Even as investors sit on the edge of the fiscal cliff, dividend stocks have never been more popular. Yet while many investors see dividends as a sign of financial strength, the way that an increasingly large number of companies are coming up with the cash to pay dividends suggests that at least in some cases, the opposite is true.
Yesterday, I took a look at the wave of special dividends that millions of shareholders will receive this month. That article concluded that even for companies with billions of dollars in cash reserves, sending substantial chunks of money back to shareholders represents a failure of sorts in businesses' ability to come up with profitable investments.
What's more troubling, though, is the fact that many of the companies that are paying big dividends don't have massive hoards of cash. Instead, they're turning to the credit markets, which have been more than happy to allow corporations to finance huge amounts in recent years. The result is a steady increase in overall leverage that could eventually bring back some of the problems that led to the financial crisis four years ago.
Borrowing with one hand to pay with the other
When it comes to regular quarterly dividends, investors typically look closely at the sustainability of company payouts. If a company's dividend exceeds its earnings by too wide a margin -- or, in some industries, its free cash flow -- then it raises concerns among shareholders that the company will have to rein in on its payouts at some point in the future. As a result, investors, sometimes prefer stocks with lower yields over others that have higher yields, simply because over the long run, they expect the current lower-yielder to keep paying and even increasing its payouts over time.
Special dividends, however, are another story. Historically, companies tended to make special dividend payouts when their cash levels got too high or when they received big cash windfalls. One of the most prominent examples was in 2005, when Microsoft (NASDAQ:MSFT) paid a total of $32 billion in cash to its shareholders in the form of a $3-per-share special dividend as part of a broader plan to return $75 billion in capital to investors over a four-year period. No one expects special dividends to be sustainable -- that's what makes them special.
Many companies simply aren't waiting to have cash on hand in order to pay special dividends. An article in The Wall Street Journal last week detailed how a number of prominent companies have issued substantial amounts of debt in order to come up with the cash to make dividend payments. Here's just a sample:
- Cruise-ship operator Carnival (NYSE:CCL) issued new bonds worth $500 million last week. That gave the company more than enough money to cover its $0.50-per-share special dividend, which should cost it about $390 million in total.
- For oil and gas exploration company Murphy Oil (NYSE:MUR), about a third of a $1.5 billion offering will go toward paying a $2.50-per-share special dividend to shareholders.
The problem, though, is that these special dividends pit shareholders against bond investors. When companies drain their cash reserves by making massive payouts, they leave bondholders with far less security that they'll get paid in full.
In response, therefore, bond ratings agencies have started to take action against special dividend payers. Fitch Ratings downgraded Costco (NASDAQ:COST) from AA- to A+ after the warehouse retailer announced its $7-per-share special dividend. Similarly, spirits producer Brown-Forman (NYSE:BF-B) incurred the wrath of S&P, which cut Brown-Forman's rating from A to A- and issued a negative outlook following the company's declaration of a $4-per-share special dividend.
The saving grace for companies is that financing costs have never been cheaper. That makes going into the debt markets for just about any reason a relatively safe move right now.
The problem, though, will come down the road, when companies have gotten used to having a thick cushion of leverage helping to inflate their returns on equity. When rates move higher, companies will face the difficulty of either having to refinance at much higher interest costs, or paying down their debt. Neither eventual solution will be easy. Investors should look closely right now at what their companies are doing before jumping in on the special dividend frenzy.
Fool contributor Dan Caplinger has no positions in the stocks mentioned above. The Motley Fool owns shares of Costco and Microsoft. Motley Fool newsletter services recommend Costco and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.