A Suspicious Dividend Yield
William is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
When I see a high dividend yield, I can’t help but be a little suspicious. A high yield can come from a justifiably low stock price, a special dividend payout, or lower cash reserves that will ultimately make the dividend unsustainable.
When looking at a company with a high dividend yield, investors must pay attention. In addition to the fundamentals, they need to consider the dividends paid out as compared to free cash flow, the cash and equivalents on the balance sheet, and the dividends as compared to net income.
Here are three different companies with a dividend yield 4% and above. Let’s see whether each can sustain its yield.
American Greetings (Dividend yield: 4%)
American Greetings (NYSE: AM) paid out $23 million in dividends last year. This equates to 44% of free cash flow and 18% of cash on their balance sheet. The dividend payout ratio of 41% sounds good -- until you start to look at the fundamentals.
Revenue, free cash flow, and net income declined 5%, 42%, and 69%, respectively, over the past five years. American Greetings may be able to pay a 4% dividend now, but can it keep that up? E-commerce is making the paper greeting card obsolete. Why go out and buy an expensive greeting card when you can subscribe to an online service for a low flat fee? The dividend sustainability here is shaky at best.
Cal-Maine Foods (Dividend yield: 4.8%)
Cal-Maine Foods (NASDAQ: CALM) sells nothing but eggs. Brand names you may or may not recognize include Egg-Land’s Best, Farmhouse, and 4-Grain. They also have an unusual dividend policy (so interesting that two fellow Fools AnnaLisa Kraft and Morgan Housel also wrote about it), in which they pay only 33% of the previous quarter’s net income. For fiscal year 2012, Cal-Maine Foods paid out 28% of the free cash flow for that year and 8% of cash and investments on its balance sheets.
Looking at their dividend history going back to 2008, you can see that they paid out a different amount every quarter. Their variable dividend policy reflects the “cyclicality of the egg industry” as you can see from the chart below. Right now, you have a mouthwatering dividend yield of 4.8%. But if the egg business heads south, the dividend yield will head down with it.
GameStop (Dividend yield: 4.4%)
GameStop (NYSE: GME),a retailer of video games, started paying a dividend this year. GameStop’s year-to-date cash flow was negative, making it impossible to compare the dividend to cash flow. But the dividend can be compared to cash on the balance sheet, as well as net income. Year to date, GameStop paid out $40 million in dividends. This equates to about 29% of cash on the balance sheet, and about 43% of year to date net income.
This sounds great, but some Foolish people have suggested that GameStop is going through a period of obsolescence as people abandon packaged games in favor of online gaming created by the likes of Zynga. Why invest in a business on the basis of a dividend yield if people are going to quit buying the product in a few years?
American Greetings and Gamestop are in a state of decline due to obsolescence brought on by e-commerce. Greeting cards are being replaced by e-cards. Packaged games are being replaced by online gaming. The dividend of Cal-Maine, while pretty attractive, will more than likely fluctuate because of the varying profitability and cash flow inherent in the egg business.
When you see a high dividend yield, make sure you compare the total dividend payout to the free cash flow, cash and equivalents, and net income. Then pay attention to the business represented by the ticker to check up on fundamental volatility, and determine whether or not demand for their products is in a state of decline. Long-term investing is the Foolish way.
stockdissector has no positions in the stocks mentioned above. The Motley Fool owns shares of American Greetings and GameStop. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.