Investing for income has become extremely popular among a variety of investors in the past few years. Ultra low bond yields in both government and corporate issues have made dividend income an increasingly important component of many portfolios. With rates unlikely to be increase to historical norms in the near future, especially considering the ongoing economic troubles in both Europe and the U.S., many are relying on dividend yields to supplement anemic bonds more and more.
However, while many dividend yields are ultra safe, some look as though they are unsustainable over the long-term, unless of course the firm is able to grow into its outsized payout rate. Below, I take a closer look at six companies on the S&P 500 that are yielding more than 5% but also have more debt than equity and are currently paying out more than 100% of their earnings as dividends. In other words, these firms are deeply in debt and are paying out more in dividends than they are obtaining in earnings, not a good combination for long term success.
Yet on the flipside, these firms find themselves in a precarious position as they have built themselves up to be ideal companies for dividend investors, forcing them to continually hike payouts in order to appease the growing masses that are investing for income. However, since they are already highly in debt and dividends are being paid out beyond what the company is earning, options are limited for these firms beyond dipping further into their reserves, unless of course we see a large uptick in earnings in the near future.
Thanks to this, investors need to take a closer look at these six firms and decide for themselves if these companies can grow into their hefty payouts and continue to be dividend champs, or if these yields should just be used as a way to supplement current income in the near term.
FirstEnergy Corp (FE)
First Energy is one of two utilities companies on this list of six, specializing in delivering electricity throughout Ohio, Pennsylvania, and New Jersey to over 4.5 million customers. Like most utility companies, its yield is rather high as the company pays out 5% to investors every year. While the yield may be nice, the capital appreciation has been even better as the company has gained close to 26% in the last half year and almost 20% in the last quarter alone. However, headwinds remain for the firm as EPS was down significantly Q/Q and looks to be down sharply this year as well. As a result, the firm’s payout ratio is now above 107% suggesting that earnings are not enough to cover the company’s yield by themselves.
With that being said, FE does have more cash than many of its peers in the space at 2.63 per share. Furthermore, its LT Debt is relatively manageable and its profit margin of 4.8% is higher than many others in the space, suggesting that the company may be more efficient than its peers. Thanks to this, if FE can manage to grow out of its current malaise, the company’s dividend could be very safe for years to come, especially if they can get it back below the key 100% mark.
Frontier Communications (FTR)
In what is the first of many communications firms on the list, FTR provides voice, data, and video services to clients across the U.S. Although its sales have grown at double digits over the past five years and over 150% when compared to the previous quarter, earnings have not kept up, suggesting a declining profit margin due to competition. In fact, despite the surging sales, EPS over the past five years is actually down 16% and when the previous quarter is compared to the most recent one EPS is down 59.9%. All of this has led to a profit margin of just 3.6% and concerns over the company’s ability to service its debt; the current ratio is under one and the LT Debt/Equity is close to 1.6.
However, the company does pay out a robust dividend yield of 8.8% giving dividend investors a nice boost to their current income that is far higher than T-bills. While the yield may be impressive, one has to wonder just how long FTR can keep this up; the payout ratio is now above 325% meaning that the company pays out three times as much in dividends as it bring in for earnings. This is not sustainable over the long term and although the company may have some room in terms of adding debt to help grow, the industry remains very competitive and investors in FTR should be concerned about their yields.
Pepco Holdings (POM)
Pepco is the second of two utilities on this list, supplying electricity to customers in the mid-Atlantic region of the United States. POM has surged so far in 2011, gaining 8.5% this year and more than 34% in the past 52 weeks. Add in the company’s 5.5% dividend yield and investors in POM have to be relatively pleased. However, despite this year’s positives, the company could see some headwinds. Competition is fierce in the utilities space and especially so along the Eastern Seaboard. While EPS is up over the past quarter and looks to grow marginally over the next year, sales have been down and EPS has slumped when looking at the last five year period.
Furthermore, the company only has eight cents in cash on hand for each share of stock, putting the Price/Cash ratio at a whopping 244.4. Additionally, the hefty yield has pushed the payout ratio up close to the 140% mark, not a good sign for a utilities company. Despite these many negatives, the company does have a relatively low debt load as its Debt to equity is just over 1.1 and its long term debt to equity is below the 1.00 mark. Since the company can presumably add debt and since earnings look to improve this year, investors should have some concern over the long term dividend of this company, but certainly less so than most of the other firms on this list.
R.R. Donnelley & Sons (RRD)
After crashing below $10 in early 2009, RRD came storming back and has been trending between roughly the $14-$20 range for the better part of the last year. EPS growth in terms of Q/Q was down significantly—more than 35%--- but the longer term prospects look better for the firm; EPS is projected to grow by 11% over the next five years. However, RRD has a very weak profit margin of just less than 2.00% suggesting that competition is extremely fierce in its industry.
Despite this, RRD does pay out a nice dividend of 5.04% and has a more manageable LT debt to equity ratio of 1.45. While this is still high, it is as least possible to bring this back into alignment over the long haul. Furthermore, the company’s payout ratio is just under 106%; while this obviously isn’t ideal, a modest growth in earnings should be able to get this back below the triple digit level, easing the concerns of dividend investors. This suggests that if RRD can fight off its competition, the payout should be relatively safe for years to come.
Unarguably the most famous company on the list, VZ is the only DJIA component to pay out a yield greater than 5%-- close to 5.5% in their case—while also having a debt/equity ratio above 1.00 and a payout ratio over 100%. The company faces extreme levels of competition from the likes of AT&T (T), Sprint (S), and a host of smaller competitors but has been able to hold its own in the marketplace. Partially thanks to many customers being fed up with AT&T and the release of the iPhone (AAPL) on Verizon, EPS at the company has been surging as of late, growing by more than 225% in a quarter/quarter comparison. This is in sharp contrast to the company’s recent past in which earnings were in a downward trajectory for a long time. Now it appears as though things are finally beginning to turn around as the company is expected to grow earnings by double digits this year and has one of the highest profit margins in the space at close to 10.5%.
Despite all these positives, the company still has a payout ratio that exceeds 150%, suggesting that its dividend may not be rock solid unless of course the company can continue to grow at a solid pace. Furthermore, the company already has a reasonable amount of debt and a current ratio below one, so while further debt could be added, one has to wonder how much more the company could take, especially without truly robust growth prospects. As a result, investors should have some concern over VZ’s payout but its solid operation and its growing earnings should help to eat into this significantly. Should this happen, it could prevent the company from issuing too much debt or eating into the cash too much in order to grow into its hefty payout.
Windstream Corp (WIN)
Don’t let WIN’s solid performance over the last year fool you, the company appears to be in some serious trouble. Q/Q EPS was down over 72% while the EPS are expected to grow by just 0.2% over the next five years suggesting that growth prospects are minimal for the firm. WIN does pay out a very handsome yield of 7.6% but this represents a payout ratio of 192%. This means that for every dollar of earnings, WIN pays out $1.92 in dividends, hardly sustainable considering the company’s LT Debt/Equity is already 9.05 and cash per share is just seven cents. With these types of headwinds, one has to wonder how this company can possibly hope to keep up its current payout to investors, suggesting that WIN is probably the riskiest of the six on this list of firms.
While this list isn’t necessarily a group of companies that investors need to avoid at all costs, it does represent a group of firms that need to be monitored closely. Their current payout rates are unsustainable over the long haul and since many of the firms are in low growth businesses such as utilities and telecoms, one has to wonder just how long these companies can keep this up. More importantly, one has to consider just what will happen if any of these high yielding firms is forced to do the unthinkable and slash payouts to a more manageable level. It never hurts to be prepared, especially when your investment is paying out more in dividends that it is taking in for earnings.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.