Many stocks can sustain high dividend yields in a booming economy when borrowing is cheap and inflation is low. But such high-yields spell a trap in the current environment.
How to identify high dividend stocks that are a trap?
Dividend stocks mostly carry huge debt and enjoy stable cash flows. Put yourself in a CEO’s shoes. On the one side, your interest on debt is rising, and inflation has increased electricity, salary, logistics, commodity costs, rent, and other expenses. On the other side, your revenue is stable, falling, or growing at a moderate rate. With this combination, your free cash flow reduces, and you are giving it all as dividends. How long can you sustain? There will come a point where you start cutting costs, and dividends are the first to take a hit.
Some measures like the dividend payout ratio and net profit hint at a dividend cut if things worsen. Three mid-cap stocks fell more than 30% in the last few months as the companies slashed dividends because rising interest expenses ate up their profits, (Algonquin Power & Utilities, Slate Office REIT, and True North Commercial REIT).
Here are three ultra-high dividend stocks that could be the next in line.
TransAlta Renewables stock
TransAlta Renewables (TSX: RNW) stock is trading closer to its March 2020 pandemic low, which has inflated its dividend yield to 7.5%. The stock looks attractive as it is near its 52-week low. The company generates wind and solar energy, which enjoys strong government support. Thus, I have been bullish on the stock throughout 2022. But right now, the company’s fundamentals are declining to a level where it struggles to keep up with dividends.
While TransAlta’s revenue (19%) and operating profit (5%) improved, its net profit halved due to high-interest expense on debt raised for acquisitions. The company is also seeing higher income tax expenses. All these are cash expenses that have reduced its distributable cash flow (DCF) below the dividend per share, resulting in a 103% payout ratio. The company expects the cash flow to fall further in 2023 as a major contract expires and the upcoming projects cannot fully offset the loss.
TransAlta is focusing on a 100% dividend payout and postponing growth activities as high-interest rates make projects less profitable. Such fundamentals are not sustainable, raising fear of a dip. Investors already priced in a dip when the stock fell 20% after the company lowered its 2023 outlook. But RNW could fall further if the company slashes dividends.
Whitecap Resources stock
Whitecap Resources (TSX: WCP) is a mid-cap oil and gas company that has been growing by acquiring oil companies. These acquisitions have increased its debt when the interest rate is high. The acquisitions are churning money for the company as the Russia-Ukraine war has created a global energy crisis. But energy stalwarts say it is the last of the oil peak as the energy industry is transitioning to renewable energy.
Whitecap has accumulated $1.8 billion in debt. A 100 basis point change in interest rate costs the company $14.5 million in interest expenses. Moreover, it has grown its monthly dividend by a whopping 239% between January 2021 and January 2023. If the oil price recedes due to a recession, Whitecap might slash dividends as it has no cash reserves and significant debt. The stock is at its seasonal peak, and the 5.25% yield is at risk if oil prices fall.
Timbercreek Financial
Timbercreek Financial (TSX: TF) gives short-term mortgages to income-generating real estate companies. The higher interest costs forced commercial REITs to slash distributions and start selling property. While Timbercreek enjoyed high-interest margins, with a weighted average interest rate of 9.7% in the fourth quarter, it also has a higher credit risk. Its distribution payout has been above 100% of its earnings per share for the last three years and 85% of its distributable income.
Any default or interest rate reduction could reduce its interest income. And if the loan volumes remain low, the company might not be able to sustain high dividends.
Investing tip
If you own these stocks, now is a good time to sell before they cut dividends and buy safer dividend stocks like Enbridge and BCE.
