The Next 2 Dividend Burnouts?

With the S&P 500 still down about 30% since the start of 2008, many wary investors have been turning to the safety of dividend-paying stocks.

In just the last three months of '08, for example, domestic dividend-focused ETFs that invest in high-yielders experienced net inflows of $1 billion.

Buyer beware
While dividends provide a source of income that helps to smooth out market volatility, crises like the present one are leaving many companies with little choice but to reduce or omit payments. According to data from Capital IQ, some 370 companies cut their dividends last year, and their stock prices had an average return of negative 56% for the year.

Though companies like Walgreen (NYSE:WAG), Yum! Brands (NYSE:YUM), and Verizon (NYSE:VZ) have continued to raise their payments this year, we've already broken the record set in 2008 for most skipped payments in one year, at more than $46 billion. Weyerhaeuser and Legg Mason are just some of the latest victims.

How can you tell whether your company is about to make a cut? In a February article, I called out General Electric (NYSE:GE), and Calumet Energy as risking dividend cuts. (GE announced a cut the following week, while Calumet has yet to do so.) Among the warning signs I pointed out:

• High yields
• High payout ratios
• Industry headwinds

Extremely high yields signal investors' skepticism that the company will be able to maintain its dividend. When National City announced its first dividend cut last year, for example, the stock was "yielding" 10%. Since then, the stock plunged, and the company was acquired by PNC. A high payout ratio -- particularly when combined with a difficult operating environment -- suggests that the company doesn't have enough free cash flow to support its payouts.

But these factors don't necessarily imply that a cut is imminent. Many other companies have continued to pay dividends they cannot afford for years, damaging their own firms -- and the value of your shares -- in the process.

I'll spare you all the details
A fascinating 2004 survey explains how and why. A team of four professors from Duke and Cornell surveyed more than 400 financial executives, discovering that 94% of executives "strongly ... or very strongly ... agree that they try to avoid reducing dividends." Many admitted to selling assets, laying off employees, borrowing heavily, or omitting important projects before cutting dividends.

See, these managers know that the market reacts negatively to dividend cuts. Several executives noted that Wall Street's response is an especially important consideration during liquidity crises, because they wouldn't want lenders to think that their company is struggling. Such a fear may be one of the reasons why Citigroup (NYSE:C) reluctantly slashed its dividend three times, apparently hoping each time that a small cut would do the trick. It may also explain why Wells Fargo (NYSE:WFC) and Morgan Stanley waited to reduce their dividends until after JPMorgan (NYSE:JPM) announced its cut in February.

But let's get back to payout ratios. Unfortunately, if a company isn't generating enough free cash flow to support its payout, the extra cash has to come from someplace else. Aside from raising revenue or cutting expenditures, there are four basic ways a company can collect the cash it needs to make such payouts:

• Burn existing cash reserves
• Borrow money
• Issue shares
• Sell assets

While some of these practices may be acceptable bandages for a difficult year, none is sustainable over the long term. A company that pursues these strategies for too long will eventually burn itself out, damaging its shareholders in the process. Even worse, it's likely that it will ultimately have to cut its dividend anyway.

So which companies might fit that description today?

Two companies risking a burnout
These two companies have paid out more in dividends than they took in as free cash flow (or were free-cash-flow negative) over the past three years:

Data from Capital IQ, a division of Standard & Poor's.
*Calculated as total dividends paid minus free cash flow.

NL's sales of things like ball bearings, security products, and ergonomics are down 31% so far this year because of lower order rates. But over the past three years, the company has never been free cash flow-positive. Still, the company continues to pay a substantial dividend.

Vector Group's dividend is in far better shape than a simple net income payout ratio would suggest, but the maker of Liggett Select and Grand Prix cigarettes still pays out more cash than it brings in.

The silver lining ...
Dividend stocks have a history of putting money in investors' pockets. However, choosing the right dividend stocks for a down market is critical to protecting your portfolio. Paying close attention to how your company funds its dividend will help you achieve the golden returns dividends offer.

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This article was originally published on March 26, 2009 under the headline "The Next 3 Dividend Burnouts?" It has been updated.

Ilan Moscovitz is neither long nor short any companies mentioned in this article. The Motley Fool owns shares of Legg Mason and has a disclosure policy.