Beware these dividend warning signs for an imminent cut to the payout and the stock price
Dividend stocks hold a special place for many investors. That regular payout is used to grow the portfolio and counted on for many to pay living expenses.
So it's no surprise that when the dividend is cut, a dividend stock can fall as much as 50% from that breach of trust between management and investor.
A dividend cut can happen at any time and to any company but their are warning signs you can follow. Watching for these dividend disasters won't keep you from losing money but they will protect you from the big drops.
I’m going to reveal exactly what I look for in dividend investing and how it can save you thousands. In fact, I’ve found a $300 billion company that almost everyone loves but that could be ready to cut is dividend.
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A Dividend Cut Can Hit at Any Time
Few events destroy as much value for stocks as a dividend cut. Besides the loss in cash payments that investors count on a dividend cut signals big problems at a company and investors rush to the exits.
We’ve seen this just in the last year with cuts at both General Electric and Teva and their stock prices got absolutely crushed afterwards.
GEs shares were already down 24% to its September earnings announcement when the dividend was cut in half, something the company had only done twice before in more than 100 years. Shares have fallen more than 50% just since the dividend cut.
For Teva Pharmaceuticals, shares had been falling for a full year when rumors started circling that the dividend would have to be cut. The price plunged just on the rumor and was confirmed less than a week later with the price falling 62% to last year’s low.
Two facts should be obvious here. First is that you absolutely must see a dividend cut before it happens and get out. I’ve talked to a lot of investors that got trapped by a stock. They saw it lose twenty or thirty percent and are thinking it can’t get much worse even with a dividend cut.
It can get a lot worse!
Second is that there are warning signs of a dividend cut. The market saw it coming in Teva’s case and there are fundamentals you can watch for to sell your investment.
I’m going to reveal three warning signs of a dividend cut, three clues I found when studying stocks that have cut their cash payout. In fact, I’ve found a hugely popular dividend stock that is flashing these red all over.
More than 100 ETFs hold this stock including the large S&P 500 market funds and it’s in almost every retirement portfolio. The stock pays a 6% dividend yield but that isn’t going to last and the bottom could drop out soon.
I’ll walk you through the warning signs first and then we’ll look at that stock and why I think you need to get out now.
How to Find Dividend Cut Warning Signs
I’m going to be honest with you. These three fundamentals are going to involve some deep financial analysis. We’re going to be looking at the financial statements of a company just as an analyst would.
If you’re not ready to do that then you’re not ready to invest in individual stocks. Put your money in an index fund and don’t worry about it.
If you are ready to do a little work, less than half an hour of stock analysis to save yourself maybe 50% when you find that company about to cut it’s dividend, then stick with me and I’ll show you how it’s done.
Too Much Debt and a Dividend Cut
So let’s get to that first warning sign and it’s the single biggest factor in a dividend cut, debt.
A company has three primary cash needs for free cash; reinvest in the business, pay off debt and return cash to investors for those that pay a dividend. Anything left after expenses and normal operations goes to one of those three needs.
When times are good, it can do all three. Unfortunately also when times are good, companies start thinking they can take on mountains of debt to acquire competitors.
When either sales after those acquisitions don’t live up to expectations or the economy just takes a hit, the company is left scrambling to make debt payments.
For example, Teva fueled itself on acquiring other drug-makers for years. It neglected its own drug development and because rates were at historic lows just refilled the pipeline buying other companies.
In 2016 it funded it’s $40 billion acquisition of Actavis with $25 billion in debt, just ballooning the amount it owed. Interest expense it owed each year tripled from $270 million to $875 million within a year.
When generic drug-makers found they couldn’t keep up the pace of price increases and competition started eroding sales…Teva was in trouble. Net income plunged to negative $16 billion last year and there was no way out but to conserve cash by slicing the dividend.
Checking the debt load on your stocks isn’t difficult. First you want to check out the statement of cash flows under cash flows from financing. This will show you if the company has been repaying debt or has added a bunch lately.
Of course, if they’ve made big headline acquisitions then you can bet it was paid for with debt.
Now just putting on more debt doesn’t necessarily mean a company will be in trouble. You also want to look at these next two factors to check if the company can support the debt.
This first warning sign is a big one for the major blue-chip company I found. I’m going to run through these other two fundamentals but when I reveal it at the end of the video, a lot of people are going to be running to their online broker.
Revenue Growth and Dividend Safety
Next look at the company’s revenue growth and cash flow from operations. Revenue is posted on the Income Statement and operational cash flow is on that statement of cash flows.
Again, a lot of companies will think making a big acquisition is going to fix their sales problem. They might even be losing sales but they think that tying another boat on to their sinking ship, that’s suddenly going to get them both to float.
Teva had seen sales flat for two years and even fell by $620 million in 2015. That $40 billion acquisition helped them make another $2 billion in 2016…but at a huge cost in extra expenses and interest payments.
It doesn’t take a financial nerd like myself to understand that buying another company isn’t going to fix your broken one. If you own shares in a company that is losing sales and management can’t do anything about it, the last thing you want them to do is try covering it up by acquiring other companies.
They couldn’t manage the one company, how the hell are they going to manage it plus the acquisition?
For operational cash flow, and this is really the king of all stock numbers, we go back to that statement of cash flows.
Now any analyst is going to spend their first year losing their ever-lovin mind looking at cash flow statements. It’s here where we spend almost all our time. Net income and that income statement is easily manipulated by management. You recognize some sales early that won’t be delivered for a while or maybe you hold off on some expenses, boom, you’ve got higher profits.
Cash, you can’t do that. The cash flow statement is a pure view of the cash generating power of the company.
So we look at net cash provided from operations and WHAAA, low and behold, even though Teva reported sales growth in 2016 and everything was supposedly glorious, it made less cash than the year before…by $317 million.
Now you’re looking at revenue stagnate and cash flow dry up but the company has more bills to pay with this mountain of debt. That cash has to come from somewhere.
Watch Out for Deceptively High Dividend Payout Ratios
Our last dividend warning sign is a high payout ratio. The payout ratio is the percentage of profits paid out to investors as a dividend. You can take the quarterly dividend times four and divide it by the earnings per share or just look for where it says dividend paid on the cash flows statement.
Here’s a fun quiz. If a company is paying most of its profits out as a dividend and those profits fall…what happens to the dividend?
The dividend’s going bye-bye!
In truth, a company can support a dividend even if profits fall if it has some cash set aside and management thinks the weak profits are only temporary but those are both big ifs.
So the question then is, what’s a high payout ratio? How much of profits can a company pay out and be safe?
That’s going to vary by industry. Some industries with super-safe sales and earnings like utility companies pay out as much as two-thirds of their profits and rarely have problems. Other companies might have trouble supporting a dividend that’s even half their net income.
The first thing you want to do is to compare the company’s payout ratio with others in its industry. Professor Damodaran of the Stern School puts out a lot of great data including the average dividend payout by industry. So you can see if a company has an abnormally high payout ratio compared to peers.
You can also just use this along with what we saw in revenue and cash flows and make a judgement call. If the company is walking a tightrope with a high payout ratio then it better have rock-solid earnings growth.
A Popular Dividend Stock Setting Up for a Dividend Cut
Now that we know the dividend warning signs, it’s time to look at that company I found that could be in imminent danger. This $236 billion company is held in almost every large market fund. Between Vanguard, BlackRock iShares and State Street – these three fund providers own over $42 billion in shares.
Investors have jumped into the shares because of the 6% dividend yield even as the price has plunged 25% since 2016.
The company is AT&T and I know a lot of you are big believers in Ma Bell. I used to be an investor myself until just recently but this one could be in big trouble.
AT&T dominates the wireless market in the U.S. and is a favorite dividend stock of a lot of investors. It’s consistently increased the dividend for decades and that creates a lot of loyalty but before you click away, hear me out because all three of these dividend warning signs are flashing red.
The company is already no stranger to debt with its amount owed surging $50 billion over the last three years to $126 billion. That amount is on top of $177 billion in pension and other liabilities and it’s about to jump another $55 billion with the approved Time Warner acquisition.
Now AT&T has some cash laying around and is cash flow positive, but interest expense is already $6.3 billion a year and set to increase.
But then we pop on over to the income statement to look at revenue growth. Now for companies that do a lot of acquisitions, buying other companies to fuel growth, this can be hard to spot. We see that AT&T has booked some decent revenue growth over the last several years but these are all on acquisitions. The years where it didn’t buy another big company, it didn’t do so well.
In fact, sales fell by $3.2 billion last year. Even worse though and this is something we didn’t talk about is that operating income, so what’s left of sales after paying expenses, fell at a faster pace.
The operating margin or op income over sales, that basic profitability of a company, has fallen a full percent to 15% last year. So not only is the company facing weak sales but it’s less profitable on those sales.
Operating cash flow isn’t any better. The company was able to make its earnings look better with a one-time tax benefit but that’s not real cash. Actual cash flow from the business dropped $193 million last year and has always been volatile.
Now if we look at that payout ratio, so we take the $0.50 per share dividend times four for an annual payout of $2 a share and divide that by the $3.24 in per share earnings over the last year we see that AT&T is paying out 62% of its profits.
That’s not ridiculously high for a telecom company but if you also look at how much the $12 billion dividend payment is compared to free cash flow of $18 billion a year, that’s two-thirds committed to the payout.
That payout ratio isn’t dangerous yet but it’s close and everything has to go right after they put on that new debt. That means all their telecom and TV business and the new media business all has to fire on all cylinders to keep cash flow safe.
Speaking of the new media business it bought with the Time Warner acquisition, that’s a completely new business model it’s getting into. Media and content isn’t exactly a cash flow business like telecom. Both businesses require a lot of capital spending but the payoff in media is much less certain and competition is extremely high. Management is going to need that cash generated by the telecom side to reinvest in the media side.
Even if the dividend isn’t cut, that 6% dividend yield just isn’t realistic for a conglomerate company working through all the integration costs.
I’m not saying the company is cutting its dividend tomorrow and it might even scrape by without a cut but what’s the upside on this thing? You might get 8% total return a year including the dividend but that’s at a risk of losing half the stock price if the dividend is cut.
The risk-reward tradeoff is all screwed up on this one.
There are other dividend stocks out there, some very good names with great fundamentals. If I’m wrong, you’ve still made money in another stock. If I’m right, you’re going to be naming your first born after me, right? Right? Yeah, you better too!
Watching for warning signs of a dividend cut doesn't mean you have to stay glued to financials all day. Watch for these three signs of dividend danger and cut your losses when a dividend cut looks imminent.