The Shocking Truth About Big Dividends

Adem is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

There's a shocking truth about dividends, one that you might not want to hear. The big truth, about big dividends, is that they're not as safe as you'd think. 

The shocking truth about dividends

Not all dividends are good dividends, and some companies are killing themselves by raising their dividends. Over time, dividend stocks do out perform the market as a whole. But, as I've written previously, a company's ability to cover their dividend payment actually matters more than what the yield is.

Just think about all the things that can go wrong when a company pays a higher dividend than it should:

Misallocated funds

When a company pays you a dividend, they're giving you money instead of putting it someplace else. Now that may sound simple but, for some reason when it comes to stocks, it's all too easy to forget.

It seems obvious that only the most profitable and successful businesses should pay large dividends. So then why does a company like Wendy's (NASDAQ: WEN) pay a $0.20 dividend and a 2.53% yield?

I love Wendy's burgers, but even the most ardent square burger aficionado would have to admit that the company has trailed industry leaders like McDonald's for eons. Wendy's is a business that essentially has no competitive advantage. It offers the same food as McDonald's and Burger King for lunch, without the impressive breakfast business. 

The burger flipping giant earned a profit of $0.17 per-share last year, and this year $0.23 is projected. At the moment, Wendy's is paying nearly all of the profits it's making back to shareholders. That may sound generous, but it's very dangerous for shareholders.

Follow me for a moment, Fools, for a brief hypothetical. Let's pretend you own and run a local restaurant. If you did, and you were competing against larger, and better positioned, competitors you'd have many places to spend the profits you earned. Advertising, food costs, and even skilled staff would be needed. But I doubt you'd pay every dollar of earnings to the owners (yourself and investors), not if you wanted to survive, yet that is exactly what Wendy's is doing at the moment. 

Perhaps Wendy's will change course but, with so much competiton and stagnant growth, this is clearly a misallocation of shareholder funds. At best this strategy will prohibit Wendy's from rapid growth and, at worst, it could materially impact its cash position. 

Dividend cuts killed this communications star

For years, Frontier Communications Corp (NASDAQ: FTR) has tried to lure investors in with a lofty dividend. This provider of cable, Internet, and phone services has left its dividend high amid earnings woes. Frontier, in many ways, is a case study of what can happen after shareholder funds are misallocated. 

In 2012, amid declining earnings and an unsustainably high payout ratio, Frontier was forced to cut its dividend by 60% and its shares sank. Investor's who chased the lofty yield that Frontier provided, were ultimately chasing a mirage. Clearly this company was paying an unsustainable dividend, but its unclear if it has learned its lesson.

Frontier Communications still seems fixated on offering an unhealthy dividend to attract investors. The company currently pays out a whopping yield of 8.77%, which seems great until you look closer. The dividend is $0.40 per share, much more than the company is earning or projected to earn going forward.

Since 2008 earnings at Frontier Communications have declined 26%; it is clear that the company is fighting to keep its head above water. So why not cut the dividend altogether for the time being and use the funds to turn around the business? It's a tough sell, but it's in the best interest of investors.

Contrast this example with Nuance Communication (NASDAQ: NUAN). Nuance is actually coming off of tremendous earnings growth, and revenue growth of 25%, in 2012 but its earnings have stumbled recently. This company provides the voice technology that powers Apple's "SIRI," and with that high profile and record earnings it could have easily paid out a dividend last year. 

If Nuance had paid a dividend, however, it would be in a much worse position today. With the extra funds devoted to R&D, Nuance has increased its presence in new technologies like "Smart TV's." 

These are two very different technology firms. Nuance is on the cutting edge of voice communication technology, while Frontier Communications is in a slow growth, rural, business. But I also think that these companies have responded very differently to tough times. One has continued down a path of unsustainability, while the other has re-invested in innovative technology. 

I probably don't need to tell you that I prefer Nuance's approach and, with Carl Icahn increasing his stake dramatically, I'm not the only one. 

Choose sustainability

Few things in life are as misleading as dividends. If dividends were a person they'd be a former childhood star, seemingly adorable and pleasant when they're small, but reckless and dangerous when they become too big, too fast.

There's nothing wrong with a check in the mail via a fat dividend, but when a company pays out too much of its earnings something is almost always wrong. By contrast, low pay-out ratio dividend stocks typically outperform the market. 

You should choose sustainability, and avoid the lure of recklessly high dividends. 

 

If you're an investor who prefers returns to rhetoric, you'll want to read The Motley Fool's new free report "5 Dividend Myths... Busted!" In it, you'll learn which stocks provide premium growth and whether bigger dividends are better. Click here to keep reading.


Adem Tahiri has no position in any stocks mentioned. The Motley Fool recommends Nuance Communications. The Motley Fool owns shares of Nuance Communications. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus