Spotting Dividend Warning Signs

Most conversations about dividends center around yield or growth. Equally important is a company’s ability to continue paying the dividend. Avoiding companies at risk of potentially cutting or suspending their dividend matters as much as finding ones capable of growing their dividend. The potential losses from owning a future dividend-cutter can far outweigh the quarterly payments you receive before the dividend is slashed or suspended.

When discussing this topic, I believe it’s helpful to think about what dividends are: voluntary cash distributions of profits. When viewed from this perspective, three things stand out. First, there needs to be enough free cash flow to pay the dividend. Second, whether there is a risk of the company’s debtors pressuring the company to cut or suspend its dividend is a consideration. Finally, it’s good to try and identify what the company’s intent is for the dividend.

Since dividends are cash payments, a company’s cash flow matters greatly. A metric I look at for all companies—regardless of if they pay a dividend or not—is cash from operations. This is the amount of cash realized from or used by normal business operations. It should routinely be positive. If it’s negative for more than one quarter, the dividend is at risk. If it’s negative for just one quarter, investigate. A company may have loaded up on inventory or had a large amount of unpaid customer bills (accounts receivable) due to the timing of orders. The answers will be provided in either the annual (10-K) or quarterly (10-Q) U.S. Securities and Exchange Commission (SEC) filing.

While on the cash flow statement, calculate free cash flow. Defined as cash from operations minus capital expenditures (capex), this number tells you how much cash is available after accounting for spending on things such as facilities and equipment. If it’s negative, it could be a potential sign that the company is unable to cover its dividend. Again, investigate a single occurrence of negative cash flow since it might reflect one-time expenditures.

Utilities may have modest levels of negative free cash flow because of their ability to recoup the cost of expenditures on power plants, transmission equipment, etc. For our Dividend Investing (DI) newsletter, a stock’s free-cash-flow payout ratio is considered. It shows how much cash a company is paying in dividends as a percentage of free cash flow.

When it comes to laying claim on cash and other assets, debtholders have priority over shareholders. This mere fact makes it important to consider a company’s ability to service its debt payments. I personally use the Z double prime score to assess a company’s risk of having significant financial distress. Developed by New York University professor Robert Altman, this ratio considers working capital, retained earnings, earnings before interest and taxes (EBIT) and equity relative to debt. Low scores are a big warning sign. (In the More on AAII.com section below, I’ve included a link to an article about the score. It’s not difficult to calculate the Z-Score.)

Another and more commonly available metric is the interest coverage ratio (earnings before interest and taxes divided by interest expense). Numbers below 1.0 indicate that profits are not covering interest payments. Look at the trend as well. A declining interest coverage ratio could put the company at risk of violating its debt covenants, thereby creating pressure from debtholders to reduce the dividend.

Management’s intent to continue paying the dividend can require a more subjective judgment. A good place to start is to look at the company’s recent earnings conference call transcripts (available on SeekingAlpha.com; type in a ticker symbol, click on earnings and then transcripts). Scan for any comments made about the dividend, the payout ratio, cash flow or debt. Then go to the company’s investor relations website (simply type “[company’s name] investor relations” into Google or another search engine). Review recent presentations for similar types of comments. Finally, look at the company’s past dividend history. If it has cut dividends in the past, it may be willing to do so in the future.

Even if a company passes all of the above tests, it still might end up cutting its dividend. Similarly, a company might fail one or more of the above tests and never cut its dividend. The goal is not to predict the future of the dividend with absolute certainty, but rather to simply reduce the odds of getting burned by a cut or suspended dividend.

Of course, the ideal situation is to find attractive stocks with cash flow, fiscal strength and management intent to grow their dividend. Those are the type of stocks we seek for our Dividend Investing newsletter.

(For those of you who are interested in learning more about the newsletter, my colleague Derek Hageman has published a special report highlighting five stocks meeting the DI criteria. It’s part of a special $1 AAII Dividend Investing promotion we’re running this week.)