Editor's note: A previous version of this article included discussion of J.C. Penney, a company that recently discontinued its dividend. For this reason, the section on J.C. Penney has been removed. We regret the error.
Dividends are one of the best reasons to invest. On top of any returns you get from the appreciation in share price, those quarterly payouts ensure that you get to paid to wait and offer a guaranteed return on your investment. Reinvesting dividends is also one of the best proven investment strategies.
But while dividends are usually a sign of a healthy, stable company, sometimes they're a relic of a once-successful business and act as a cover-up for the internal strife of a struggling company that should be spending its capital on operations rather than treating shareholders. Those companies know that cutting or suspending dividends often leads to dramatic drops in share price and a crisis of confidence in the company. Let's take a look at the supermarket chain SUPERVALU (NYSE: SVU) as an example.
The chart below tells you most of what you need to know:
As revenues declined, the share price tumbled along with it, sending the company's dividend irrationally higher, even as it was operating at a loss. The only thing that isn't accurate here is that the dividend yield is now zero. Under increasing pressure to pay down debt and turn the company around, management made the decision to suspend the shareholder kickbacks in July, and the market responded by slicing the stock price in half. SUPERVALU, despite paying what was once a healthy dividend yield, has been anything but a super ride for shareholders.
Let's take a look at some other stocks whose dividends are on life support.
1. Best Buy (NYSE: BBY): Like SUPERVALU, which has gotten squeezed as Wal-Mart and Target have expanded their grocery offerings, Best Buy has also become a victim of Amazon.com and the growth of online retail. Shares have lost more than half their value in the last five years as revenue growth has stalled, same-stores have declined, and profits have thinned as the chart below shows.
Despite these increasingly difficult circumstances, by increasing dividends and buying back shares, Best Buy executives have chosen to prioritize shareholders over the general operations of the company. In its last two years, cash returned to shareholders through dividends and share repurchases has exceeded free cash flow. In less than a year, Best Buy's cash pile has dwindled from near $2.4 million all the way down to $680,000, and its net tangible assets, essentially a proxy for liquidation value, have dropped by nearly 40%.
While a 3.8% dividend yield might be appealing to shareholders, this strategy does not look sustainable. Management needs to refocus on making the brand more competitive, and reversing the recent downward trend. The decision to suspend share buybacks for the rest of the year looks like a step in the right direction, and new CEO Hubert Joly may be able to help guide this turnaround.
2. Nokia (NYSE: NOK): This one may be the most obvious of the bunch. Nokia badly missed the smartphone train, which now seems to be just a two-person race between Apple and the Android phones. Revenue has declined in recent years and the share price has sunk like a rock as the chart below shows.
Oddly enough, Nokia's dividend yield has risen despite the company cutting payouts several times, a sign of a continuously falling stock price. Efforts to partner with Microsoft have fallen flat, and as the mere incremental improvements in the iPhone 5 demonstrate, the smartphone market seems to be maturing. Consumers happy with their current selection are unlikely to switch, and grabbing market share will become more difficult as overall market growth slows. Dwindling resources don't help, either.
In 2011, dividends paid out more than doubled the phone maker's free cash flow, even as the company incongruously issued new shares. Nokia's balance sheet may be strong enough to endure more years of decline, but a 6% yield does not look sustainable.
Foolish takeaway
Companies tend to avoid cutting or suspending dividends as the market often pushes the stock in response, but paying off shareholders while the business operations are bleeding cash is not a sustainable strategy. These companies would be better off spending that money to reinvest in the business, since pleasing customers, not shareholders, is the only way to provide long-term value for shareholders. For now, these companies seem to be playing a waiting game with shareholders. You know the dividend cuts are coming; you just don't know when.
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