In the world of investing, one of the best ways to predictably build long-term wealth is by purchasing and holding solid dividend stocks. After all, between simple share price appreciation and steadily rising dividends over time, the power of compounding can yield staggering financial rewards.
But investors also shouldn't assume every dividend is built to last. To the contrary, our market is full of cautionary tales of dividends being cut or even suspended entirely. So how do you know if that's about to happen? We asked three Motley Fool contributors to offer compelling signs a company is about to cut its dividend. Read on to see what they said.
Matt DiLallo: When a company goes out of its way to proclaim the safety of its dividend, despite what the numbers suggest, it can be a contrarian sign that the dividend is about to be cut. That's been hammered home after countless energy companies over the past year went out of their way to proclaim the safety of their dividend only to cut it months later.
Take ConocoPhillips (NYSE:COP), which last year pounded the table on the safety of its dividend on almost every quarterly conference call. CEO Ryan Lance even started off one call saying, "The dividend is safe. Let me repeat that. The dividend is safe." Meanwhile, CFO Jeff Sheets noted on another call that ConocoPhillips' "top priority is the dividend." In fact, ConocoPhillips management team would even say that the purpose of a dividend is that it should be "consistent and grow over time." However, with oil prices continuing to weaken the company changed its tune this year and slashed the dividend by 66%. Clearly, the dividend was not safe, and the company's top priority was to actually stay in business amid the worst oil market downturn in decades.
Seadrill (NYSE:SDRL) is another prime example of a management team that seemed to doom its own payout. Despite a significant slowdown in the offshore drilling market, Seadrill pronounced in August 2014 that the dividend was not only "sustainable until at least the end of 2015" but that it felt "increasingly comfortable that this period can be extended well into 2016 without any significant recovery in the market." However, with oil prices turning south over the next 90 days, Seadrill changed its tune. The very next quarter it said, "In light of the changes that have taken place since our last report, the Board has taken the decision to suspend dividend distributions for the time being." Suffice it to say, its visibility wasn't as clear as it thought.
That's the problem with management pronouncements: They are based on the hope that conditions will at least stabilize in order for the company to be in the position to maintain the payout. Unfortunately, market conditions could very well grow much worse than management was anticipating, forcing them to eat crow and cut the payout.
In short, this is what has happened to oil producers like ConocoPhillips and a handful of others over the past year. The reality is, oil prices have fallen as far as they have because there are producers out there, primarily state-owned oil companies in the Middle East, that can produce oil for cash costs far below even today's oil prices (looking at you, Saudi Arabia).
This is exacerbated when your sole business is producing and selling something like oil or natural gas, and the business lacks any diversity of cash flows, and why integrated oil companies such as ExxonMobil (NYSE:XOM) and others have been able to maintain their dividends. As much as ExxonMobil's upstream production business has struggled over the past year, its refining and chemicals segments have continued to operate profitably.
ConocoPhillips and other independent producers don't have that luxury. Factor in the debt-heavy balance sheets of many U.S. producers due to aggressive expansion in recent years, and that's another bill to pay before the dividend gets covered.
Bottom line: When there's a low-cost gorilla in the corner, there's always more risk of a dividend cut. When the product you're dealing with -- like oil -- is historically volatile, the low-cost producer controls the market when things turn down. If a business isn't one of the lowest-cost producers, that's a sign the dividend is at risk.
Steve Symington: Generally, companies aren't compelled to give much warning before they cut their dividends. But another glaring red flag is when the financial performance of a business's core operations fails to provide the flexibility to invest in coveted growth initiatives.
Take Barnes & Noble (NYSE:BKS), for example, which only just reinstated its dividend last summer after a four-year hiatus. More specifically, Barnes & Noble suspended its payout altogether in early 2011 so it could free up cash to invest in its questionable digital growth initiatives. That's not to say the idea didn't sound compelling on the surface; Barnes & Noble was selling twice as many e-books online as it did physical books in stores at the time. And it had only just finished launching three different Nook tablets, which in theory were to help its e-content business sustain what it viewed as significant momentum to make up for the ailing bricks-and-mortar side of the company.
Fast-forward to today, however, and you'll see Barnes & Noble is now striving to pare losses from its Nook business, sales from which declined more than 33% year over year last quarter, to $51.7 million, hurt by lower device and content sales amid a sea of well-funded Nook competitors. To be fair, Barnes & Noble has also enjoyed improved bookstore sales trends in recent quarters. Though retail sales declined 1.2% last quarter, to $1.38 billion, hurt by lower online sales and store closures, comparable-store sales excluding Nook products actually climbed 1.3%, thanks ironically to strength in Barnes & Noble's decidedly un-digital adult coloring books, toys and games, music, and gift businesses.
In the end, while it might have been easy to admire Barnes & Noble's ambitious digital initiatives early on, let it suffice to say given the weakness of its core business at the time, it didn't do investors any favors by cutting its dividend to fund the effort.
Jason Hall owns shares of Seadrill. Matt DiLallo owns shares of ConocoPhillips and Seadrill. Steve Symington has no position in any stocks mentioned. The Motley Fool owns shares of and recommends ExxonMobil. The Motley Fool owns shares of Barnes & Noble. The Motley Fool recommends Seadrill. 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.