2 Key Warning Signs of a Dividend Cut

Few events destroy as much shareholder value as when a company cuts its dividend. Management plans years ahead when setting the dividend payment because of the disastrous signal it sends when cash comes up short.

Sometimes though, a cut in cash return is inevitable.

Shares of General Electric (NYSE: GE) were already down 37% to its November 2017 earnings announcement when management halved the dividend. The iconic industrial company had only cut its dividend twice before in 100 years.

The shares dropped more than 10% on the announcement and are down another 50% from before the dividend was cut.

For Teva Pharmaceuticals (NYSE: TEVA), shares had been falling for a full year when rumors started circling that the dividend would have to be cut. The stock plunged on July 24 of last year as investors feared the worst with shares losing 46% in just two weeks.

These examples illustrate two important points for dividend investors. First is that no matter how bad shares are performing, it can still get worse if the dividend is cut. Second is there are warning signs you can watch for to avoid getting caught in a cut.

Warning Signs Of Dividend Death

The first warning sign is runaway debt, especially when it’s connected to a strategy of acquisitions for growth.

Slow-growing companies love to fund sales growth through acquisitions, papering over management’s inability to drive organic growth. The strategy can keep a sinking ship afloat for a while, but it isn’t long before earnings fail to meet expectations and cash comes up short. Teva had been on a buying binge for years, but it was the massive $40 billion acquisition of Actavis in 2016 that put it over the edge.

That one deal ballooned debt by $25 billion and tripled the annual interest expense to $875 million. When generics came under pressure and sales failed to materialize, it was clear that cash flow was in trouble.

Monumental acquisitions might be good for management’s ego, but they often don’t work out for shareholders. Watch a company’s interest coverage, the earnings before interest and taxes (EBIT) divided by interest expense, as well as debt-to-equity versus peers.

Another warning sign of dividend trouble can be found in sales growth and cash flow from operations.

Acquiring other companies can be a profitable strategy but shouldn’t be used to hide management’s inability to create sales from existing business. If sales and cash flow are barely moving versus industry peers, trying to integrate another acquisition is only going to complicate matters.

Tying another boat to your sinking ship might keep them afloat temporarily but it’s only a matter of time before both go down.

Teva had seen sales flat for years and even booked a decline of $620 million in 2015 revenue. The massive Actavis acquisition boosted the top-line by $2 billion but at a huge cost in additional operating expenses and interest.

Again, there’s nothing wrong with acquiring companies that will boost growth but doing it solely as a way of hiding management’s inability to drive organic sales will mean an inevitable day of reckoning as debt grows.

These two warning signs alone will help you avoid the worst dividend disasters but there are also positive screens you can use to find solid stocks for cash return.

Looking For Solid Dividend Stocks

Finding great dividend stocks in the first place means screening for companies that value cash return to shareholders and management that can produce the kind of organic growth to not only support their dividend but put more cash in your pocket.

BlackRock (NYSE: BLK) is a leader in the ETF space, adding $18 billion in assets under management (AUM) to its iShares product line in the second quarter. Total AUM grew 11% from the prior year to $6.3 trillion and the company increased its operating margin by nearly 2% from the 2017 period.

The iShares line makes BlackRock a favorite among passive investors and that has helped the company drive profitability through lean operations. As the largest asset manager in the world, the company has the efficiency of scale to thrive even as fees become more competitive.

The shares pay a 2.6% yield with a 33% annualized pace of dividend increases since 2015. Management has turned 6% annualized top-line growth into 15% earnings growth over the last five years.

Paychex (Nasdaq: PAYX) is set to do well as the gig economy grows and more small businesses need its outsourced payroll solutions. The company continues to expand into other services including record-keeping for retirement plans, human resources, and health benefits.

The difficulty of switching payroll and other outsourced services means the company’s small business customers provide stable revenue predictability. Management has been able to translate this into 7% sales growth and 11% annualized earnings growth over the last three years.

Shares pay a 3.1% yield with a 10% annualized pace of dividend increases since 2015. The company has been able to acquire smaller peers to boost growth but has no long-term debt and a healthy balance sheet.

Risks To Consider: Shares tend to start falling well before a dividend cut, making it emotionally difficult to cut losses and sell. Watch for the warning signs and don’t be afraid to take a small loss.

Action To Take: Watch for the warning signs of a dividend cut and position in companies with growing payments that can support investor cash return.

— Joseph Hogue

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Source: Street Authority