Early Warning Signs of a Dividend Cut

Investors Dividend Growth Stocks look for stocks that will provide a predictable, sustainable and growing income from dividends. It is bad when a company fails to raise its dividend at its appointed time; However, it is much worse when a company cuts its dividend. In most cases the companies' investors should not have been surprised because there are usually early warning signs that foretold a dividend cut was imminent.

Here are three signs that a company is heading toward a dividend cut:

I. Change In Business Conditions

An abrupt or permanent shift in a company's business model as a result of business conditions could lead to a dividend cut. During the financial crisis, virtually all businesses experienced an adverse change in business conditions. However, the pertinent question is to what degree? Consider these four examples:

Gannett Co. (GCI) operates as a media and marketing solutions company in the United States and internationally. It operates through three segments: Publishing, Digital, and Broadcasting. With the mass adoption of the internet, traditional news outlets such as newspapers are experiencing a slow death. After several years of declining earnings, GCI cut its quarterly dividend in March 2009 from $0.40 per share to $0.04 per share. The company has paid $0.20 per share since In March 2012, half of what it was paying at its peak.

Pfizer's (PFE) is world's largest pharmaceutical company. However, in Feburary 2009 it wasn't "too big to fail." At that time the company cut its quarterly dividend from $0.32 per share to $0.16 per share. After years of unsuccessful attempts to get approval of a "blockbuster" drug, the cash rich company sought a merger partner with a good drug pipeline. In anticipation of it proposed combination with Wyeth, PFE cut its dividend. Since then, its dividend has increased to $0.24 per share.

CenturyLink, Inc. (CTL) operates as an integrated telecommunications company in the United States. It has aggressively grown over years with the acquisitions of Embarq, Qwest and Savvis. This growth has financially challenged the company; so much so, that it has left its quarterly dividend flat at $0.725 from March 2010 to March 2013 when the company cut its dividend to $0.54.

Pitney Bowes Inc. (PBI) is the world's largest maker of mailing systems, also provides production and document management equipment and facilities management services. Like GCI, the industry in which PBI operates has probably seen its best days. The decline in the mailing services industry is forcing PBI to reinvent itself. In May 2013 PBI gave in and cut its quarterly dividend from $0.375 to $0.188.

II. Dividend Yield Above Historic and Industry Norms

A dividend yield that is higher than average and/or higher than others in the industry are indications, not all is well with the company. The market is adjusting to compensate for the higher risk of holding the company. When dividend yields start creeping up, it is time to start evaluating if the company can continue to pay its dividend.

Consider Bank of America Corp. (BAC). Between 2000 and 2007 the company's dividend yield hovered in the 3%-4% range. In 2008, the dividend yield ranged from around 5% to the teens prior to its dividend cut. The same situation occurred with General Electric (GE) over the same period. GE's dividend yields from 2000-2007 normally were in the range of 1.5%-3.5%. However, in 2008 the dividend yield more than doubled as investors lost confidence in the company. Eventually, BAC and GE cut their dividends.

III. Diminishing Cash Available to Pay Dividends

Ultimately, the ability of a company to pay its dividend is determined by its cash position - both cash on its balance sheet and its ability to generate cash flow. All the companies above had one thing in common - a deterioration of cash flow available for paying dividends.

GCI's free cash flow peaked in 2004 at $1.3 billion. Since then it has declined in 5 of the last 7 years and was at $742 million in 2008. Though GE's free cash flow was increasing, the company was taking on significant debt. GE's debt increased from $201 billion in 2000 to $524 billion in 2008 and it could no longer afford its dividend.

A Look Ahead

Unfortunately, there will be more dividend cuts in the future. It is just part of the business landscape and the ever-changing economic tide.

One company I am watching carefully is Nucor Corporation (NUE). It is the largest minimill steelmaker in the U.S., Nucor has one of the most diverse product lines of any steelmaker in the Americas. Unfortunately, the prolonged economic downturn has taken it toll on NUE. Back in March 2009, Nucor Chairman, Chief Executive and President Dan DiMicco said in a statement, "The economy has fallen off a cliff -- and there is no visibility as to the timing of the recovery." Things have continued to deteriorate since then, currently the company's free cash flow payout is at the unsustainable rate of 876%.

Conclusion

The above three items will help you determine which companies are at risk of cutting their dividends. Cash is king, so pay special attention to free cash flows and debt levels. Buy and hold is not buy and forget - never take your eyes off your investments.

Full Disclosure: Long NUE in my Dividend Growth Portfolio. See a list of all my dividend growth holdings here.

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