When a Dividend is No Longer Safe

By David Sterman
September 09, 2010

As the global economy began to slump badly in 2008, hundreds of companies slashed or eliminated their dividends. Since then, the economy has slowly rebounded, and as it has improved, so have dividend payouts. But any new sign of economic weakness, including a double-dip back into recession, could lead to a fresh round of dividend cuts.

If you see a stock fall sharply while its dividend stays constant, that company’s dividend yield is likely to spike sharply higher. And that can’t last. Newspaper publisher Gannett (NYSE: GCI) saw its shares plunge in 2008, which pushed its dividend yield up to 20%. But few investors chased that yield, because they knew it had to be cut to help horde cash. A $1.60 dividend in 2008 became a $0.16 dividend in 2009. If you see your investment’s dividend yield spike to unusually high levels, you'll probably be looking at a future dividend cut.

Before deciding what to do with their company's dividend policy, management teams look at two items: profits and payout ratios. So when analyzing a company's yield, paying particular attention to the health of projected cash flow and the current payout ratio will help you draw the best conclusion. A good way to judge a dividend's strength is to ask yourself these two questions:

1) How secure will cash be during a downturn (and how profitable will the company be), and

2) What's the current payout ratio (how much of the cash flow is being paid out to support that dividend)?

Answering these questions takes a little work. First, go back over the last five years to see if the company's cash flow has been steady, even with all of the ups and downs in the economy. If it has, than the company is fairly economically insensitive, and the dividend is likely to remain safe -- especially if the company didn’t cut the dividend in 2008, as many companies did.
 

Second, look at the company's current payout ratio. If the company is only paying out 20% or 30% of its cash flow in dividends, and cash flow falls only moderately during historical downtimes, then the dividend is likely to be safe. If a company is paying out 80% of its profits every year, and profits fall by half, the company will either have to cut the dividend in half or take money from the balance sheet to support the dividend.

Caveat Emptor: Real Estate Investment Trusts (REITS) and Master Limited Partnerships (MLPS) are notorious for their erratic dividends thanks to high payout ratios and a high degree of economic sensitivity. So if you like either of these investment vehicles for their income-producing features, then be prepared for dips and spikes in the payout ratio over the years.

Dividend-paying utilities have the strongest track record in terms of dividend support. But their share prices could fall if bonds and CDs ever to start to offer high yields once again. That’s an unlikely scenario for the near-term, but a reminder that even these “safe” investments can see their share prices weaken, offsetting the gains from the dividend payout.

Looking for Fresh or Rising Dividends

Of course if the economy starts to pick up, investors may be treated to rising dividends or even see some companies issue payouts for the first time in history. Those companies are typically near the end of a long capital expansion campaign, and as the needs for cash dwindle while cash flow remains strong, they can start to offer a nice payout. 

For example, DirecTV (NYSE: DTV) has spent more than a decade building out its cable satellite service, and has recently commented that the network expansion is now complete. So profits, rather than being re-invested, are going right into the bank.  DirecTV generated more than $1.4 billion in free cash flow in the first half of 2010, up more than 30% from a year ago. Free cash flow could approach $3 billion this year, and approach $3.5 billion next year.

In addition to a stock buyback that has taken the share count from above 1.1 billion in 2008 to a projected 700 million in 2012, management hints that a dividend may be coming next year. If DirecTV chose to apply $2 billion of its annual free cash flow, then investors would be looking at a $2.25 annual payout, which equates to a healthy 5.8% dividend yield.