Dividend investors are enamored with yield. Obviously, they want to get paid as much as they can. It’s why stocks like Annaly Capital Management (NYSE: NLY) and its 13.5% yield are so popular.
But what many investors ignore in their search for yield is safety. What good is a high yield if the dividend is cut in the near future? Not only does an investor receive less income when a dividend is cut, capital can be lost, as the stock usually tanks as a result.
When I look to add a stock to The Perpetual Income Portfolio, yes, I’m looking to obtain as high a yield as I can, but only if I’m comfortable the dividend is safe. If I’m not confident, then I won’t recommend the stock no matter how juicy the yield is.
To analyze the safety of a dividend, look at the payout ratio, which is the percentage of net income paid out in dividends – although I use a slightly different formula. I look at cash flow from operations and free cash flow instead of net income, because net income, or profits, can be manipulated fairly easily with accounting tricks. Cash flow, which represents the actual amount of cash that came into a business versus the cash that went out, is a more accurate representation of a company’s business.
So let’s take a look at a couple of companies whose dividends may not be entirely safe.
The first one is Meridian Biosciences (Nasdaq: VIVO). It pays a 3.7% yield and business has been strong. I applaud management’s desire to return a significant portion of profits to shareholders. However, they return too much. Their stated goal is to have a payout ratio (based on earnings) of 75% to 85% each fiscal year.
My threshold for the payout ratio is 75%. Anything higher and the dividend could be in jeopardy if the company has a bad year.
Meridian just reported quarterly results and earned $9.6 million in the quarter. Its dividend payment of $0.19 per share should come out to approximately $7.9 million, which equals 82% of its net income.
The company’s cash flow results weren’t released. But in the last quarter, dividends ate up over 80% of free cash flow and in the three prior quarters, dividend payments were more than 100% of both earnings and free cash flow. The company has about $24 million in cash and no debt.
With earnings expected to grow this year and next year, paying the dividend shouldn’t be a problem if Meridian hits its numbers. However, if they experience a hiccup in business and net income falls, the company may have to dip into its cash to keep the dividend the same. And if business stalls for more than a quarter or two, the company would have to think seriously about cutting its dividend.
Let’s look at another.
Portugal Telecom (NYSE: PT) paid a dividend equal to all of its free cash flow in 2011. It did the same in 2010, but dividends didn’t eat up all of its free cash flow prior to that.
The company has 6.4 billion euros in debt and 5.7 billion euros in cash and it’s located in a country that’s facing difficult times right now. Keep in mind, it does a lot of business in Brazil, so it’s not solely focused on Portugal. But the Portuguese portion of the business is something to worry about, particularly since its payout ratio based on free cash flow is 100%.
Should the company run into trouble, it will likely cut the dividend the way some of its peers have. The 7.2% yield is attractive. But I’m concerned it’s not sustainable.
For both companies, I’m not saying a cut in the dividend is imminent, but if you’re an investor in these stocks, you should be watching the financial statements very closely to see if there’s any trouble on the horizon. Often, a company won’t cut the dividend immediately after reporting a bad quarter. They’ll wait to see if things improve. But then a quarter or two down the road, investors get hammered when the dividend is reduced.
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