Wednesday, September 19, 2012

When Issuing A Dividend Can Be Dangerous

A dividend can actually be a huge red flag depending on where the company gets the money for it. If you know what to look for, a company paying or increasing its dividend is not always a good sign. How does your favorite dividend paying company get the money for those annual or quarterly payments? Have you seen the statement of cash flows and income statement? Do you bother to dig deep to learn as much as you can about the companies that you are investing in? You definitely should take the time to understand where the money is coming from. You need to know the balance sheet, statement of cash flows, and income statement inside and out of companies you potentially want to invest in. Anything less than thorough due diligence can leave you vulnerable. Here are two examples of companies issuing or increasing their dividend when they possibly should have considered other options.

Rising Dividends And Sinking Revenue

Investors love stocks that offer a dividend in both good times and bad. Dividends typically show investors that a company is financially sound and has the resources to payout a portion of its proceeds back to its shareholders. But, what happens when companies continue to issue dividends when revenue or profits are starting to lag? It is a red flag when a company raises dividends despite lower revenue or profits. For example, FLIR Systems (Stock Symbol – FLIR), the makers of night vision and infrared devices primarily for the US military recently raised their quarterly dividend by 17% despite its sales missing their Wall Street predictions this quarter by over $200 million. Even though revenue was down, the company boasted a 9% increase in profits in the fourth quarter almost solely because of operational cost cutting measures. There is only so much cost cutting measures that companies can continue to make before they reach the limit, and increasing their dividend even while revenue is slumping is not helping.

Borrowing To Pay For A Dividend

Publically traded companies can often find a better use for the cash on their books rather than using the money to increase dividends while they have a high debt loads. In most cases, paying dividends if they are still adding to their long-term debt can eventually lead to trouble. Companies are essentially borrowing funds to pay dividends to its shareholders instead of retiring its debt. For example, KB Home (KBH) has a dividend yield of 1.9%, over $900 million in cash on the balance sheet, and almost $1.8 billion in debt. KB Home continues to issue and increase its dividend despite the trying housing market and its debt load. If investors are not careful, there is a potential for company executives to manage their earnings in order to continue to pay dividends and increase their dividend payouts by using debt to the detriment of their long-term shareholders.

The Bottom Line





Most investors love dividend paying stocks because they are typically large, blue chip companies with slow and steady growth. Dividend paying companies provide a bit of comfort, safety, and conservatism to an investor’s portfolio. But, dividends are not always what they seem. There is an incredible pressure on corporate executives to continue paying dividends, to keep increasing dividends year in and year out, and keeping up the appearance of a healthy dependable company. Investors can be at risk if you do not dig deeply into how companies are continuing to raise their dividends and make payments in both good times and in bad and fluctuations to their revenue and profits.
What do you think? Is it okay for a company to borrow money to pay their dividend? Should companies continue to raise dividends each year because that it what is expected of them despite patches of declining profits or revenues?

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1 comment:

  1. When I evaluate a company to decide if I want to buy, one of the measures I consider important is the company's net income growth. I look at how the company's net income has performed, and how it is projected to do going forward. I will frequently dig through the management discussion sections of the 10Q and 10K reports, looking for the management's explanation of how they expect to continue to grow profits. If a company has had a short term drop in net income, I try to dig in to determine if it is a temporary setback (if it had to take some one time charges) and determine if this scenario appears likely to repeat.

    I do not have a problem with a company continuing to raise dividends despite a single "bad year", but one that is showing signs of trying to continue to do so despite strong headwinds tends to make me nervous. A specific example of this is Pitney Bowes. The company's 10.1% yield is very tempting, but I keep shying away. Their sales and net profits have been declining as the US Postal Service continues to lose sales, while their penetration into foreign markets to provide similar services to postal customers in other countries lags.

    That said, I plan to keep an eye on PBI as they are still profitable and management is trying to shift the company into new (and hopefully growing) areas. I'd be quite happy to buy this stock in a few years when the yield is significantly less if the company manages to finally get the company back to growing, but I won't invest today as such an investment would be far too risky.

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