Sometimes it's necessary, although it's never pretty: from time to time, firms slash their dividends.
Rarely will a company signal its intention to do so -- management will often insist that the dividend remains a top priority even as its core business is deteriorating. Eventually, however, it becomes too much, and companies must trim or even eliminate their dividends in order to remain solvent. While it's impossible to predict with any certainty, there are a few telltale signs investors can watch for, including a challenging business environment and an increasingly high payout ratio.
Yielding almost 8%
Energy stocks have had a tough time in recent quarters. The price of crude has remained depressed for several months, devastating the businesses of many major industry players. Some have reacted by trimming their payouts. In February, ConocoPhillips cut its dividend by more than 60% -- the first cut in 25 years. Others, such as Chesapeake Energy, have suspended their dividends entirely.
One company that could be poised to follow suit is British giant BP. The company's dividend was a frequent topic of discussion during the company's most recent earnings call back in February, with analysts repeatedly probing management about its health. BP's chief executive Bob Dudley insisted that maintaining the dividend was the company's "first priority," but that did little to allay concerns.
BP currently pays an annual dividend of $2.40. Given that the company's stock is presently trading near $30 per share, that gives it an astronomical yield of almost 8%. Market participants appear highly skeptical that the company can continue paying.
BP brought in $20.3 billion of operating cash flow last year, of which $18.7 billion went toward capital expenditures. It paid out $6.7 billion to investors in the form of dividends, raising additional cash through asset sales. BP's management believes that operating cash flow can cover capital expenditure and the current dividend if Brent crude prices stay around $60 per barrel. Unfortunately for BP, a barrel of Brent crude currently fetches less than $40. Should oil prices remain depressed, or fall further, BP could cut its dividend.
Paying out more than it's taking in
Another firm in a challenging situation is WWE. The dominant provider of wrestling entertainment yields about 2.62% right now. That's solid, but not impressive. Still, WWE could be forced to cut its dividend if its business does not improve.
The company currently has a payout ratio of 150%, meaning that it's paying out about 50% more than it earns in net income. In 2015, WWE generated $24.1 million in net income, but paid out $36.3 million in dividends to its shareholders. Its total cash holdings dropped from $47.2 million at the beginning of the year to about $38 million at the end. During the company's earnings call in February, WWE CFO George Barrios admitted that the company's dividend payout "is very high relative to earnings."
If WWE's business does not improve, the company could be forced to cut its dividend as a method of keeping its balance sheet intact.
Plenty of earnings power, but a challenging future
Finally, retailer GameStop is one company dividend investors should approach with caution. The video game specialist currently yields around 4.70%, giving it one of the most attractive dividends in the retail space. On paper, that dividend appears sustainable -- the company has a moderate dividend payout ratio of around 38%. Still, challenges to its core business model could strain its ability to return capital to shareholders.
GameStop derives the overwhelming majority of its revenue from the sale of video game software. Last quarter, the sale of video games generated just over half the company's revenue, and almost 70% of its gross profit. The challenge is that videogames are increasingly shifting toward digital distribution. Major video game publishers have said that around 20% or more of their games are now sold over the Internet -- cutting GameStop out of the equation entirely. In the long-run, as bandwidth speeds increase, this issue will only become a more pressing challenge. Eventually, some publishers expect that all of their business will be conducted digitally.
If that happens, it's hard to imagine that GameStop will be able to maintain its present payout.
Sam Mattera 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.