Dividend investing is perhaps the most-followed strategy among retail investors in the market today. Diversified dividend portfolios offer reliable income while also outperforming non-dividend-paying stocks in the long run. However, not all dividends are created equal. Retailers American Eagle Outfitters (NYSE:AEO) and Abercrombie & Fitch (NYSE:ANF), for example, have special properties that could change them from strong dividend payers to divided cutters in just a few quarters. Are these retailers' dividends safe?
A tough business
It is difficult to develop a durable competitive advantage in retail. American Eagle and Abercrombie may have strong brands, but so do their competitors. A strong brand is necessary to compete in retail -- it is not a competitive advantage.
However, the lack of a durable competitive advantage is not these retailers' biggest problem. American Eagle and Abercrombie have a bigger threat for dividend investors: massive operating leverage. High operating leverage means the companies have large fixed costs that cannot be easily cut when there's a revenue problem. As a result of this operating leverage, American Eagle and Abercrombie can pay decent dividends in good times, but bad times can quickly crunch profits and necessitate dividend cuts.
It looks like American Eagle and Abercrombie are headed for bad times. Both retailers prospered in the years leading up to the Great Recession; rising revenue unlocked large increases in profitability that was enabled by operating leverage. However, both are now struggling to maintain revenue, leading to a sharp downtick in operating earnings.
Since most of American Eagle's and Abercrombie's expenses are related to running the stores and distributing inventory, cutting these costs would lead to a further reduction in revenue -- creating a vicious cycle of cutting costs to offset falling revenue. Falling revenue can lead to falling net income and that can necessitate a dividend cut. As a result, the retailers' best chance of maintaining their dividends is to right the ship and grow revenue.
At the moment, American Eagle sports a 3.9% dividend yield and Abercrombie has a 2.8% dividend yield. However, the outlook has turned darker for both in the past year.
Abercrombie reported a 25% decrease in adjusted earnings in the third quarter due to weak demand -- a terrifying prospect for a retailer that depends on catching each new trend. The company also revised downward its full-year earnings guidance to $1.50-$1.65 per share. To top it off, longtime CEO Michael Jeffries -- who led Abercrombie's stunning turnaround in the 1990s -- recently announced his departure from the company. Abercrombie & Fitch stock is down about 13% over the past year.
Meanwhile, American Eagle's shares sold off after reporting disappointing third-quarter results and giving disappointing fourth-quarter guidance. The stock is back near where it was before reporting earnings, but is down about 8% over the past year.
Moreover, there is no easy path back to growth for these retailers. Both brands appear to be losing their cachet with teenagers. A recent study conducted by Piper Jaffray found that millennials are increasingly tending toward individuality rather than blending in by wearing the same brands. The study's publisher asserts that, while demand for legacy brands like American Eagle and Abercrombie has stabilized, it is still far below its peak.
Surviving vs. thriving
Ultimately, Abercrombie's and American Eagle's sales will likely flatten out and the two retailers will probably adapt their inventory to ride the next trend. However, their respective dividends could take a hit in the meantime. The companies' payout ratios soared in recent months as earnings nosedived. American Eagle's payout ratio comes in at 83% of the high end of its 2014 earnings based on guidance given at the end of its third quarter. Abercrombie's payout ratio is at 48% of its adjusted 2014 earnings guidance, having retreated from over 100% of trailing earnings at one point in the year. By comparison, neither retailer's payout ratio exceeded 50% during the latest recession -- even though the dividends and yields were roughly the same as they are today.
So, while earnings may recover enough to cover coming dividend payments, the dividends are clearly less safe than they were during the Great Recession. Another missed trend could force payout ratios over 100% -- thus paving the way for dreaded dividend cuts.
Ted Cooper has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.