With interest rates at historic lows, income investors have naturally gravitated to high-yield dividend stocks in recent years.
But while dividend investing has historically proven the best long-term way of growing one’s income and wealth, you must be careful of avoiding dividend value traps (companies whose yields are high for good reason).
One way to avoid high-dividend traps is to thoroughly dig through a company’s key financial statements to understand if its cash flow can support its dividend while also meeting needs for growth investments and keeping the balance sheet healthy.
Many investors don’t have the time or knowledge to properly assess a company’s dividend risk. That’s one reason why we created Dividend Safety Scores, which comb through a company’s most important metrics to answer the question, “How safe is the current dividend?” Investors can learn more about how Dividend Safety Scores are calculated and review their real-time track record by clicking here. Some of the notable companies our Dividend Safety Scores have flagged as high risks of a dividend cut prior to their announcements include Kinder Morgan Inc (NYSE:KMI) and ConocoPhillips (NYSE:COP).
We used our Dividend Safety Scores to identify 10 high-yield dividend stocks that carry above-average risk of a dividend cut sometime in the future.
Today, we’ll look at each of these high-yielding names that are potentially too good to be true. The point: to discover what it is about each of these stocks that could make them a grenade waiting to blow a hole through your portfolio.
High-Yield Dividend Stocks to Avoid: Williams Partners LP (WPZ)
Dividend Yield: 9.9%
Williams Partners LP (NYSE:WPZ) is one of many midstream master limited partnerships (MLPs) that investors expected to supply generous, secure and growing distributions thanks to America’s shale oil and gas boom.
Unfortunately, the long-term fixed-fee contracts that underpin much of the MLP’s distributable cash flow, or discounted cash flow (DCF, what funds the payout), proved not as resistant to the oil crash as many had hoped.
This was due to Williams Partners’ heavy exposure to natural gas liquids or NGLs, which were not fixed-fee. Add in falling demand from gas producers (it has more volume risk than superior MLPs such as Enterprise Products Partners) and the need to negotiate lower rates with one of its biggest customers, Chesapeake Energy Corporation (NYSE:CHK) and Williams has struggled to maintain a sustainable coverage ratio.
That’s even with its sponsor, Williams Companies Inc (NYSE:WMB), recently slashing its dividend by 69% to support it through a major waiver of incentive distribution rights (IDRs).
Now in fairness to Williams, the last quarter’s coverage ratio was a secure 1.08. However, given the large backlog of projects the MLP will need to fund in the coming years (to grow its DCF and pay down its monstrous debt load), income investors still need to be wary of the security of the distribution.
After all, with a debt/EBITDA ratio of 15.6, Williams’ creditors could easily force it to cut the payout if energy prices don’t quickly recover.
High-Yield Dividend Stocks to Avoid: BP plc (BP)
Dividend Yield: 6.9%
As one of the world’s largest integrated oil majors, the fact that BP plc (ADR)’s (NYSE:BP) shares have been bloodied over the past few years thanks to the worst oil crash in more than 50 years is hardly a surprise.
However, while the yield on BP shares may appear attractive, investors need to keep in mind that the income investing thesis for this stock is predicated on oil prices quickly recovering to much higher levels, and staying there.
That’s because BP’s current cash flows have been hammered by low oil prices, so the company has been paying its dividend with a combination of asset sales and debt. That has resulted in one of the highest leverage ratios of all the oil majors — 5.9. That’s nearly double the industry average of 3.04.
And while BP isn’t the only oil giant to pay out dividends through taking on debt — Exxon Mobil Corporation (NYSE:XOM) and Chevron Corporation (NYSE:CVX) have been doing the same — the difference is that those companies started out with much stronger financial positions.
In addition, Exxon and Chevron have historically had much better management, with stronger capital allocation skills that have resulted in both better returns on shareholder capital (and profitability), as well as more consistent dividend growth records.
In fact, both XOM and CVX are dividend aristocrats, which means if you want to own a blue-chip oil giant as a potential long-term investment in an oil recovery, these two are far better choices than BP.
High-Yield Dividend Stocks to Avoid: Annaly Capital Management (NLY)
Dividend Yield: 10.1%
Annaly Capital Management, Inc. (NYSE:NLY) is America’s largest mortgage real estate investment trust (mREIT). And while Annaly has an impressive long-term track record — 11.1% CAGR total returns vs the market’s 6.2% since 1997, when it came public — there are some major headwinds to Annaly being a good dividend stock in the coming years.
Most notably, rising interest rates will put a lot of pressure on the mREIT’s ability to cover its quarterly dividend of 30 cents per share. That’s largely due to higher interest rates creating higher funding costs in the repurchase market (Annaly’s key source of funding).
On the plus side, a steeper yield curve could mean higher earnings on new loans the mREIT invests in, but there is a the issue of declining book value to deal with. Specifically Annaly — which is mostly invested in agency backed (i.e., government-insured) residential home mortgage-backed loans — will see the value of its loan book under a lot of pressure as rates rise.
While NLY has hedged against some of this risk, Annaly remains highly interest-rate-sensitive. In fact, in its most recent quarter, its interest rate sensitivity to a 75-basis-point increase in long-term rates actually increased by 1 percentage point to 6.6%. That means the value of its net assets will fall by about 8.8% per 1% increase in interest rates.
Since mREITs have to pay out the majority of earnings as dividends, it must tap both debt, and equity markets for growth capital. A rising interest rate environment will make both more challenging, especially since mREITs generally track their net asset value per share.
To give NLY credit, management has spent the last few years diversifying its business away from pure agency backed debt and into commercial mortgage and middle-market loans. This could eventually help Annaly achieve some cash flow stability, but in the short to medium-term shareholders have to be ready for some potentially painful dividend cuts.
High-Yield Dividend Stocks to Avoid: CenturyLink (CTL)
Dividend Yield: 8.9%
CenturyLink Inc (NYSE:CTL) is one of the several regional telecoms that are nothing more than value traps. This is a result of the secular decline in legacy hardline telephone services that have forced the company to attempt to grow through acquisitions of things like broadband internet and data centers.
Unfortunately for shareholders, better funded and larger rivals such as AT&T Inc. (NYSE:T) and Verizon Communications Inc. (NYSE:VZ) have steadily eroded CenturyLink’s market share and margins over the years.
What’s worse, the large amount of debt the company took on to acquire rival rural telecom rivals (such as Embarq in 2008 and Qwest in 2011), not just haven’t been able restart growth, but in fact forced a dividend cut in 2013.
Even worse? The company’s junk credit rating means higher costs of capital that will only make achieving profitable future growth all the harder.
Yet even with the lower payout, CenturyLink has struggled to maintain the security of the lower dividend. With a FCF payout ratio that continues to rise (47% over the last 12 months) and a higher-than-average debt load, CenturyLink faces major challenges when it comes to defending its new core markets against the threat of 5G wireless broadband internet against titans like AT&T and Verizon.
While the current payout may not be in imminent peril, this is another case in which management will probably need to cut the dividend in the future to attempt to remain relevant in a highly capital-intensive industry thanks to a lack of economies of scale.
High-Yield Dividend Stocks to Avoid: GlaxoSmithKline (GSK)
Dividend Yield: 5.5%
GlaxoSmithKline plc (ADR) (NYSE:GSK) is one of those high-yield pharmaceuticals that may initially appear like a solid dividend holding, until you dig deeper and see numerous red flags that make it a blue chip to avoid.
For one thing, Glaxo has struggled for years to grow its top line. While revenues did grow year-over-year in 2015, that figure still is off nearly 10% from three years ago. That’s mainly due to the loss of patent protection on some of its main cash cow drugs such as Advair which represents 15% of total sales. Increased generic competition has meant that GSK has had to focus increasingly on cost-cutting measures to try to maintain its earnings and cash flow.
But even those efforts haven’t been enough.
For example, the FCF payout ratio has climbed to an unsustainable 132%, and the company has had to fund more and more of the payout with debt. That has contributed to a massively leveraged balance sheet with a debt/EBITDA ratio of 5.1, more than double the industry average of 2.25.
This puts dividend lovers in a tough spot with Glaxo. On one hand, the large development pipeline means that the company has the potential to restart sales growth, but it will likely mean having to redirect cash flow from dividends to R&D efforts.
In other words, management is likely to have to make a hard choice between short-term pain and long-term gain, and investors owning Glaxo for income and payout growth are likely to be disappointed in the coming years.
High-Yield Dividend Stocks to Avoid: AstraZeneca (AZN)
Dividend Yield: 5.2%
AstraZeneca plc (ADR) (NYSE:AZN) is one of Europe’s largest drug makers, and I’ll admit that at first the yield, which is among the highest 3% of global pharma companies, appears tantalizing.
But it’s very important to remember that successful dividend investing is about more than just a high current yield. Investors also need to look at the two other factors: dividend safety and long-term growth potential.
From that perspective, AstraZeneca looks far less attractive. For example, its trailing 12-month EPS and FCF payout ratios are a dangerously unsustainable 140% and 236%, respectively. Which basically means that the company is having to dip into its $6.8 billion in cash reserves to pay the current dividend, which hasn’t grown since 2011.
And with AstraZeneca facing stiff top- and bottom-line headwinds thanks to the upcoming patent expirations on two of its largest, and most profitable drugs — Nexium and Crestor — the company’s current focus on cost cutting is badly needed just to keep the current payout going.
In other words, while AstraZeneca’s yield may be among the highest in its industry, there is good reason for that. With numerous growth challenges ahead, and superior pharma companies to choose from — such as Pfizer Inc. (NYSE:PFE), AbbVie Inc (NYSE:ABBV) and Johnson & Johnson (NYSE:JNJ) — long-term dividend growth investors should probably avoid this stock.
High-Yield Dividend Stocks to Avoid: Ericsson (ERIC)
Dividend Yield: 8.2%
Telefonaktiebolaget LM Ericsson (NASDAQ:ERIC) — better known as just Ericsson — used to be one of the preeminent names in telecom equipment, but in recent years it’s struggled with falling market share.
In fact, between 2009 and 2015 it’s global market share fell from 33% to 27%, as low-cost Chinese rivals such as Huawei and ZTE have proven highly effective at undercutting its high-end products.
This has forced the company to try not one, but two corporate restructurings over the past five years to focus on cost cutting in an effort to stem the bleeding to its EPS and free cash flow. Those efforts haven’t proven successful, and while the company’s current strategy of focusing more on software-based services is the right move given where the industry is going, at the same time dividend investors have little reason to feel confident about the company’s distressed payout.
That’s because Ericsson has struggled with dangerously high EPS and FCF payout ratios in recent years. In fact, those have now risen to alarming levels of 81% and 132%, respectively, over the past 12 months.
And given that Ericsson’s new corporate strategy is one with far lower barriers to entry (and thus potentially even more cutthroat competition), it seems likely that ERIC’s dividend is likely to get a potentially severe haircut sometime in the future.
High-Yield Dividend Stocks to Avoid: GameStop (GME)
Dividend Yield: 5.6%
At first glance, GameStop Corp. (NYSE:GME) appears to be a pretty good high-yield dividend stock. After all, the yield is mouthwatering, and the EPS payout ratio of just 40% means that cash flow covers the current dividend almost three times over. Better yet, since the company began paying a dividend in 2012, it has grown it at an impressive rate of 16.6%.
But remember that our goal should always be to own companies for the long-term, and that means asking what kind of future growth prospects, as well as moat (competitive advantages), a company possesses.
GameStop’s core business model, in which it buys and sells new and used video game consoles, and games on physical disks is largely obsolete and likely to go the way of Blockbuster Video.
That’s because of two main factors. First, the upgrade cycle for video game consoles has gotten longer and longer and now measures about six years. That means that GME’s bread-‘n’-butter boom times now come less frequently.
More dangerous to the company’s prospect, however, is that the video game industry is now moving away from physical disks and towards online distribution. Since GameStop has built its brand around being the place to go to buy and sell old games, as major distributors such as Sony Corp (ADR) (NYSE:SNE) and Microsoft Corporation (NASDAQ:MSFT) move toward a more video games as subscription service, the company faces an existential threat.
The fact is that GameStop’s sales peaked in 2011 and its brick and mortar same store sales are falling at 6.5% annually. The company has only been able to grow EPS via a prodigious amount of buybacks (6.5% CAGR over the last five years), much of which has been funded by cost cutting from closing down stores. Which means that the days of dividend growth investors being able to rely on this paragon of a bygone era for growth is fast approaching an end.
High-Yield Dividend Stocks to Avoid: Westpac Banking Corp (WBK)
Dividend Yield: 5.9%
Westpac Banking Corp (ADR) (NYSE:WBK) is one of Australia’s four oligopolistic banks, which means it has strong government regulations minimizing its potential competition. This means WBK enjoys massive profitability, with a net margin of 35.5%, and return on equity of 13.4%. That’s about double the average of the global banking industry.
So why am I warning investors away from such a strong earnings and cash flow generator? Four main reasons.
First, much of those impressive profits are a result of the bank’s overleveraged balance sheet, represented by a debt/equity ratio of 3.2, about triple that of the industry average.
Second, all that debt is largely built up around the massive housing bubble that has continued to grow in Australia thanks to its impressive 25 years without a recession. But thanks to slowing growth from Australia’s main import partner, China, that streak may be about to end. Which could mean major trouble for the nation’s housing market, and rising default rates for Westpac Bank.
Let’s not forget that Westpac’s dividend has declined for four straight years, largely due to its sky-high payout ratio of 88%. With the risk of a recession growing to its highest level in a decade, and the bank trading at a 27% premium to its 13-year median yield (indicating it’s potentially greatly overvalued), the fact is WBK represents a relatively poor risk/reward ratio. That’s especially true given the very weak prospects for future dividend growth.
Lastly, we can’t forget that Australia has a 30% dividend tax withholding rate, which means Westpac’s yield is not nearly as attractive as it may initially appear.
High-Yield Dividend Stocks to Avoid: Telefonica (TEF)
Dividend Yield: 7.7%
Telefonica S.A. (ADR) (NYSE:TEF) is one of the largest telecom companies in the world with a dominant presence in Europe as well as fast-growing Latin America. However, the key risk factor for dividend investors here stems from two major factors.
First, this is a monstrously capital-intensive industry, and in order to compete in Latin America with America Movil SAB de CV (ADR) (NYSE:AMX) (the region’s largest wireless provider, and one with a stronger balance sheet), Telefonica has had to spend like crazy to maintain, expand and upgrade its network.
That has resulted in a lot of debt. And combined with increasing pricing competition from its many well-capitalized rivals, this has resulted in sales, margins and returns on capital declining steadily since 2007.
This has resulted in steady declines in dividends over the past few years, including a suspension in 2012. And yet the EPS payout ratio remains an unsustainable -1,429%. And while the FCF payout ratio of 76% is much better, keep in mind that a high debt load means that the dividend isn’t likely to grow anytime soon.
In fact, until Telefonica can turn around its sales, margins and returns on capital, the payout is likely to continue shrinking.
As of this writing, the author was long JNJ, XOM and VZ.