The Next 2 Dividend Burnouts?

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

Just last month, investors poured $440 million into the Vanguard Dividend Appreciation ETF alone.

Buyer beware
While dividends provide a source of income that helps to smooth out market volatility, crises like the recent 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 in 2008, and their stock prices had an average return of negative 56% for the year.

So how can you tell whether your company is about to make a cut? Last year, I argued that General Electric (NYSE: GE) and Calumet Energy were risking dividend cuts. (GE has since done so.) It wouldn't surprise me if GE's dividend rose again over the next few years, but given its reduced profits, I don't expect its payouts to regain the level they'd attained before its historic cut for some time.

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, 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 (NYSE: MS) waited to reduce their dividends until after JPMorgan Chase (NYSE: JPM) announced its cut. Today, JPMorgan is again rolling in it, and could probably afford to reinstate its former dividend. Morgan Stanley and Wells Fargo could afford to pay more than they are, while Citigroup continues to struggle. But all of them will probably want to wait to see what kind of new capital requirements they'll need to meet under reform legislation first.

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 spending, 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 the business will ultimately have to cut its dividend anyway.

So which companies might fit that description today?

Two companies risking a burnout
These two stocks 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.

Instead of calculating its payouts based on adjusted free cash flow figures, as master limited partnerships frequently do, Copano's policy (made possible by its "unique [LLC] structure") is to pay out the cash on its balance sheet, minus its liquidity needs at the end of each quarter. While Copano's capital spending is largely related to its pipeline expansion, the company has been able to afford steadily increasing payouts in excess of its free cash flow for more than five years by borrowing money and issuing shares.

Nordic American doesn't pay a set dividend -- instead of funding set dividends and capital expenditures with operating cash flow, as most dividend payers do, Nordic distributes cash to shareholders based on its net operating cash flow, and funds capital expenditures by issuing new shares.

To his credit, Nordic American's CEO is totally forthright about his company's strategy of indirectly supporting large dividend payouts with massive share issuances. As he told my colleague Mike Pienciak, "Given that Nordic American pays out all earnings as dividends, a growth model that relies on retained earnings is not right. Rather, Nordic American will continue to go to the capital markets." But that seems a little like the company is paying the left hand with the right hand, and the right hand with its foot. In the end, the sustainability of such a model -- you be the judge -- depends upon the company maintaining a healthy stock price.

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 other companies mentioned in this article. The Motley Fool has a disclosure policy.