The Next 2 Dividend Burnouts?

With the economy still shaky, many wary investors have been turning to the safety of dividend-paying stocks.

In just the last three months of 2008, 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.

While, in 2009, companies such as Johnson & Johnson, IBM (NYSE:IBM), and Northrop Grumman (NYSE:NOC) continued raising their payouts, Standard & Poor's reports it was "the worst year ever" for dividends. BB&T (NYSE:BBT), SunTrust (NYSE:STI), Simon Property Group (NYSE:SPG), and Fortune Brands (NYSE:FO) were some of its high-profile victims.

So how can you tell whether your company is about to make a cut? Last December, I argued that Frontline and Host Hotels were risking dividend cuts. (Both have since done so.) Among the warning signs these companies exhibited:

• High yields.
• High payout ratios.
• Industry headwinds.

Extremely high yields indicate investors' skepticism that the company will be able to maintain its dividend. 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 companies have continued to pay dividends they cannot afford for years, damaging their own companies -- 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 -- such as the present one -- because they wouldn't want lenders to think their company is struggling. Such a fear may explain why even in a credit crunch, HSBC (NYSE:HBC) cut its dividend twice, apparently hoping at first that a limited cut would do the trick.

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 products are down 27% over the past 12 months because of lower order rates. But the company has not been free cash flow-positive for nearly three years. Still, it continues to pay a substantial dividend.

While Navios Maritime's net income payout ratio may look secure, and it pays a fairly modest dividend relative to its capital requirements, the company hasn't been free cash flow positive since 2004.

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 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. Fortune Brands is a Motley Fool Stock Advisor choice. Johnson & Johnson is an Income Investor recommendation. The Motley Fool has a disclosure policy.