The two stocks in this article both have dividend yields over 6%. Stocks with such high yields tend to have higher-than-average risk.
Focus on total return not high yield. Just because a stock has a high yield does not mean it will generate better total returns. In fact, if you put dividend paying stocks into 5 baskets (called quintiles), the highest yielding quintile actually has lower total returns than the 2nd highest yielding quintile.
– Tip 1 from ‘10 Critical Tips for Dividend Growth Investors’
The stocks examined in this article pay out much of their cash flows as dividends. This means there’s little cash left over for growth.
In addition, these businesses are highly leveraged and could face a liquidity crunch in the near future. In short, the two S&P500 stocks examined in this article have a high risk of cutting their dividend payments.
Risky High Yield Stock #1: ONEOK, Inc.
ONEOK (OKE) stock currently has a tremendously high dividend yield of 11.5%. The company has paid steady or increasing dividends every year since 1989.
The company’s most recent Value Line report says the following:
The dividend is not covered by earnings, and the high yield suggests some uncertainty regarding sustainability. On top of that, leverage is greater than we would prefer.
The quote from Value Line above describes the perilous situation ONEOK is in.
The company generated about $270 million in cash flows net of interest expense in its most recent quarter. ONEOK pays around $125 million a quarter in dividends. Dividends are taking up close to half of the company’s cash flows.
This leaves less than $150 million a quarter for both growth and maintenance capital expenditures. ONEOK is averaging over $300 million a quarter in capital expenditures this year. The company is forced to finance the other ~$150 million in cash it needs to continue funding its business, growth, and dividends.
To make matters worse, ONEOK has around $8.7 billion in debt on its books, and under $40 million in cash. Of the $8.7 billion in debt, close to $1 billion is coming due in the next year.
With an absurdly high 11.5% dividend yield, issuing new shares is unattractive for ONEOK right now. With its high debt burden, the company will likely have difficulty tapping debt markets as well. This could create a liquidity crunch for the company in which management will have to choose between continuing to pay its dividends and continuing to fund growth.
Kinder Morgan (KMI) was recently in a similar situation – and they chose to cut the dividend by 75%. Here are 3 lessons to learn from Kinder Morgan’s dividend cut.
Risky High Yield Stock #2: Spectra Energy (SE)
Spectra Energy stock offers investors a 6.4% dividend yield. The company’s stock is down more than 30% so far this year due to falling oil prices. Spectra Energy has paid steady or increasing dividends every year since 2007.
In its most recent quarter, Spectra Energy realized distributable cash flows of $223 million. This amount includes spending on maintenance capital expenditures. The company paid out around $248 million in dividends.
When your dividend is more than the amount you have to distribute (before investing in growth), something has to give.
Like ONEOK, Spectra Energy’s balance sheet is far from clean:
- Pension underfunded by around $100 million
- $14.24 billion in debt versus $0.34 billion in cash
- $1.3 billion of debt is due in the next 12 months
The company’s recent stock price declines make now a poor time to issue new shares to fund growth (and dividends). Additionally, Spectra Energy carries a tremendous amount of debt.
High debt and an inability to fund the dividend and growth make Spectra Energy a prime candidate for a dividend cut if oil and gas prices continue to stay low.
While both of the stocks above appear to offer attractive yields, they are far too risky for dividend growth investors who rely on stable, growing dividends.
Stocks with large debt loads and high payout ratios are especially at risk of business downturns. Declining oil and gas prices are the negative catalyst that is exposing highly leveraged firms in the historically volatile oil and gas industry.
In general, you can safely have an above-average yield with little growth, or above-average growth without an exceptionally high yield. Business models that offer both high payout ratios and rapid growth are likely overly dependent upon outside financing. When things go bad (and something bad will always happen at some point), the fragility of this type of business model is exposed.