Are These 2 Dividends Too Good to Be True?

Investors can lose a lot of money if they stretch for yield. Here are two high-yielding stocks that are poised to cut their dividends.

The Motley Fool

In the world of dividends, there are essentially two types of companies.

The first group focuses on paying a consistent, growing dividend, which makes up anywhere from 30%-60% of cash flow, depending on factors like the maturity of the business, the strength of the balance sheet, and the comfort level of management. These companies generally yield between 2%-5%.

The other group is a holdover from the income trust days. They’re generally mature businesses, without much growth, who pay out anywhere from 80%-100% of earnings to shareholders. These companies generally yield anywhere from 6% to double-digits, depending on the market’s outlook for the business and the quality of earnings.

Investors who choose to put money to work in these high-yielders are taking the risk that the company won’t be able to cover its dividend. When a business pays out most of its earnings, there isn’t much room for error. Just a small decline in profitability can prove disastrous to a company with an overly generous yield. Once the dividend gets cut, the share price often falls too, as spurned investors flee to the exit.

While I don’t have a magic ball, I did predict in a past article that Just Energy (TSX: JE)(NYSE: JE) would cut its dividend. It simply had too much debt and its earnings weren’t stable enough to continue paying out such a generous yield. Here are two more stocks I wouldn’t touch with a 10-foot pole.

Student Transportation

I want to like Student Transportation (TSX: STB)(NYSE: STB), which contracts with school districts to transport children to school. The company operates more than 11,000 vehicles in 225 different school districts, and transports hundreds of thousands of students to school each day. What’s not to like?

The company pays out a generous monthly dividend, which yields just a hair under 8%. So far in 2014, it has paid out almost $0.28 per share in dividends to shareholders, while earning only $0.06 per share. Once you dig a little further, you discover the company has never earned enough to cover the dividend.

So how does it continue to pay? The answer is simple — it’s borrowing money and using it to pay the dividend. Since the end of 2010, the company has paid out $139 million in dividends. It also borrowed an additional $77.3 million during that period, yet only saw the value of its equity rise by $31.1 million. That’s even after giving out a bunch of shares in lieu of cash dividends, since investors get a 3% bonus if they take their dividend in the form of new shares.

Unless the company finds a way to increase margins significantly and earn enough to cover the dividend, it’ll eventually be forced to cut it.

Atlantic Power

Even though Atlantic Power (TSX: ATP)(NYSE: AT) has already cut its dividend once, back in 2013, I believe it’s only a matter of time until it does so again.

The company is currently turning around operations. It has successfully refinanced some short-term debt, meaning it doesn’t have any major debt maturing until 2017. It also has an impressive portfolio of gas, wind, and solar assets. Investors who buy the company now and tuck it away for five years will, at least in this writer’s opinion, do well.

However, in the meantime, it makes all sorts of sense for the company to eliminate the dividend. The market has zero confidence that it can maintain its payout, and investors who are buying at these levels are far more interested in the capital gains. Eliminating the dividend is an easy way for the company to save almost $50 million per year, which would help pay down its bloated debt load.

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 Nelson Smith has no position in any stock mentioned in this article.

More on Investing

Silver coins fall into a piggy bank.
Tech Stocks

How to Turn a $500 TFSA or RRSP Into $50,000

Are you looking to convert a $500 TFSA into $50,000? A little discipline and patience can help you achieve it.…

Read more »

Pot stocks are a riskier investment
Cannabis Stocks

5 Things to Know About Cannabis Stocks Before 2023

Cannabis stocks like Canopy Growth (TSX:WEED) are struggling, but there are positives to draw on as well.

Read more »

STACKED COINS DEPICTING MONEY GROWTH
Stocks for Beginners

3 Best-in-Class Stocks to Build Long-Term Wealth

Looking for stocks that might create generational wealth over the long term? Here's a top growth, value, and income stock…

Read more »

TFSA and coins
Dividend Stocks

TFSA Couples: How to Invest for $777 of Passive Income Each Month

The TFSA or Tax-Free Savings Account can be used to buy and hold a portfolio of blue chip dividend stocks…

Read more »

A close up image of Canadian $20 Dollar bills
Dividend Stocks

Investing in the Stock Market Could Turn Your $1,000 Into $100,000: Here’s How

The stock market can convert a $1,000 regular investment into $100,000 without making too risky bets. Here’s a simple strategy…

Read more »

Bank Stocks

3 Top Stocks to Buy Now in a Once-in-a-Decade Opportunity

Given their discounted stock prices, these three quality stocks offer a once-in-a-decade buying opportunity.

Read more »

Various Canadian dollars in gray pants pocket
Stocks for Beginners

Here’s an Absolutely Brilliant Way to Earn Passive Income

Here’s a simple and unique way to earn passive income that does not involve working more, buying a property, or…

Read more »

Make a choice, path to success, sign
Stocks for Beginners

Canadian Investors: 2 Once-in-a-Generation Buying Opportunities

You can grab these two once-in-a-generation buying opportunities in Canada right now to get super rich in the long term.

Read more »