When Issuing A Dividend Can Be Dangerous

The broken piggy bank - dangerous dividends The following post is written by Hank Coleman at MoneyQ&A.

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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35 Responses to “When Issuing A Dividend Can Be Dangerous”

  1. MoneyCone

    Feb 21. 2012

    A responsible company has to balance its obligation to its shareholders and to its customers at the same time growing the company.

    When the hoopla about dividend paying companies die down, only the most responsible survive.

    Always pay attention to where the dividend is coming from. Thoroughly enjoyed this post!

    • The Dividend Ninja

      Feb 21. 2012

      MoneyCone I enjoyed the post as well. Hank is an awesome writer – he really knows his stuff!

  2. Hank

    Feb 21. 2012

    Thank you! You are both very kind. I’m really looking forward to writing more for the Dividend Ninja!

  3. Modest Money

    Feb 21. 2012

    Hi Hank. Good to see you over on Dividend Ninja too. Issuing dividends when a company is not in a financial position to do so is a bit of a sneaky move. They know that lots of investors will not take the time to see whether that company can actually afford to give out dividends. Many people will just see the dividends are coming in and will not bothering to look into it further.

    • Hank

      Feb 21. 2012

      You are right. Borrowing in order to pay their dividend or not painting their finance picture honestly as to where their dividend is finance from is definitely sneaky. Some people go as far as listing it as a financial shenanigan one step below accounting fraud.

  4. spbrunner

    Feb 21. 2012

    I agree and thanks for a post that might just educate some dividend investors.

    Unfortunately, the market can really hammer a stock paying company that has the temerity to decrease dividends. Over the long term companies can have problems or may need to restructure. A company’s problems may not be of its own making. This last recession has really been hard for a lot of companies.

    Investors can be very harsh and unforgiving of a company that touches the dividend. We need to get away from that and look at any changes logically. But a lot of investors are quite happy as long as dividends are not touched and they often do not seem to care where the money to pay them comes from

    • Hank

      Feb 21. 2012

      @spbrunner I actually disagree with you a little bit about your argument. I think that companies deserve to get hammered when they lower or discontinue paying out their dividends. Classic finance states that a company’s share price is the present value of all its future earnings including dividends. If a company lowers dividends for whatever reason, their share price deserves to go down. What we need to encourage as a society and shareholders though is that we would rather a company bite the bullet and decrease its dividend if it needs too instead of succumbing to financial schemes and borrowing simply to keep their dividend.

      • spbrunner

        Feb 22. 2012

        Personally, I like to look at cases individually and decide on Buy, Sell, Hold or ignore.

        But do not get me wrong. I do not mind that other people think differently. It was because of this I was able to pick up TransCanada at a very good price on a dividend decrease.

  5. Poor Student

    Feb 21. 2012

    Borrowing to increase a dividend is a terrible idea, I think anyone can see that. I never even would have thought companies would do that. How do you go about finding out that companies are doing this?

    I love dividends but they also make me very wary when I start to see yields that are too high or when dividends are being paid when it doesn’t appear to make sense.

  6. The Dividend Ninja

    Feb 21. 2012

    Hank thanks for the excellent post! At the end of the day I think it is extraordinarily difficult for the average investor to look at the balance sheets or cash flow statements and tell what is really going on.

    Companies dilute their shares to increase earnings (i.e. use share buybacks), use different measures to analyze payout ratios etc. For many companies it seems to just be a printing press, when they need more cash just issue some bonds or preferred shares. Of course they can continue to pay and increase the dividends ;)

    As David Trahair points out in his new book, Crushing Debt, never before haev we seen so much debt even at the corporate level.

    Excellent post Hank…
    Welcome aboard!

    Cheers
    The Dividend Ninja

  7. My Own Advisor

    Feb 22. 2012

    Good post Hank!

    While I agree it’s dangerous if some companies borrow to pay shareholders, I suspect for large, established blue-chip companies this practice is quite rare.

    I’d like to see some statistics on that – that would be interesting.

    It’s not uncommon for some utility companies to be deep in debt, but still pay a dividend, since their capital expenditures are huge and significant, for infrastructure purposes. That said, does it mean folks won’t be paying their gas bills, their hydro bills, their water bills? Highly unlikely – so the dividend is rather safe, in relative terms.

    I love dividends, but this where other metrics need to be watched, like payout ratio. Take SLF (Sun Life) for example. Their dividend is not sustainable at current levels. Don’t know what I’m going to do, when they eventually cut their dividend.

  8. AverageJoe

    Feb 22. 2012

    You’re right. Investors often are so enamored with the dividend increase that they forget to do their homework. Nice piece, Hank! Great guest post, TDN! Thanks!

  9. MyMoneyDesign

    Feb 23. 2012

    Is there ever a general ratio you look for to tell if a company is just paying a dividend to pay it even though they probably shouldn’t? You somewhat hint at this with your FLIR example.

  10. JP @ Novel Investor

    Feb 24. 2012

    Some great advice. Reminds of NAT, a shipper that has been consistently issuing new shares the past few years (diluting its shareholders) in order to maintain a dividend that should have been cut two years ago. Several years ago, MSFT took on several billion in debt only to turn around and issue a special dividend. It may seem good for the shareholders but in reality are they good moves for the company now and several years down the road. Doubtful, I’d rather have a company cut or suspend its dividend than take unnecessary measures just to make shareholders happy.

    • Hank

      Feb 24. 2012

      Microsoft is a very interesting issue. They borrowed money at a very low interest rate to pay dividends to its shareholders so the company would not have to repatriate income back to the US that it earned overseas. Even though Microsoft has almost $37 billion in cash and cash equivalents, it is almost entirely overseas and not in the US. Microsoft’s dividend has more to do with political environment in the US than the company’s financial health. This is one example of how due diligence when investing and investigating pays off and bucks the trend talked about in this article.

      http://www.bloomberg.com/news/2010-09-13/microsoft-is-said-to-plan-debt-sale-to-pay-for-dividends-buy-back-shares.html

      • JP @ Novel Investor

        Feb 24. 2012

        I agree that MSFT was an interesting issue. If the company brings the cash back, that money is potentially triple taxed, once dividends are paid (foreign, US and income taxes). Not good for shareholders and it’s not the only dividend paying company with a large cash horde overseas.

        Which brings up the question are shareholders better off with a company borrowing money to pay dividends (special or not) in order to avoid additional taxes? And if so what is the interest rate cutoff, if there is one, where it’s no longer profitable from a shareholder perspective?

        That said, you are absolutely right, due diligence is required when investing. Something that can’t be said often enough.

  11. Nice post Hank. Love the discussion too.

    Apple is probably facing a similar thing as Microsoft with money oversees and the demand for dividends from investors.

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