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.
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.
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.
Forget about those 2 companies, invest in this one instead!
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Fool contributor Nelson Smith has no position in any stock mentioned in this article.