5 troubling signs for dividend/income trust investors

Posted by on August 11, 2008 in Investment Information

I am back from my one week vacation from the blog. Thanks for your patience. While I was gone, Philip Morris announced that it will purchase all of the shares of Rothmans Inc. at $30.00/share as endorsed by Rothman’s board of directors. On the surface, this sounds great since this is a 16.9% premium to Rothman’s stock price as of July 30 (the last trading day before the offer was announced) and the transaction, subject to shareholder approval, would close at the end of October 30. Thus, the shareholders get their money quick. BUT, Rothmans is suspending the dividend it usually pays in September. Given the dividend is quite substantial (over 5% dividend yield), this is a pretty significant and adverse move for shareholders.

Coming on the heels of BCE electing to suspend its dividend until it privatizes (maybe Bell’s new marketing campaign should incorporate “we are cheapER” as a slogan on top of all its other marketing slogans ending with a word with an “er” on it), this is a troubling new trend for dividend investors. In light of recent reports that it is not anticipated most banks will increase their dividend this year, which is not altogether surprising, we appear on the cusp of some bad news on the dividend front. As smart investors, what troubling signs should dividend and income trust investors look for before its too late?

  1. A large spike in dividend payout ratio not attributed to a dividend increase: A dividend payout ratio is the percentage of yearly earnings/profits paid to investors in the form of annual dividends. If a company has earnings of $1 million a year and pays $200,000 of that in dividend, its dividend payout ratio is 20%. In other words, the ratio depends a lot on how much profit a company makes every year. A large spike in the dividend payout ratio would indicate the company is beginning to be less profitable. If the ratio begins to accelerate upward quickly without a dividend increase, the company is in big trouble if you are a dividend investor. A good example is Bombardier several years ago as its profits crashed quickly and the dividend was cut immediately as a cost cutting move. More recently, a lot of banks in the U.S. saw their dividend pay ratio go from the 30-40% to 60-70% very quickly and dividends were predictably slashed.
  2. The number of shares is increasing for non-business reasons. This was a favorite trick of the income trust industry during its peak. The formula basically went like this: payout most if not all of your profits in distributions/dividends (in some cases, some income trusts paid more than their profits in distributions and were dipping into their bank account). To keep the machine going, keep issuing new shares not for acquiring the competition or investing in new technology but to keep paying your shareholders. In other words, you are robbing Peter to pay Paul- you are raising money to pay your older shareholders (almost like a Ponzi scheme). Banks in trouble have begun doing this- they are issuing millions of preferred shares to prop up their balance sheet and as a way to keep paying dividends but all they are really doing is loading up on more debt (albeit safer than the junk they bought).
  3. Large debt raises. This is probably not as large a factor since most lenders do not have appetites for lending large amounts of money. As I have indicated previously, large amounts of debt begin to impair the ability of a company to pay dividends.
  4. The business stops investing or maintaining its machinery/equipment. This is another favorite trick of the income trust industry. Dividends and/or distributions are paid out of free cash flow (defined as cash flow from operations minus capital expenditures). Thus, there is two ways to increase free cash flow: (i) become more profitable; or (ii) stop spending money on capital expenditures by not maintaining machinery and equipment or not replacing machinery or equipment. The best analogy would be a city who holds the line on tax increases by running their 30 year buses one more year. Eventually, this catches up to you- productivity falls, competitors who invest in growth gain more market share, talented employees leave etc. While this move may forestall any short-term dividend halt or decrease, it bodes poorly for long term dividend growth. Most financial reports will list capital expenditures as a reporting line. The other way to find out is look at the free cash flow reporting line on annual reports. If it goes up but cash flow from operations is steady, it may indicate the company is making this number look good by decreasing capital expenditures (in mature business, this is not as large an issue)
  5. Business begin to diversify. Other than Wal-Mart, there is no such thing as a category killer business anymore. Businesses make money by dominating a niche or industry (hence, the hue and cry to break up GE). Transcanada is now a model dividend paying stock but it began to diversify several years ago, ended up doing nothing well and slashed the dividend. Bombardier in the early 2000′s built railway cars, airplanes, snowmobiles and engaged in financing. It did none of them well and the company had to slash its dividend as part of the restructuring process which saw non-core assets sold off. Brookfield Asset Management, speculated by some as a next dividend stock, only became market darlings once it began to focus on infrastructure and infrastructure asset management and sold off all of its non-core holdings. Most businesses have one edge to beat the competition. As soon as it takes its eye off of maintaining its edge, history shows it gets into trouble.

The above are early warning signs that a dividend paying stock may be going off the rails. In these times, its best to drill down beyond dividend yield and see what, in fact, the company is going to maintain and, hopefully, boast your dividend payment.

1 Comment on 5 troubling signs for dividend/income trust investors

By Tax Resource Blogger on August 24, 2008 at 9:41 pm

One thing that often concerns me about income trusts is the underlying potential liability risk. You OK if the trust owns shares but what if the trust just runs the business?

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