The last few times I've delved into the world of dividends and income investing, a common question has arrived in my inbox:
How can you tell if a dividend is unsustainable and due for a fall?
It's a good question. When a company cuts its dividend, it doesn't just reduce your income stream; you also lose the price protection from the yield, and the underlying stock often falls as well. No fun at all, to say the least.
Luckily, this question has been covered before in these parts. Motley Fool Income Investor lead analyst Mathew Emmert provided my personal favorite in How to Be a Dividend Investor. In the article, Mathew outlines different levels of free cash flow, funds from operations, or other earnings measurements to use, depending on the type of company being analyzed. They're only general rules, and subject to judgment by the analyst (that's you), but they're a great starting point. Save that article for later, though, because we're about to take a look at a couple of current dividend-paying companies you can scratch off your research list.
Don't see this flick
Most readers here already know that abnormally large dividends -- say, over 5% for non-REITs -- generally mean that something is amiss. However, when the bulk of those dividends is financed by one-time dividends, the picture becomes a bit cloudier. In the case of Regal Entertainment Group (NYSE:RGC), the picture isn't cloudy -- it's exactly as it appears.
To begin, let's assume that we haven't been holding shares of Regal but are considering it today. This means we'll be stripping out the effect of the one-time dividend in the current yield, but we'll be living with the debt on the balance sheet. Assuming that the dividend payments hold steady, this leaves us with a 6.2% dividend yield, which is fairly attractive in and of itself.
Regal generates a fairly large amount of free cash flow, but the problem here is debt, which totals $1.6 billion, primarily from the two special dividend payments made in the last two years. With EBITDA of $98 million in the last quarter and interest expense of $28 million, Regal can adequately pay its interest and portions of its debt for now. It's when you walk the rest of the way to the dividend that things become less pretty. To this end, I expect that Regal will generate slightly more free cash flow than it needs for its current dividend payments, though in the most recent quarter the company was free cash flow negative and still paid out dividends of nearly $44 million.
That's the numbers side of it. The other concern is growth within the theater industry. Some analysts believe that as home theatre experience continues to improve and more homes are filled with HDTVs, going to the movies will become less and less popular. I follow the logic, but I'm not sure that's the way it will play out. Personally, I wait out a lot of movies until they're available from Netflix (NASDAQ:NFLX) or Blockbuster (NYSE:BBI), but there is still something special about going to the movies. But the bottom line is, there isn't enough security in the free cash flow to justify safely owning the stock for the dividend.
Would you like to see our bank account?
Electro-Sensors (NASDAQ:ELSE) is a micro cap with very little trading activity but a hearty 3.8% dividend yield and a rising dividend payment each year. While many investors simply wouldn't look at a micro cap for dividends, I know some would -- myself included. Electro-Sensors is an interesting example, so let's take a look.
Two things stand out on Electro-Sensors' balance sheet. There's no long-term debt, and there is a pile of cash. In fact, the $14.5 million in cash and short-term investments is just slightly below its current $13.5 million market cap. If the company had a decent amount of free cash flow, this would be an interesting opportunity. Unfortunately, the market has pretty much picked over all such opportunities and Electro-Sensors hasn't had any free cash flow in the last three years, though it did eke out a tiny bit in the most recent quarter.
While it's clear that Electro-Sensors is funding its dividend from interest on its cash and its short-term investments, there is a bit more to the story. The bulk of the company's short-term investments are made up of two large holdings in August Technology (NASDAQ:AUGT) and PPT Vision (NASDAQ:PPTV). But while Electro-Sensors does make for interesting reading, it's not the type of investment to look for if you desire a sustainable dividend yield, because the dividend isn't funded from operations.
Foolish final thoughts
There is a fine balance to income investing. It's not the dividend alone, but the combination of the dividend and share-price appreciation that makes income investing work. To that end, companies that are paying out too high a ratio of their free cash flow in dividends most likely cannot afford to maintain or expand their business in the long term, nor can they afford to grow the dividend payment substantially. Unless these companies are severely marked down in the market, which does happen on occasion, the portion of the total return from capital gains will be missing.
For more dividends to run away from, see:
Don't just take my word for it. Consider a free 30-day trial to Motley Fool Income Investor to learn about solid dividend-paying companies and receive our special report on Dividend Time Bombs. There's no obligation to buy if you aren't completely happy.
Nathan Parmelee has no financial stake in any of the companies mentioned. The Motley Fool has an ironclad disclosure policy.
