I write a great deal for our Income Investor service, which I believe is a tremendous tool for helping people invest a good portion of their portfolios. I invest a large chunk of my own portfolio in the kind of dividend-paying companies that Mathew Emmert's newsletter recommends every month.
This investing style earns me a great deal of email, and one of the regular questions I receive from readers is whether it's possible to tell in advance if a company like moribund Woolworth or Eastman Kodak
We saw that happen on Monday, when Movie Gallery
So, were there signs that Movie Gallery's dividend was in jeopardy? I believe so, but they didn't appear until April, when the company incurred a heap of new debt to fund its $1.1 billion acquisition of Hollywood Entertainment.
Generally, the way to tell that a dividend is in trouble is that it can't be funded by free cash flow. However, in Movie Gallery's case, free cash flow remained positive. The problem for Movie Gallery was the one-time huge cash outlay for Hollywood Entertainment -- a cash outlay so large, in fact, that it dwarfed the sum of positive free cash flows that the company had been able to achieve over a number of years.
Fortunately, there were other ways besides free cash flow for investors to tell that the dividend was in trouble. A first sign appeared on Aug. 12, when Movie Gallery reported negative earnings before tax for its fiscal second quarter (ending July 3) of -$13.9 million, a deficit caused entirely by $16.9 million in interest expense associated with the debt incurred to buy -- you guessed it -- Hollywood Entertainment. Since Movie Gallery had only $51 million in cash on the books at the end of the quarter, it was easy to tell that this large, recurring interest expense would sooner rather than later choke the company's ability to pay a dividend.
The second warning occurred on Sept. 15, when Movie Gallery announced that same-store sales would be lower than expected over the remaining two quarters of the year. A third warning happened on Sept. 23, when the company announced that it was seeking additional debt financing.
Investors who didn't heed any of these three warnings and held on to Movie Gallery's stock got hurt badly on Monday. However, learning to be sensitive to warning signs like the ones mentioned here may help investors avoid such pain in the future should a similar scenario arise -- and I'll bet it will.
In the case of Movie Gallery, a dividend cut was necessary to conserve cash that the company needed for paying down debt. However, the dividend cut is clear evidence that Movie Gallery has bitten off more than it can chew with its acquisition of Hollywood Entertainment and that it will be a long time before the debt load is under control.
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