Wow, why own any stock if it doesn't pay a dividend? While the S&P 500, and its tracking exchange traded, fund, SPY (SPY), is up over 15% for the year, and stocks such as Apple (AAPL) are up over 30% in the last year, the recent sell-off has been brutal.
While the S&P 500 is down around 8% in the last week, many cyclical sectors, such as energy, the industrials, and the financials, have sold-off hard. Market leaders such as GE (GE), Citigroup (C), Caterpillar (CAT), and Exxon-Mobil, (XOM), have also performed poorly.
Still, the one type of mutual and exchange traded fund that has held up very well during the recent sell-off is dividend funds. Leading dividend stocks, such as Altria (MO), AT&T (T), Kimberly-Clark (KMB), and Walmart (WMT), are at or near these stock's 52-week highs. Dividend stocks such as Procter & Gamble (PG) and Clorox (CLX) have also performed well over the last year despite pulling back recently.
I have been a huge proponent of the right kind of dividend investing, investing in companies with strong growth and significant free cash flow, for some time. In fact, my first article and many subsequent articles recommended Lorillard (LO), Altria, and other tobacco companies even when many analysts were negative on this sector several months ago.
Still, there are strong signs today that a number of companies are raising and financing dividend growth with cheap debt, not actual earnings.
Company executives are not stupid, and management understands that the primary reason many investors hold stock in companies such as AT&T, Altria, and many other leading dividend names, is for the dividend.
Today, while consumers and small businesses struggle to obtain adequate or reasonably priced capital, companies are able to issue bonds at historically cheap levels. Just two years ago Walmart and IBM (IBM) actually issued a 1-year bond at below 1%.
The corporate bond market is indexed to the U.S. treasury market, and, obviously, inflation expectations. With companies that have even mediocre credit rating able to issue bonds and refinance long-term debt at appealing and lower rates, many companies have been aggressively issuing debt to raise dividends when these companies' earnings have been modest to flat.
Just recently, Deere (DE) raised its dividend 7%, despite having less than 5% growth, and Freeport-McMoRan (FCX) raised its dividend by 25%, while the company's year-over-year net income and earnings plunged. Freeport-McMoRan's dividend raise came after the company was able to use its strong cash flow to refinance long-term debt at 3% and call bonds trading at over 8%.
In an environment where demand for fixed income investments remains high, rates are artificially low and it's important to know which companies are likely to have the earnings power to continue to raise dividend payouts when capital becomes more expensive.
This is why I question the idea of looking at recent dividend raises from many leading dividend stocks with modest long-term growth prospects when evaluating the prospects of these companies to continue to significantly raise dividends over the long term.
Altria recently reported a nearly 8% gain in redefined adjusted earnings per share on a year-to-year basis. However, the company's net income has been consistently declining for several years. Altria's net income has dropped 4% a year on average over the last five quarters, and the company's net income has declined each of the last three years.
Altria has raised its dividend by nearly 30% even while the company's net income continues to decline. Altria continues to finance its dividend with debt, its payout ratio is around 80%, and the company's long-tem bonds are trading at over 8%, and the company recently took out an addition $1 billion dollar credit lines. With Altria's long-term bonds trading at around 8%, its likely a 2-3% rise in interest rates would make the cost of capital for Altria rise over 6%.
AT&T's recent record of dividend raises also look unsustainable as well. While AT&T has on average doubled its dividend every 12 years since 1984, the company's payout has risen from 54% to 70% over the last three years, even while the company's free cash flow has remained flat. AT&T's payout ratio is very high, with competitors such as Verizon (VZ) paying out around 55% of earnings. AT&T has had significant recent growth, but the company's average earnings per share growth from 1999 to 2009 was 1.4%, and the company's recent subscriber growth was less than 1%. AT&T free cash flow in 2011 was also weaker than in 2007.
AT&T has nearly $65 billion in debt, and the company's interest rate coverage of 3 is below average. Obviously the company has a very stable revenue stream, still a modest raise in interest rates will likely limit this company to raise its dividend by more than 2-3% a year if the company continues to have trouble growing its free cash flow.
Procter & Gamble has doubled its dividend nearly every 8 years since 1974, but the company's recent buyback and dividend has also been financed by increasing debt. While Procter & Gamble's payout ratio of nearly 44% is fairly low, the company's is using over 95% of net income for buybacks and dividends, and the company's buyback program is similar in size to the dividend payout.
While Procter & Gamble has been able to finance its recent dividend and buyback program by issuing nearly $2 billion in new debt, and the company now has nearly $50 billion in debt on its balance sheet. Analysts are also projecting Procter & Gamble to grow at just 5-6% over the next 5 years, and the company has significant exposure to Europe.
To conclude, past performance is often a good predictor of future results, but recent results can also be misleading. While companies with little organic growth and flat cash flow are able to continue to maximize buybacks and dividends with cheap debt today, interest rates are likely to be moderately to significantly higher over the long term. If companies with heavily leveraged balance sheets, modest growth, and minimal pricing power face inflation and rising borrowing costs, many of these companies may have to reduce payout ratios significantly over the next decade.