The S&P 500’s Shakiest Dividend

Want proof that we’re not out of the woods just yet? Last Thursday, the Dow fell as much as -9.2% in just minutes before snapping back nearly as fast. One eight-minute span during the day wiped out almost $700 billion in equity before the market rebounded, according to Bloomberg.

Now, normally I’m hunting down the brightest spots for you to lock in income streams and capital gains. For instance, I predicted that European stocks being dragged down proved to be a big winner in light of the EU bailout.

But with the recent happenings, I wanted to do something a little different this week.

If you’ve read this newsletter for long, I’m sure you’ll remember my “Safest Dividend in the S&P” article. I published an updated version a few weeks ago, and it proved to be one of the most popular features.

But there’s a flipside to that coin. If you now know the safest dividends in the S&P, shouldn’t you also know the least safe… especially given the clear signals that the economic rough patch isn’t through yet?

With this in mind, I’ve taken the criteria I used to uncover the safest stocks, and put it to use to uncover which S&P 500 stocks might be the most in danger of a dividend cut.

Safety Criteria #1: Yield
It only makes sense that our search starts with the most important factor — yield. There may be some stocks out there currently yielding 2-3% and in danger of cutting their dividend, but those don’t really catch my attention.

Instead, I sorted through all of the S&P 500 common stocks to find those yielding above 6% — these are the stocks that income investors are likely to have in their portfolios.

If you remember back in March, 13 stocks in the index yielded above that mark. Today, that number has risen to 15 (3% of the S&P).

Now that we’ve found a select few companies to focus on, we can move to our next factor of dividend safety: earnings power.

Safety Criteria #2: Earnings Power
It’s “Dividends 101” that a company’s earnings are what fund its payments. So if we’re looking for sick dividends, it only makes sense to find those companies seeing problems with their earnings.

Now, some people simply use net income for this step, but I prefer to look at operating income. Operating income is the profit realized from the company’s day-to-day operations, excluding one-time events or special cases. This metric usually gives a better sense of a company’s growth than earnings per share, which can be manipulated to show stronger results.

Taking our original 15 candidates, I searched Bloomberg for those that have seen negative operating income growth over the last year. Eight members of our original list have seen a drop: 

Company OI Growth Yield
Frontier Communications (NYSE: FTR) -1.2% 12.8%
Federated Investors (NYSE: FII) -8.5% 9.4%
Windstream (NYSE: WIN) -13.8% 9.3%
Diamond Offshore (NYSE: DO) -2.0% 7.9%
Reynolds America (NYSE: RAI) -2.5% 6.6%
AT&T (NYSE: T) -6.8% 6.5%
Pepco Holdings (NYSE: POM) -8.9% 6.4%
Qwest Communications (NYSE: Q) -5.8% 6.2%

Keep in mind that just because a company shows up on this list, it doesn’t mean their dividend is in danger — it simply means they are high yielding and operating income dropped over the last year.

Safety Criteria #3: Dividend Coverage
No measure of dividend safety carries as much weight as the payout ratio. By comparing the amount of profit earned against how much is paid in dividends, we can know whether a company can continue paying its current yield, even if conditions worsen.

Below, I’ve listed those stocks with payout ratios above 90%. Remember, anything above 100% means the company is paying out more than it earns, increasing the likelihood of a future cut. 

Company Payout Ratio
Diamond Offstore (NYSE: DO) 96%
AT&T (NYSE: T) 100%
Pepco Holdings (NYSE: POM) 167%
Qwest Communications (NYSE: Q) 400%
*Ratio for most recent quarter

Safety Criteria #4: Outlook and Other Factors
Simply because a company is seeing slowing business conditions and a high payout ratio doesn’t automatically mean a cut is coming. In fact, many companies have a sense of pride in maintaining their dividend payouts — even in the face of adversity.

#-ad_banner-#So to pinpoint what could be the shakiest dividend in the S&P 500, I decided to take a look at a few different factors that could give a hint to a future cut. This includes earnings forecasts, cash positions, dividend history, and anything else that might tip the scales one way or another.

Blue-chip AT&T (NYSE: T) paid out slightly more than it earned in the first quarter (for a payout ratio of 100%), but I think the chances of a cut are doubtful. The company has more than $2.6 billion in cash it can use, and also has a proud history of rising payments to investors. Factor in that depreciation costs (a non-cash charge that impacts earnings, but not cash available to pay dividends) are substantial, and I think the chances of a cut are further reduced.

Pepco (NYSE: POM), an energy company, is certainly an interesting situation. The company paid out $60 million in dividends in the first quarter, but only earned $36 million. While that raises a red flag, the company has more than $1.2 billion in retained earnings, which it can dip into if needed to fund any shortfall. Given that the first quarter performance appears to be an aberration, that Pepco has plenty of retained earnings, and a track record of maintaining the dividend, I think the payment is safe for now.

Qwest (NYSE: Q), which has paid out as much or more in dividends than it has earned for nearly a year, almost took the crown as the shakiest dividend. But it does sit on more than $1 billion in cash — and recently announced a takeover by CenturyTel (NYSE: CTL). With the cash hoard and a takeover on the horizon, the chances of a dividend cut now appear slim.

Which brings us to our final candidate — Diamond Offshore (NYSE: DO).

Diamond Offshore, an oil and gas drilling contractor, earned $2.09 per share in the first quarter while paying $2.00 in dividends, for a payout ratio of 96%. Meanwhile, earnings are estimated to fall more than -15% this year, according to Yahoo! estimates.

In fact, the company has already beat me to the punch — cutting quarterly dividends to $1.50 per share to compensate for the less-than-rosy outlook. While that certainly helps, I’m not so sure it’s positively the end of dividend cuts.

The biggest drag is the cloudy outlook on offshore drilling given the recent disaster off the coast of Louisiana. Diamond has heavy exposure to the region, and there’s no telling just yet what (if any) new regulations will be imposed and how they will impact business. In fact, the share price has already fallen from about $90 to $75 on the fears.

Diamond Offshore does carry a large cash balance of nearly $1 billion, which should help secure the dividend for the time being, but with clouds on the horizon, this is one income stream that I would pass up for now.

P.S. There is still plenty of hope for income investors. Carla has uncovered several picks with secure dividends that are yielding up to 21.1%. For more on these picks just follow this link.