Like most investors, I'm usually looking for the safest and most attractive income streams. I search for stocks offering the highest yields, most reliable income and best opportunities for dividendgrowth.
But there is a flip side to this bright picture. Some stocks look like safe income plays on the surface, but are really ticking time bombs. These stocks pay out more in dividends than they earn. Eventually, funds run out and they are forced to cut the dividend.
For this reason, every income investor should know the warning signs of a stock in danger of a dividend cut. The most obvious sign is a dividend payout at or near 100% of earnings. That means every penny the company makes is supporting thedividend -- nothing is left over to re-invest in the business or pay back loans.
There are other danger signs to watch out for as well. Earnings power is key. If a company can't grow earnings, odds are that dividend growth will stall as well. Companies with large amounts of debt are especially risky, since they may end up cutting dividends to free up cash to pay creditors. A huge red flag is also companies that borrow money to fund the dividend. This may work as a temporary measure, but is unsustainable in the long-term.
With these risk factors in mind, I went in search of likely candidates for dividend cuts.
Barnes & Noble (NYSE:BKS)
On the surface, Barnes & Noble looks attractive. After all, it offers a $1.00 dividend and rich yield. But looks can be deceiving. This bookseller faces eroding sales and growing competition from the likes of Amazon.com (NASDAQ:AMZN). Barnes & Noble recorded consecutive quarters of operating losses and cash flow of only $29 million in the last three quarters. This fell far short of the $43 million it needed for dividend payments. Debt is high at $630 million and cash reserves are small at only $27 million. Barnes & Noble is exploring "strategic alternatives," which usually means seeking a buyer. The most likely suitor, Borders (BGP) would eliminate the dividend entirely.
Nucor Corporation (NYSE:NUE)
Steel-maker Nucor has been plagued by soft demand from construction markets in 2010. Company management says this year's fourth quarter could be its most challenging. Nucor made a token one penny increase in the annual dividend to $1.45 this month, but the current rate isn't sustainable if Nucor's markets don't rebound soon. At present, the dividend payout rate for Nucor is 225%. The company produced $448 million of cash flow in the past 12 months -- less than the $500 million needed for dividend payments. Nucor has a $2 billion war chest to cover shortfalls for a while, but the dividend could be in jeopardy next year if cash flow doesn't improve.
Anworth Mortgage Asset Corp (NYSE: ANH)
Yields that look too good to be true usually are, and such is the case with Anworth. This investor in mortgagebacked securities was hit hard by the mortgage market meltdown. Anworth's per share earnings fell to only $0.66 in the first nine months of 2010 and analysts estimate full-year earnings will be only $0.88. At that level, Anworth can't cover its $0.92 annual dividend. With payout at 102%, the risk increases for a dividend cut. Anworth has only $2.1 million of cash to cover shortfalls until the mortgage market improves and few are anticipating much of a recovery next year.
World Wrestling Entertainment (NYSE:WWE)
The last time World Wrestling Entertainment hiked its dividend was three years ago, and this company's financial performance has turned lackluster of late. While operating income rose modestly during the past nine months, this company's cash flow, a far better measure of its ability to pay the dividend, declined sharply to $28 million. World Wrestling has already paid $62 million in dividends this year. With payout exceeding cash flow twice over, there is a risk the $1.44 annual dividend may be cut.
Atlantic Power Corporation (NYSE:AT)
Independent electric power producer Atlantic Power produced income of only $6.8 million in the first nine months of 2010 and $31 million of operating losses last year. Consensus analyst estimates look for earnings of just $0.15 this year and $0.97 next year. Atlantic Power has a $1.07 annual dividend, so it won't be covering dividend payments from earnings anytime soon. Cash flow paints a slightly rosier, but still troubling picture. Atlanta reported $49.8 million of cash available for distributions this year, which just barely covers $48 million of dividend payments. But the payout rises above 100% in the fourth quarter because of an October stock offering that adds 9% to the share count.
Action to Take --> Looking at dividend payout and other danger signs can help ferret out stocks at risk of a dividend cut. If you hold any of the above stocks, beware. A dividend cut may be on the horizon, which is the last thing an income investor wants.
Portfolio risk can be reduced by diversifying your stock holdings across sectors and countries. For instance, if you held only financial stocks, your dividend income would have plummeted during the recession when once-reliable payers like GE (NYSE:GE), Bank of America (NYSE:BAC) and Citigroup (NYSE:C) were forced to cut dividends. Investors who held a mix of stocks from a variety of industries fared much better and suffered much smaller declines in income.
Lisa is a stock analyst with nearly 25 years of investment research experience. She earned a MBA in Finance from the University of Chicago in 1987.
This article originally appeared on StreetAuthority
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