Life is getting increasingly difficult for income investors.
Largely because dividend payments are becoming less secure.
First-quarter earnings for S&P 500 companies are expected to come in below last year’s levels for the sixth successive quarter, with energy and financial stocks showing the biggest declines.
And auditors have issued more “going concern” warnings for their S&P 500 clients than at any time since the Great Recession began in 2008.
A company’s auditor generally issues a going concern warning when the company has already suspended any dividends it was paying.
For example, a going concern was recently issued for Linn Energy LLC (LINE), an aggressive oil- and gas-producing master limited partnership (MLP) that thought it had cracked the problem of fluctuating oil and gas prices by hedging in the futures markets. That is, until prices went down and stayed down, at which point the futures market hedges ran out.
Linn was then exposed as an overleveraged company producing oil and gas at a running loss.
Any dividend investors who owned Linn before 2014 as a stable MLP with a history of dividend increases have been very unlucky in terms of both income and capital.
Most Than Just MLPs Are in Trouble
There are a number of companies beyond MLPs that pay dividends in excess of earnings, relying on depreciation to provide adequate cash flow. These companies are especially vulnerable in an earnings downturn.
For example, CenturyLink Inc. (CTL), a telecom company with large fixed assets tied up in landline services, paid a dividend of $2.16 per share on $1.58 of earnings per share (EPS) last year.
When a company does that for enough years, it’s sure to run out of money when earnings have even just a mild downturn.
Frontier Communications Corp. (FTR) is in the same business. The company doesn’t seem concerned with making a profit at all, attempting to grow by buying portfolios of fixed-line customers that nobody else wants.
Frontier cut its dividend in 2013, and appears likely to do so again. The stock price has been on a steady downward trend since I owned it in 2010 at about double its present level.
Some companies rely on a mature business to generate cash flows for dividends, but this doesn’t last forever.
For example, Vector Group Ltd. (VGR) is primarily in the cigarette business, and relies on the fact that it doesn’t need to invest much in this mature business. So the company pays out dividends that far exceed its earnings.
With negative tangible net worth and negative cash flow after dividend payments, its dividends can’t be considered a reliable source of income.
Beware the Buyback
As well as the cash flow drain of dividends themselves, some companies further imperil their dividends by undertaking massive stock buyback programs.
Such programs do nothing for retail investors (who don’t usually get direct buyback offers), and serve mostly to avoid the dilution of earnings that would otherwise happen through management stock option grants.
Take a look at Caterpillar Inc. (CAT), which offers a nice 4.1% yield on its stock. This yield is modestly covered by the last four quarters’ earnings.
However, the company placed the dividend in danger through $2 billion of stock buybacks in 2015, which exceeded the dividend and soaked up most of the company’s depreciation allowance. This resulted in a net drain of $900 million in cash.
The 4-traders website forecasts that Caterpillar’s earnings will be down marginally in 2016, still leaving the dividend covered, but raising the question of where this year’s stock buyback will come from.
In an environment of squeezed earnings, Caterpillar’s dividend is clearly endangered – and it’s the stock buyback program that’s causing the problem.
Finally, Newmont Mining Corp. (NEM), the precious metals miner, is one company whose dividend was listed as “endangered” by Kiplinger in December. But its operating environment has improved so much that an increase is more likely than a cut at this point.
The company’s yield is currently only 0.3%, but while both energy and precious metals mining dividends were slashed during the resources downturn, there may be some upside in the precious metals sector among those few companies like Newmont that still pay dividends.
How to Protect Yourself
For dividend security in what is promising to be a difficult year, look for a stable business model, modest vulnerability to a downturn, ample dividend cover, and a track record of taking the dividend very seriously without wasting cash on buyback operations.
Vectren Corp. (VVC) is a regulated electric and gas utility with one million customers in Indiana and Ohio. It pays a dividend of $0.40 quarterly, about 1.5 times covered by earnings, with a track record of increasing its dividend for over 50 years.
Best of all, it doesn’t do stock buybacks (it’s likely that regulators don’t allow it to). Its yield is currently only 3.2%, but it allows you to sleep at night.
Modern finance and the economy can make it more difficult to find solid income plays, but they can certainly be found, albeit mostly at high prices.