Know the funding behind dividends

By DAVID MOON, Moon Capital Management, LLC
September 16, 2012

Imagine a family that regularly spends more than it earns each year. By regularly increasing their home equity line of credit they create the illusion of affluence, going on ever-more extravagant vacations, dining out nightly and making jaw-dropping gifts to charitable organizations.

As we now know, that type of behavior disastrously laid the groundwork for the 2008 credit crisis. It is a financial scheme that works perfectly – until it quits working.

You might be surprised where else you find unbalanced balance sheet management –where borrowed money is freely distributed.

And no, I’m not talking about the U.S. federal government. That’s too easy.

A number of high dividend paying companies are using leveraged ploys to create the illusion of prosperity – and many of the companies’ shareholders don’t have a clue of the risks they’re taking.

Investors are seeking safe havens and alternatives to bonds as traditional income vehicles. The problem is that a number of companies that pay apparently attractive dividends do not generate enough cash from operations to fund those dividends. They are borrowing the cash to pay shareholders each year – the equivalent of putting it on a credit card.

In the past five years Duke Energy has spent $2.8 billion more on operating and capital items than it has generated in operating revenues. In that period it paid a total of $6 billion in dividends. How did Duke do it? By borrowing $9.9 billion over those five years. How safe does that 4.70 percent dividend yield look, especially if the company eventually pays higher interest rates on debt that now equals 47 percent of its capital base, up from only 35 percent four years ago?

There are plenty of companies with enticing dividend yields that are engaged in this gambit. Entergy, American Electric Power, Southern Company, Sysco, Meadwestvaco and Dr Pepper Snapple are examples of companies paying dividends in excess of 3.40 percent, yet none of them generate enough cash to fund that dividend.

We recently identified more than 500 companies that don’t earn the cash they distribute as dividends.

As long as a company makes enough money to service its interest costs and required principle payments, shouldn’t this perpetual debt strategy work fine?

That’s the same faulty, contorted logic used by a generation of unqualified borrowers and (at best) incompetent mortgage lenders.

One risk of the borrow-yourself-into-dividend-prosperity strategy is that the operating income of a company might slow to the point that it struggles to pay its bills and fund the dividend. When this happens, it is pretty common to see the company reduce or completely eliminate its dividend. J.C. Penney paid a 3.00 percent dividend yield – that is, until it completely eliminated its dividend in May 2012.

Another risk is that a company’s higher debt levels may be manageable at historically low interest rates, but even slight rate increases can swing a marginal company from profit to loss.

And don’t think that because you own mutual funds instead of stocks that you aren’t exposed to this risk. Ask your advisor if any of your funds’ own stocks with this problem.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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