Do You Recognize the 3 Early Warning Signs of a Dividend Cut?

How safe is your portfolio from a dividend cut?

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cautionI call them sucker yields.

Many dividend-thirsty investors get excited when they uncover a stock offering a double-digit yield. And in today’s income desert with interest rates so low, who can blame them?

But believe me, it’s just a mirage. In my decade of investing, nothing signals trouble like a double-digit yield.

There are exceptions, of course. But chances that any particular ultra-high-yield stock will turn out to be a bargain are slim.

Case in point: Just Energy (TSX: JE)(NYSE: JE).

In an effort to conserve cash, on June 5, 2014, the gas and energy utility announced its second dividend cut in two years. Its new annual payout will drop from $0.84 per share to $0.50 and will now be paid out quarterly instead of monthly. As part of its ongoing strategy to divest non-core assets and reduce debt, the company also sold off its water heater rental arm to competitor Reliance Home Comfort for $505 million.

While this will certainly be a disappointment for Just Energy’s shareholders, the dividend cut didn’t come as a shock to analysts who knew what to look for. Indeed, Just Energy exhibited the three tell-tale signs of a dividend cut long before any announcements were made.

First was the significant deterioration in its underlying business. Just Energy has been adding net customers at a much slower pace than in previous years. Also, new customers tended to be less profitable than those who left, reflecting the growing competition in the industry.

Second was the company’s unsustainable high payout ratio. Last year, the company paid out 126% of base funds from continuing operations, which could only be funded through asset sales and debt issues. That couldn’t go on forever.

The final sign was the stock’s high dividend yield itself. Before the distribution was cut, the trailing yield on Just Energy’s shares was north of 13%. The market was clearly saying that it didn’t think this dividend was sustainable. It was a tip-off that there were problems beneath the surface even if they weren’t evident at first glance.

Unfortunately, Just Energy isn’t the only dividend that looks weak. Using the lessons learned from this episode, we can look across the Canadian marketplace and identify other vulnerable dividends.

Twin Butte Energy’s (TSX: TBE) dividend could be at risk after its production outlook came in well below the street’s expectations last month. The junior oil and gas producer is struggling to stave off production declines at its legacy wells, making it difficult to generate enough cash flow to both fund its operations and pay shareholders. Given that the stock yields 10.4% today, the market doesn’t see this payout as sustainable either.

Atlantic Power Corporation’s (TSX: ATP)(NYSE: AT) distribution also looks weak. The company, which owns and operates a fleet of power generation and infrastructure assets across North America, currently yields 11.3%. However, given that the company hasn’t turned a profit in years, that payout looks unsustainable.

The bottom line: Don’t be lured in by double-digit yields. Like moths to a flame, these juicy payouts often attract rookie investors. However, these dividends are rarely sustainable.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Robert Baillieul has no positions in any of the stocks mentioned in this article. 

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