4 Dangerous Dividend Stocks to Avoid for Retirement

by Will Ashworth | October 30, 2013 11:53 am

4 Dangerous Dividend Stocks to Avoid for Retirement

no note 630 300x253 4 Dangerous Dividend Stocks to Avoid for RetirementHow do you tell if a company’s dividend is unsustainable?

Some look at the current yield in comparison to its peers. If we are talking about the packaged goods industry, for example, and Company A has a yield of 15% while Company B’s is 3%, most likely there’s something’s wrong with Company A’s business, thereby reducing the value of its stock.

Others look for an unusually high payout ratio. So, if Company A pays out 75% of its earnings in the form of dividends while Company B dishes out just 37.5% of its earnings, it’s possible Company A has an earnings issue, and the dividend may be in trouble.

Income expert Roger Conrad uses free cash flow[1] rather than earnings when examining a stock’s payout ratio. All things being equal, free cash flow is a much better indicator of a company’s overall health.

Using the FCF ratio as my guide, here are four stocks that possess an unsustainable dividend. Each of these companies has big problems — income-seeking retirement investors beware.

Too Much Debt

windstream185 4 Dangerous Dividend Stocks to Avoid for Retirement

Windstream Holdings’ (WIN[2]) net debt sat at $8.9 billion as of the end of June. That’s more than nine times shareholder equity. See, right there I’d be on to the next stock.

Cloud computing is a big deal these days, so I get the sexiness of its business — but when interest eats up almost 75% of its operating income, you have to at least second-guess its long-term viability, let alone keeping the dividend at 25 cents per quarter.

WIN’s free cash flow for the trailing 12 months is approximately 99 cents a share, while it pays out $1 in dividends. That’s right — it’s currently paying out 100% of its free cash flow in the form of dividends, leaving nothing for debt repayment, acquisitions, working capital or its $400 million underfunded pension. Eventually this will come back to haunt it. (By comparison, Frontier Communications (FTR[3]) pays out 53% of its free cash flow annually, leaving it with almost $400 million for other things.)

Windstream’s 11.7% yield is a ticking time bomb for retirement investors.

Up in Smoke

VectorGroup185 4 Dangerous Dividend Stocks to Avoid for Retirement

Cigarette manufacturer Vector Group (VGR[4]) has paid out a 5% stock dividend every September since 1999 in addition to its regular quarterly cash payment. As a result, share count over the past 15 years has grown by 233% to 90 million outstanding at the end of 2012. In the same period, its operating income has increased by just 109%, suggesting that its dividend payouts are increasing at an alarming rate in comparison to its earnings growth.

In 2013, it expects to pay out $246 million for its interest expense and dividends. With only $155 million in operating profits to cover these two items, its debt continues to swell.

At the end of the second quarter VRG had $929 million in total debt — almost 400% greater than when it began its 5% stock dividend back in 1999. The argument for an investment in VRG is that its combination cash/stock dividend program allows you to earn 12%-15% annually.

That’s true enough.

The big downside here is that there doesn’t appear to be any upside to its revenue. Eventually, it’s going to run out of ways to cut costs … and when that happens, its growing interest expense will force it to reduce the cash portion of its dividend payout. Although it hasn’t had to do that just yet, it can only go so long before this house of cards caves in on itself.

Its cash yield of 9.7% plus the additional 5% stock dividend is awfully enticing. At the end of the day, however, it’s important to remember we’re talking about a company that sells discount cigarettes. Eventually people will come to their senses and stop buying them. When that happens, owning 50% of real estate shop Douglas Elliman is not going to be its savior.

Patents Expiring 

PDL 4 Dangerous Dividend Stocks to Avoid for RetirementSearch as you may, but there are scant investment possibilities in the health care sector when it comes to high-yielding stocks appropriate for retirement. The only option over 5% is currently PDL BioPharma (PDLI[5]) at 7.1%. While it’s definitely an enticing yield, it comes with a whole slew of concerns that you won’t get investing in something like GlaxoSmithKline (GSK[6]), which yields more than 4% annually. Sure, you’re not going to hit a home run with your capital, but you won’t be facing the prospect of almost your entire licensing royalties disappearing at the end of 2014.

PDLI needs to replace the royalty revenue it’s losing from Roche (RHHBY[7]) and Biogen (BIIB[8]). Thus, it’s gone a buying binge in search of new licenses it can purchase and then farm out to bigger firms like Merck (MRK[9]), which sold $1.6 billion of Janumet (Type 2 diabetes) in 2012.

Currently, PDL’s free cash flow for the trailing 12 months is $251 million, for a FCF payout ratio of just 36%. That’s the kind of payout ratio income investors should be shooting for. Unfortunately, the ratio comes with an expiration date 14 months out … which places a great deal of pressure on its future deals. If PDL BioPharma doesn’t do enough by the end of next year, its management will simply wind down the business.

I’m not a pharma expert, so I don’t know the likelihood of that happening. Nor do I understand the industry well enough to know with certainty that the next 14 months will lead to a successful transition. But I do know there are safer yield options in the health care sector — and unless you can afford to speculate with your retirement account, I’d stay away from its enticing yield. It could be gone with a flip of the switch.

Hang Up the Phone

oi185 4 Dangerous Dividend Stocks to Avoid for Retirement

It’s been a difficult year for Oi SA (OIBR[10]), Brazil’s largest landline operator, whose stock is down 44% year-to-date through Oct. 29 — a 70-percentage-point swing from the S&P 500. Over the past five years it’s achieved an annualized total return of -11.2% compared to 12.8% for the iShares Latin America 40 ETF (ILF[11]). Brazil’s pension funds can’t be too happy about this situation.

The company’s board had finally seen enough by late January, firing CEO Francisco Valim and replacing him in June with Portugal Telecom (PT[12]) veteran Zeinal Bava. The CEO has implemented a new business strategy that includes cutting the dividend payout in 2013 by 75% to $228 million from the $913 million originally forecast. It will continue with this reduced amount through 2016.

Oi SA has $13.5 billion in net debt as of the second quarter, 26% higher than Q2 2012. Bava needs to seriously conserve cash. While Oi SA has cut the dividend as far as it can without sacrificing its corporate objectives, I have to think dropping it entirely will still be a consideration if it can’t improve free cash flow substantially over the next few quarters.

Yes, its yield of 22% ($228 million in dividends divided by 546 million ADS-equivalent shares equals 42 cents divided by share price of $1.87) is incredibly enticing. However, many analysts in Brazil are recommending clients avoid its stock until it does what it says it’s going to do. Analyst Andres Medina-Mora of Corporativo GBM SAB believes it will take years to unwind[13] the problems at the telecom.

Don’t fall for the rhetoric or the double-digit yield. It’s not sustainable. Either Oi SA will fold like a cheap suit or your yield will drop down to industry norms. Either way, it’s an aberration — and it’s definitely one to avoid for retirement.

As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.

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Endnotes:
  1. free cash flow: http://www.investingdaily.com/11135/sustainable-dividends-depend-on-the-payout-ratio/
  2. WIN: http://studio-5.financialcontent.com/investplace/quote?Symbol=WIN
  3. FTR: http://studio-5.financialcontent.com/investplace/quote?Symbol=FTR
  4. VGR: http://studio-5.financialcontent.com/investplace/quote?Symbol=VGR
  5. PDLI: http://studio-5.financialcontent.com/investplace/quote?Symbol=PDLI
  6. GSK: http://studio-5.financialcontent.com/investplace/quote?Symbol=GSK
  7. RHHBY: http://studio-5.financialcontent.com/investplace/quote?Symbol=RHHBY
  8. BIIB: http://studio-5.financialcontent.com/investplace/quote?Symbol=BIIB
  9. MRK: http://studio-5.financialcontent.com/investplace/quote?Symbol=MRK
  10. OIBR: http://studio-5.financialcontent.com/investplace/quote?Symbol=OIBR
  11. ILF: http://studio-5.financialcontent.com/investplace/quote?Symbol=ILF
  12. PT: http://studio-5.financialcontent.com/investplace/quote?Symbol=PT
  13. take years to unwind: http://www.bloomberg.com/news/2013-08-19/oi-ceo-bava-says-investment-plan-will-convert-skeptics.html
  14. Sign up for our Retirement Insights e-letter: https://order.investorplace.com/index.jsp?sid=CN8114

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