In the past six years, profits have been steadily dropping at dieting firm Nutrisystem (Nasdaq: NTRI). Per-share profits of $3 back in 2007 are in the distant past, and the company is now earning a tenth as much. Still, Nutrisystem stands by its annual dividend, which is on track to be 70 cents a share for the fifth straight year.
The fact that this stock sports a dividend yield of close to 10% is why investors continue to give this company a fresh look. But it's quite likely that Nutrisystem's run of 70-cent-a-share dividends will eventually come to an end. Without a dividend in place, this stock could tumble to fresh multi-year lows.
How do we know that Nutrisystem is headed for a dividend cut? Because the balance sheet has been bled dry. Nutrisystem had $57 million in cash at the end of 2011. That figure fell to $20 million a year later -- and if Nutrisystem maintains its dividend, that sum will soon evaporate.
This isn't to suggest that Nutrisystem is in deep trouble. CEO Dawn Zier, who took the reins of the company in late 2012, has outlined a series of steps to turn operations around that will hinge on business streamlining, product innovation and improved marketing efforts.
Those things cost money, however, and the company will need to take steps to conserve cash wherever possible. So a dividend cut (or outright elimination) could come as soon as the next quarter, as Zier realizes how crucial it is to retain cash.
The Dividend Trap
Nutrisystem is one of many companies that fall into a trap of sticking by a dividend -- even when reality dictates a dividend cut. You can spot these firms simply by comparing the dividend streams to profits. If the dividend is higher than earnings per share (EPS) for an extended period, then something will have to change.
Take wireless communications firm NTELOS Holdings (Nasdaq: NTLS) as another example. In five of the past six years, the dividend has been higher than EPS. This company's EBITDA (earnings before interest, taxes, depreciation and amortization) margins peaked at 37% in 2008 and have slid to a recent 28%. In an industry where pricing pressures are bound to get only stronger, margins are likely to keep compressing, and sooner rather than later, that dividend will need to be cut.
Yet here's the key difference: Nutrisystem will probably need to get rid of its dividend, whereas NTELOS really only needs to reduce its dividend. And if you can get a handle on what the future dividend payments will be, you might be able to spot a bargain.
For example, in the case of NTELOS, the current dividend of $1.68 a share equates to a 12% yield. Perhaps the dividend only needs to be cut to $1. That would work out to be a 7.3% yield, which could serve as a catalyst for renewed interest in this stock. (Other telecom service providers typically have yields in the 5% to 6% range, which is why NTELOS would be appealing with a safer yet higher-yielding stock -- once that dividend cut takes place.)
The Relief Rally
Roughly a year ago, I took a look at a pair of companies that sported such absurdly high dividend yields that I had to wonder whether the dividend was going to be eliminated.
Propane distribution firm Inergy (NYSE: NRGY) had seen its shares slump badly as many assumed the dividend would be eliminated. I argued that investors would be relieved to learn that the dividend would be only partially cut. Sure enough, that's what happened, and shares staged a nice relief rally.
The other stock I mentioned in that article, Two Harbors Investments (NYSE: TWO), has also tacked on a solid 25% gain since then as investors have come to see that the company can maintain a dividend above $1 a share for the foreseeable future.
Risks to Consider: It's unwise to short a stock in anticipation of a dividend elimination. Companies can hang on to their dividend longer than you have the stomach to short it.
Action to Take --> The rules here are fairly straightforward. Don't hold on to any stock that looks to be on the cusp of an outright elimination of its dividend. Nutrisystem may actually make for a good investment after the dividend is gone -- but you may as well wait for that inevitable dividend cut first.
In addition, you can assess almost any high-yielding stock to try to gauge what kind of cut may be coming. If the cut will still produce a dividend that produces a respectable yield, then you may be positioned for nice upside, as the examples of Inergy and Two Harbors show.