LUMN - Painful Dividend Cuts: The Biggest Warning Sign I Failed To Heed

2023-06-14 08:00:00 ET

Summary

• Dividend growth investing can be extremely rewarding.
• However, dividend cuts can be extremely painful.
• I share the biggest warning sign of painful dividend cuts and five recent examples of it playing out.

History has shown that investing in dividend growth stocks can be an effective way to outperform the S&P 500 ( SPY )( VOO ). However, it has also shown that dividend cutters and eliminators massively underperform the market:

This implies that one of the most important goals of a dividend investor is to avoid stocks that will cut their dividends. While it is not always impossible to avoid these unfortunate landmines due to black swans such as COVID-19 which undermined the dividends of otherwise very sound companies, there are certainly warning signs that indicate that a dividend cut is likely.

Unfortunately, I have not always given proper heed to these red flags and have paid the price with some pretty severe and costly dividend cuts in my portfolio. That said, at other times I have been able to identify these risks and have avoided the painful cuts and the often-accompanying total return underperformance.

In this article, I will discuss the biggest warning sign that a dividend is not safe and share five recent examples of how it played out.

The Biggest Warning Sign Of An Impending Dividend Cut

Many retail investors focus purely on the payout ratio of a business or even its dividend track record when determining if its dividend is safe or not. After all, if the company is generating plenty of cash flow to cover its dividend payout and it does not have a history of slashing its dividend, it is surely safe, right?

Unfortunately, this is not always the case. In fact, in my experience, many of the most devastating dividend cuts are not due to a lack of cash flow coverage of the dividend, but rather due to an overleveraged balance sheet. Here are five recent serious examples of this.

Dividend Cut Example #1: Hanesbrands ( HBI )

HBI appeared to have a very sustainable dividend when I bought it in early 2021 with a low payout ratio of just 33% and a reasonable leverage ratio of 3.22x. However, what I failed to take into account was three key factors:

1. HBI's bottom line - and therefore its payout ratio and leverage ratio - were artificially improved by the fact that HBI had received a significant tailwind from the COVID-19 outbreak due to the rapid increase in demand for HBI's personal protective equipment as well as the short-term boost to demand for its other products thanks to the generous government stimulus checks being sent out.
2. HBI's business is highly cyclical with a lot of operating leverage. As demand for its PPE evaporated and stimulus driven demand dried up, HBI saw a dramatic reduction in demand.
3. The COVID-19 lockdowns and related stimulus programs were going to wreak havoc on global supply chains and drive four decade high inflation. These macro factors severely hurt HBI's business model, further exacerbating its operating leverage driven plunge in earnings per share.

Thanks to these headwinds - on top of the company's focus on investing in its Full Potential Plan and an unforeseen cyber attack on the company - HBI's payout ratio and leverage ratio soared. With interest rates also rising rapidly and HBI having to amend its debt covenants to pacify lenders, HBI had little choice but to eliminate its dividend. The stock took a severe beating along with it, leaving me with heavy losses on my once promising - and initially highly profitable - investment:

Dividend Cut Example #2: Algonquin Power & Utilities ( AQN )

Another example is my investment in AQN. I assumed that its BBB credit rating, regulated utility and highly contracted renewable power generation focused business model, impressive track record of rapid dividend growth, and statement on its 2021 annual report that it had low exposure to floating interest rates meant that I had little to worry about concerning its dividend. While dividend growth was likely to slow moving forward due to a slightly elevated payout ratio, the dividend itself seemed quite safe, or so I thought.

Unfortunately, I failed to look hard enough at AQN's funding plan for its recently announced aggressive acquisition (that ended up not even going through) to realize that it was funding this acquisition with a combination of equity and mostly floating rate debt (that it then planned to refinance at long-term fixed rates opportunistically). Unfortunately, interest rates soared much faster than management expected and the stock tanked, driving the cost of equity up dramatically as well.

As a result, in order to save their investment grade credit rating and put the company on firmer long-term footing, AQN had to slash its dividend pretty steeply and the stock suffered deep underperformance in the lead up to the announcement of the cut in anticipation of this austere measure.

Dividend Cut Example #3: Lumen Technologies ( LUMN )

Fortunately, I have not always gotten crushed by dividend cuts and was able to avoid several of them or even time entries into stocks after the cuts as the company was about to pivot to long-term growth.

An example of this is LUMN. The company seemingly had enormous free cash flow coverage of its dividend and management was talking incessantly about pivoting to revenue growth. However, the reality of the business was much different, with top and bottom line results perpetually underperforming management guidance and no signs of material deceleration of business disintegration.

Moreover, the balance sheet still had a lot of leverage on it. While management said that it was fine with running leverage a bit above management's target range as it invested aggressively in a pivot to growth, what ended up happening was that the business continued to shrink, interest rates soared, and inflation rose rapidly. What that meant was that their growth CapEx budgets became more costly than they originally anticipated, their leverage ratio grew faster than they originally anticipated (due to rapidly shrinking EBITDA), and the burden of taking on additional/servicing existing debt to simultaneously pay out the dividend and invest in growth was growing ever more costly.

In desperation something had to give, and the dividend was the obvious choice. Fortunately, I sold my shares at only a modest loss before the dividend was eliminated, as the decline since then has been absolutely devastating to shareholders as the company has yet to turn things around:

Dividend Cut Example #4: Energy Transfer ( ET )

An example of a stock that I was able to successfully pile into after its distribution cut is ET. In late 2020, with the energy sector in turmoil due to the COVID-19 lockdowns and an energy price war between Saudi Arabia and Russia, ET's increasingly bloated leverage ratio was endangering its investment grade credit rating, especially with ongoing concerns about the status of the Dakota Access Pipeline at the time. As a result, management halved its distribution payout and the stock had one of its worst runs in its history:

While this was a painful hit for people who bought prior to COVID-19 set off a chain reaction of events that led to the devastating distribution cut, I was fortunately able to buy it on December 3rd, 2020 in anticipation of management making the right moves to aggressively deleverage.

Since then, the distribution has not only been fully restored, but has actually exceeded its pre-cut levels and is on the path to long-term consistent annual growth. Moreover, ET units have delivered tremendous outperformance over that period:

Dividend Cut Example #5: AT&T ( T )

Last, but not least, dividend stalwart and retiree favorite - T - has had a very rough period over the last few years. While I was warning investors against buying it in late 2020 and 2021 prior to its painful dividend cut and severe underperformance since then, the reasoning for my cautions should not be surprising to you by now.

Many investors thought the dividend was safe given that its earnings easily covered the dividend. However, they failed to notice - as I had failed to do with HBI and AQN - that T had overburdened its balance sheet with debt-ridden acquisitions of capital-intensive, no-moat businesses that were guzzling capital to stay economically viable. As a result, T finally got to the point where it had to choose between saying goodbye to its investment grade credit rating or slashing its dividend. It obviously chose the latter in a move where it simultaneously spun off a large chunk of its debt.

However, since then it has failed to deliver any meaningful turnaround and remains weighed down by significant leverage with management struggling to meet its free cash flow generation objectives.

Investor Takeaway

Dividend investing is a great way to build wealth over the long term and also serves as a great way to live off of investments regardless of current market volatility.

However, to make it work, it is absolutely essential that investors avoid dividend cuts as much as possible. To do so, they must carefully analyze a balance sheet to ensure that it is not going to weigh a company down and force it to slash its dividend. I have learned this mistake the hard way, though thankfully I have also been able to apply this lesson successfully several other times, saving myself large amounts of money in the process.

For further details see: