Tuesday, March 19, 2013

Are these high yield dividends sustainable?

When I analyse dividend paying companies, I always look for strong competitive positions. This is because a company in a strong competitive position might be able to enjoy rising profits for several decades. As a result, it might be able to boast a long streak of regular dividend increases. However, changes in technology can jeopardize a company’s economic moat. This could mean that the company might be unable to not only afford to keep raising dividends. In addition, such companies might find themselves in a precarious position, where the dividend has to be sacrificed, in order to maintain the business.

The dividend rate is usually determined by the company’s Board of Directors, who take a look of near term prospects for the business. If the Board expects that the company would be able to generate a higher amount of earnings over the next two, five and ten years, they are much more likely to boost distributions. As a result, sometimes there might be a short term disconnect between current year earnings per share and dividends per share. In this article, I have highlighted two high yield dividend stocks, whose dividends are at risk of a dividend cut. I have always argued that dividend investors should avoid chasing yield at all costs.

Over the past 20 years, we have seen plenty of companies fall victims to the rapidly changing world. Even some boring companies with strong moats have been victims of the process. Examples include newspapers, photography, mail and fixed line telecoms. These industries would have to adapt very well to the new world of technological innovation, or they would be extinct. Even if these companies can support the current high dividend payments for the next one or two years, their long-term prospects are grim.

Windstream Corporation (WIN) provides communications and technology solutions in the United States. The company derives its revenues from wireline operations. The long term trend is for erosion in wireline revenues, given the wide adoption of wireless technology. The company has managed to plug the hole in its dwindling customer count by making acquisitions. That being said, the dividend payment has not been covered for several years. Windstream’s peer CenturyLink (CTL) recently cut distributions in February 2013, which led to steep declines in shares of other fixed-line telecoms such as Windstream (WIN) and Frontier (FTR).  Given the expected erosion of the company’s customer base, and the competition from wireless, cable and VoiP technology, it seems like it is only a matter of time before the firm would find that it has to cut the dividend.

Most analysts are using cash flow payout ratios when analyzing telecom firms such as Windstream. Their calculation adds non-cash items such as depreciation expense to the net income amounts as the denominator in the cash flow payout ratio.  While using a cashflow payout ratio is appropriate for a real estate investment trust, it clearly shows a lack of basic understanding behind the wireline telecom model. A REIT owns a building with a useful life of 30 years, which would probably would still be there for a few decades after it stops accounting depreciation, and would still be a useful asset for generating revenues. A company like Windstream on the other hand, needs to continuously invest in its technology and equipment simply to keep its operations functioning normally. The telecom equipment that you had purchased even five or ten years ago would likely need some improvement or replacement. In addition, the company is also trying to invest in its future in order to still be able to generate revenues after the wireline segment dies off. As a result, analysts should be looking at earnings only, and those who ignore this logic have an increased likelihood of suffering devastating losses in dividend income and principal investment amounts. A look at the company’s ratio of capital expenditures to depreciation over the past four years shows that for every dollar in depreciation, the firm had to invest almost one dollar in new capital projects.

In Millions of $
Capital Expenditures

At the same time, the dividend payout ratio has been increasing over the past four years, and has reached stratospheric levels:

Diluted EPS Excluding Extraordinary Items
Dividends per Share - Common Stock Primary Issue
Dividend Payout Ratio

As a result, I find that the dividend is at a risk of a cut at present levels.

The second company I will profile today is Pitney Bowes Inc. (PBI), which provides software, hardware, and services to enable physical and digital communications in the United States and internationally. This dividend champion has raised dividends to shareholders for 30 years in a row. The company has slowed down on the rate of increase in dividend payments in recent years. The dividend has been increasing at 2 cents/year since 2008. Currently, the stock yields an above average 9.70%, and has a dividend payout ratio of 70%. The forward dividend payout ratio is 77%. The stock is trading at a forward P/E ratio of 8, which is low. The yield is very high and the P/E is very low. This could be the market’s way of saying that the current dividend payment might be difficult to maintain, and that it could be at risk of a cut. A company’s stock price could be temporarily pushed down by shareholders who do not believe in the long-term outlook for a company. If the stock price goes up, the yield and P/E would return to normal levels. The low P/E ratio could signal a stock that is undervalued, or it could be the market’s way of saying that future earnings would be much lower going forward. Overall, a dividend yield of 10% is something that you do not see every day. In most cases of common stocks of your typical corporation, this high yield is a warning sign of an impending dividend cut.

The issue with the company is that it is providing postage processing equipment such as postage meters to organizations. Revenues have been declining, and the outlook for the business is not very bright. The company has tried to reposition itself in the new digital document environment, and eliminate costs from its structure, but the truth of the matter is that physical mail processing by organizations is destined to decline over time.

Full Disclosure: None

Relevant Articles:

Seven wide-moat dividends stocks to consider
Highest Yielding Dividend Stocks of S&P 500
Dividend Cuts - the worst nightmare for dividend investors
Don’t chase High Yielding Stocks Blindly
Dividend Champions - The Best List for Dividend Investors

This article was included in the Carnival of Personal Finance # 403

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