividend in 2020 when the coronavirus pandemic was in full swing. And Dominion Energy trimmed its dividend when it sold a major division. Dividend cuts happen, and you will eventually have to deal with one yourself. Here's the way to tackle this headache without losing too much sleep.
1. Look at the dividend history
Of the stocks listed above, mortgage real estate investment trust (REIT) Annaly has the brightest red flag. Although REITs are specifically designed to pass income on to investors in the form of dividends, not all REITs have achieved the same level of dividend success. While Annaly's 12.5% yield might be tempting, even the most cursory look at its dividend history would show you that it isn't a reliable long-term dividend stock.
In fairness, a single dividend cut shouldn't lead to an instant no. But the 10-year-long downtrend at Annaly is a clear warning sign for investors. In fact, any more than one cut should lead to some serious questions about the sanctity of the dividend, with investors probably better off erring on the side of caution.
2. Track performance
Companies that are doing well generally don't cut their dividends. So investors should always examine financial performance before purchasing a dividend stock and monitor it thereafter. Companies go through good and bad times, but weak performance is a risk that shouldn't be ignored. Advance Auto Parts is a good example. Its trailing-12-month earnings rose dramatically during 2020 and early 2021 but then started to trail off in late 2021. The complicating factor here was the swift increase in the dividend that happened at the same time as the sharp jump in earnings. It shouldn't have been shocking that the dividend was trimmed as earnings trended back to more normal levels.
AAP Dividend Per Share (Quarterly) data by YCharts
Another example of this would be B&G Foods (BGS 1.19%), which cut its dividend after its earnings came under pressure. The key in this case, however, was that the company's ability to cover its interest expenses fell precipitously as well. One of the quickest ways to free up cash for other things is to cut the dividend. Investors paying close attention to financial performance could have seen the increasing risk in both of these situations.
3. Leverage matters
B&G Foods is an interesting example because it has a history of using significant amounts of debt. Leverage can increase financial returns, but it can also amplify the pain during periods of weakness. Comparing B&G Foods to an industry stalwart like General Mills (GIS -0.77%) is telling.
BGS Dividend Per Share (Quarterly) data by YCharts
B&G's debt-to-equity ratio of 2.6 is much higher than General Mills' 1.1. General Mills covers its interest expenses by a robust 9 times, with a recent low at a still solid 5 times. B&G Foods' interest coverage never got above 4 times over the past five years and sank below 1 when earnings started to decline. Conservative dividend investors should focus as much on the balance sheet as the earnings statement, favoring financially strong companies.
4. Assess before reacting
So there are some clear signs of dividend risk that investors can watch out for that will help them to avoid dividend cuts. But they will likely still show up from time to time in your portfolio. Simon Property Group is an interesting case given that this REIT owns enclosed malls. Its properties were effectively shut down during the early days of the coronavirus pandemic, leading the company to trim the dividend. That's hardly unreasonable given the severity of the situation. But Simon did the same thing during the Great Recession and then got right back to the dividend increases. With that background, selling based on the 2020 cut would probably have been rash. With the dividend having been increased seven times since the cut, it seems pretty clear that sitting tight despite the dividend reduction was probably a good call.
Dominion Energy comes at this topic in a different way. In 2020, the utility sold its midstream pipelines business, which was a meaningful source of cash flow. It cut the dividend because the company's makeup had materially changed. That's not as problematic as poor business performance or having too much leverage. Spinoffs are another time when dividend cuts probably shouldn't be read into too deeply.
The story is always different
Every company travels its own path, so there's no single way to address the risks that investors face when it comes to dividend cuts. However, there are general guidelines that can give you a head start. First, avoid companies that have a history of dividend cuts. Second, monitor financial performance to keep track of dividend-paying ability. Third, stay away from companies that make aggressive use of leverage. And fourth, don't overreact to a dividend cut -- sometimes there is a good reason for the reduction and a more positive future ahead.
