NPI:CC - Don't Fall for These 2 Dividend Stocks: Cuts Are Coming

2023-09-13 12:30:00 ET

The Bank of Canada’s 5% interest rate has started showing its impact on the economy and interest-rate-sensitive stocks. The central bank hiked the interest rate to reduce inflation to its targeted 2%. But rising energy prices increased inflation to 3.3% in July. If inflation increases further, another rate hike is possible. Interest rates are good up to a certain point at which borrowers can comfortably pay their loans without sacrificing their growth plans. But the 5% interest rate has slowed economic growth and forced some commercial REITs and small utilities to cut dividends, sell properties, and pause or reduce capital spending.

True North Commercial REIT and Algonquin Power & Utilities slashed dividends this year to preserve cash to service their debt. More companies could follow if the central bank increases interest rates or maintains a 5% rate for longer.

Two stocks that could see dividend cuts

I have identified two dividend stocks walking on thin ice with cash flows and dividend payments. If things improve in 2024, these stocks might sustain current dividends. But if the economy moves into a recession, these stocks could cut dividends.

Real estate dividend stock

So far, office REITs have slashed distributions, but retail REIT SmartCentres REIT ( TSX:SRU.UN ) could be next. It sustained during the pandemic dip thanks to government subsidies and Walmart stores that remained open during lockdowns. But SmartCenters did take a hit from the low rental income. Its distribution payout ratio has been above 90% since the pandemic and reached an alarming rate of 98.6% in 2022.

Its debt was 10 times its adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA). Both these ratios show that the REIT’s cash flows are stressed. It is using almost all its funds from operations for distributions while having an occupancy of 98.2%. The REIT has paused new development initiatives until market conditions improve.

The stock price of SmartCenters REIT has dipped more than 10% this year. While this dip has created an opportunity to lock in a 7.7% distribution yield, it has also increased the risk of a distribution cut. When a dividend stock cuts dividends, its stock price nose dives. Those who expect a dividend cut are staying away from the stock, waiting to buy it on the dip that will follow a dividend cut.

Energy dividend stock

Another dividend stock that has been bearish throughout the year is Northland Power ( TSX:NPI ). Its stock price fell more than 34% and it is trading at its pandemic low of $24. The company’s second-quarter net profit fell 92% year over year to $22 million as the European Union imposed a price cap on renewable energy producer’s market revenue. This price cap will remain till 2024, while the situation is expected to stabilize in 2025.

Northland Power still expects to meet its 2023 guidance of $1.30 free cash flow (FCF) per share, that’s a 92% distribution payout ratio. A significant portion of its adjusted EBITDA comes from wind energy. If the climate is not conducive and wind energy output doesn’t reach its desired level, it could stress the company’s profits.

Northland’s renewable energy peers are undergoing significant restructuring. TransAlta Renewable is getting acquired by its parent TransAlta, and Algonquin Power is looking to sell the renewable energy business. The renewable energy sector is at a weak spot. If the economy falls into a recession, Northland could be forced to cut dividends.

The plus side for the energy company is its diverse geographical presence in the Americas, South Korea, Japan, and Taiwan. The 34% dip in its stock price comes on the back of weak fundamentals . If you are still bullish on the stock, you could buy it when the fear of a recession either materializes or fades.

Investing tip

Not all stocks that fall are a buy at the dip. Instead of investing in the above stocks for which dividend payments are risky, you can consider buying dividend aristocrats like Enbridge and BCE that have strong balance sheets and stable cash flows to fund dividend payments.

The post Don’t Fall for These 2 Dividend Stocks: Cuts Are Coming appeared first on The Motley Fool Canada .

Fool contributor Puja Tayal has no position in any of the stocks mentioned. The Motley Fool recommends Enbridge, SmartCentres Real Estate Investment Trust, and Walmart. The Motley Fool has a disclosure policy .

2023