How to Destroy a Company

A recent Wall Street Journal article pointed out a frightening trend re-emerging on Wall Street as the credit market starts to thaw. Unfortunately, the economically illiterate financial engineers who brought you the last credit bubble have apparently returned … with a vengeance.

And they've brought back with them one of the worst ideas ever to rear its ugly head in the heat of the last credit bubble: Borrowing to pay dividends. If ever there was a completely avoidable mistake that far too often leads to catastrophe, that'd be it.

Unnecessary risk
In that Journal article, aircraft-parts manufacturer TransDigm (NYSE:TDG) was called out for borrowing $425 million, $360 million of which will be paid as a special dividend. That act of financial engineering brought with it a debt downgrade at Moody's to the junk rating "B3." So not only is the company engaged in the extremely cyclical business of making aircraft parts, but it's potentially putting itself in long-term financial peril to make a one-time payout.

Perhaps it hasn't learned the lessons of leveraged failures like Cerberus' debt-fueled buyout of Chrysler, or the bankruptcy that Dex Media went through after borrowing to pay a dividend to its private-equity owners.

A better way to pay dividends
Don't get me wrong. Well-designed dividends are fantastic. Throughout this economic meltdown, I've used changes in companies' payouts as signals of their true financial health. Likewise, the payments themselves have provided important ballast against a stagnant economy. But for a dividend to be a positive for a company and its investors, it needs to have the following characteristics:

1. It needs to be paid out of operating cash flow. When a company borrows to pay a dividend, it's clearly not sustainable, as bondholders will soon tire of taking on excessive risks to reward stockholders. However, a dividend that's paid from operating cash flow has a much higher chance of continuing as long as that business can operate profitably.

2. It should let the company retain financial flexibility. By borrowing to pay a dividend, a company obligates itself to long-term interest coupon payments and eventual principal repayment (or refinancing), for the sake of a single payment. Those coupon payments increase the burden a company must clear to earn a profit every year, and the debt itself reduces a company's ability to borrow cash to expand its business. Contrast that to a dividend paid out of operating earnings, which carries with it no such long-term liability.

3. It ought to drive shareholder-friendly management behaviors. When a company gets serious about its dividend, it starts structuring its operations around ensuring its dividends can continue to be paid for the long haul. That requires the company to prioritize:

• Delivering cash flows, instead of merely accounting earnings;
• Making investments that provide profitable growth, rather than empire-building;
• Using debt judiciously to build the business, rather than merely "lever up"; and
• Ensuring there's a sufficient cash stash to both pay the dividend and operate the business.

A few names
Here are just a few companies that have consistently raised their dividends over time, and have done so again without taking on extra debt:

Data from Capital IQ, a division of Standard & Poor's.

By keeping their payout ratios below two-thirds of earnings, they're able to both reward shareholders and ensure the business keeps running smoothly. With cash from operations stronger than earnings, you can rest assured that those dividends are well covered by real business results. And best of all, with both a rising dividend and reduced debt over the past year, these companies have done a great job of rewarding shareholders while simultaneously protecting their businesses.

Only a few are worthy
At Motley Fool Income Investor, we're not interested in the potentially company-destroying results that come from borrowing money to pay one-time dividends. Instead, we actively seek out the strongest regular-dividend-paying companies we can find for our members. Solid companies offering consistent, well-managed dividends provide the cornerstone of our investing philosophy.

If you're tired of being burned by one-time gimmicks and are ready to invest your cash in companies that treat their owners well over the long haul, you can look over our list of "buy first" stocks, free for 30 days. Simply click here -- there’s no obligation.

At the time of publication, Fool contributor Chuck Saletta owned shares of Lowe's, which is a Motley Fool Inside Value recommendation. TransDigm is a Motley Fool Hidden Gems selection. Waste Management is an Income Investor and Inside Value pick. The Fool has a disclosure policy.