My longer time readers know that dividend cuts have been one of my favorite topics. It is of high importance for me to ring the bell in order to help investors get more cautious with their investments. There are no risk-free stocks. The same applies to proclaimed “bond-proxy” dividend stocks, no matter which useless title they hold in connection with their dividend series. Today, I’m presenting two more kings I have on my radar for a cut.

Summary and key takeaways from today’s Weekly
– Dividend titles sound nice, but it is investing based on past performance.
– Titles like kings are highly praised in the dividend bubble, but they are by no means prone from painful dividend cuts as several examples have shown.
– Today, I am looking at two more candidates with deteriorating fundamentals.

I’ve never been a die-hard fan of the dividend investing fetish strategy, especially when it is based on series and those obscure aristocrats and kings titles.

My kick-off in this direction was with my article about what I see as a megatrend for this decade, namely dividend cuts in March 2023 when it was clear that interest rates are going up sharply (see here).

What sounded like unbelievable blasphemy to many has proven to be a right call.

The reason is straightforward: this thinking is based on the past. Isn’t investing about the future? This is where both viewpoints collide.

Thinking rationally about it, investing grounded on past performance is a recipe for disaster. Mix in a completely different investment environment, namely high interest rates again, many over-levered balance sheets, the end of outsourcing / cheap labor as well as aggressive tax hikes and tariffs – how can one assume nothing has changed?

Self-explanatory, this has major implications for everyone’s investment strategy, the more so if it is centered around dividend stocks and buy and hold.

To make it clear: I am not a perma-bear who sees the end of dividends. This won’t happen. But I was right and still believe that more cuts are coming, even among the famous dividend kings where the safety of a dividend is assessed almost solely on how long a company has been paying or raising their dividends in a row.

I am still seeing lots of posts about dividend picks, which dip to buy and praising long series as a proof for performance. But when a cut is announced, the surprise is big.

Well not on my side, as many likely coming cuts can be anticipated way in advance.

While a cut often takes longer to materialize as no management wants to be the one to end a decades-long series, it’s better not to be sitting on a sinking ship. What often happens is that the market gives you signals. Stocks which where once en vogue, suddenly drop and drop, no matter how great the run before was. And later at some point, an unavoidable cut occurs.

This damages dividend-drunk people twice, obviously through the cut, but also often through huge capital losses. You can check for yourself the names below for how much their stocks dropped. It won’t comfort anybody to have accumulated 20% in dividends when the stock is down by 50% or more…

Among those where I have warned (either here on the blog or on Twitter and YouTube) about a coming dividend cut are:

• 3M (ISIN: US88579Y1010, Ticker: MMM); > 60 years, slashed by 54%
• Leggett & Platt (ISIN: US5246601075, Ticker: LEG); > 50 years, –89%
• Walgreens (ISIN: US9314271084, Ticker: WBA); almost 50 years, –48%
• W.P. Carey (ISIN: US92936U1097, Ticker: WPC); 25 years, not a king, but an aristocrat, –20%
• Intel (ISIN: US4581401001, Ticker: INTC); neither, but a “must-own” high yielder, –66%
• also others, but these are the most prominent

Cases like Altria (ISIN: US02209S1033, Ticker: MO, see here) are still in progress.

Where I haven’t warned about in time are the (former) kings V.F. Corp. (ISIN: US9182041080, Ticker: VFC, slashed even twice in a single year, in total by 82%) or most recently Telephone and Data Systems (ISIN: US8794338298, Ticker: TDS).

Most often the reasons are too much debt and lousy legacy businesses with growth issues and / or difficulties in their operations in general, but also inflation-losers. The latter from above, TDS, is a telecom company, hence an infrastructure business. These are often viewed as proof no matter what due to their non-cyclical business.

Today, I will present two more dividend kings for a likely coming cut, where the first is also an infrastructure business.

Energy and commodity stocks are in a correction, some of my ideas also went into correction mode. These could be great buying opportunities, as the theses have not changed!

I recently closed my silver mining idea after +85.1%. There are more such gems among my member-exclusive picks where the potential hasn’t played out yet while the underlying businesses are doing great.

Join me and my members on our journey to beat the markets!

^{both as per 05 June 2024 market close – since August 2022}

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American States Water

This is insofar a bit provoking, as American States Water (ISIN: US0298991011, Ticker: AWR) is THE dividend king with a series of 70 years of dividend hikes, no matter what, at least regarding to the list I found on dividend.com (see here).

Based on this source, AWR is currently the only one having reached this milestone.

Note: the list also includes already occurred cuts.

American States Water provides water and electric services to residential, commercial, industrial and other customers in the United States.

In their latest dividend announcement, they say to have a series of 69 years – in the end, I don’t know why the first source claims 70 years, but AWR is certainly a company with one of the longest dividend series when it comes to frequent increases. The yield is only 2.4%, but many see it as a safe dividend growth play.

By crossing the 50 years barrier, one qualifies as a king, just for context.

As a regulated utility company offering services one needs every day and in many cases without competition, it is safe to assume that sales are somewhat predictable and that margins are high.

This is indeed the case, as we can see.

If we also have a look at the payout ratio (dividend per share to earnings per share), we can comfortably lean back on a safe dividend, as it looks.

Solid business and easy case, isn’t it?

Yes and no.

The other often overlooked part of the truth is that these businesses due to their regulation are not free to hike prices as they like. So in an inflationary environment we are still in, costs keep up rising (disinflation, i.e. slowing down inflation is still inflation – whether the official numbers are true is a different question).

In essence, this means that these capital intensive businesses feel the pressure of rising costs. Below, you can see capital expenditures rising, too. Over the last ten years, Capex has gone up by ~150%, while sales increased only by 22%.

At the same time, earnings per share are up nearly twice and the dividend is even slightly more than two times higher.

How can this be, when investments dramatically outpace sales growth?

A lot is debt-financed.

And this is where the story will have to end, sooner or later. They can’t just stop investing, as a big chunk is only maintenance expenditures. Debt is up almost by a factor of 4x (blue column above). By the way, the black columns (yes, there are some), are cash they have on hand.

So we are dealing with a rather not really liquid business (on the financial front), with high needs for investments.

To complete this quick overview, we need to look at interest expenditures, debt maturities / refinancings and cash flows.

With the tailwind of higher operating margins, operating income (blue below) increased by ~50%. Interest expenditures (black below) over the same timeframe are up more than twice.

On this front, there is still enough buffer, as debt was issued in the low interest rate environment. So, looking at the earnings-based payout ratio, everything looks solid.

Debt maturities look the following:

Until 2028, no big principle has to be paid back.

Debt is structured very long-term, so it does not pressure the company immediately.

What I do not like, though, is the fact that operating cash flow (below, blue) has been shrinking over the last ten years (so much on sales and earnings growth), while investments as written above have increased dramatically (black).

The result is very poor free cash flow (green) which in most years, even before interest rates were hiked, was negative. In 2022 and 2023 it dropped to new lows, effectively intensifying cash burn / drain.

With little cash and negative free cash flow, it becomes hard to pay a yearly dividend of currently ~62 mn. USD while maintaining high and rising investments into the business.

With net debt to EBITDA having been on the rise, too, capacity for more borrowings is somewhat limited, though not excluded.

As said, I cannot rule out a one or two more dividend hikes.

The company could also issue more debt. But higher debt lowers the equity portion of the enterprise value, especially when interest rates are high.

But overall, from the point of financial stability, this looks like a poor bet.

I don’t care whether this is a utility or whatnot and how long its series has been. I would go even so far that most utilities will cut their dividends sooner or later, as they all show similar developments. In France for example, the nuclear power operator EdF was nationalized due to its growing debt and investments with negative free cash flow.

I do not see the government taking this one private, but debt cannot be increased perpetually.

A look at the chart also indicates that the best times – at least for now – are behind AWR with the stock being where it was in 2019 and trending lower. Interestingly, it is still very expensive with a PE ratio of 23x which does not take into account debt.

It is a race against time and a bet on lower interest rates, not on the development of the business itself. This is dangerous.

Let’s have a look at a completely different type of business.

Stanley Black & Decker

According to the dividend.com list, Stanley Black & Decker (ISIN: US8545021011, Ticker: SWK) is not among the top ten, but with a series of 57 years it is a highly praised dividend king nonetheless.

The company is known for hand tools, power tools, outdoor products and related accessories it sells all over the world. Thus, it has an entirely different profile than AWR, as this is a cyclical, unregulated business in a competitive environment.

However, a look at the chart shows already that something’s not right:

In contrast to AWR, Stanley Black & Decker is not just roughly a quarter below its highs, but more than 50%. To make it even worse, the stock is trading on levels where it has been already ten years ago.

This is unlikely due to a healthy financial condition or a flourishing business.

The dividend yield is currently 3.7%, but what about its prospects?

Let’s do the same overview like above with AWR, starting with the long-term development of sales (blue) and margins (black = gross, green = operating).

While sales have under some fluctuations risen over time, unlike at AWR, margins are an issue for SWK. Gross margins have fallen from the high-30s to now 26–27%. While this might sound okay, the effect on operating margins is devastating, as they have effectively halved from solid double digits to only 5% as of late.

The progressively rising dividend has been covered by earnings per share until 2022 and 2023, when this equation didn’t work out anymore.

To be fair, the company did some asset impairments, so these were one-time effects, but nonetheless, despite being non-cash activities, impaired assets suggest that future business will likely run slower, as the affected assets are worth less now.

Next, while the cash situation looks a lot better than at AWR, the development of the debt load has been similar.

The rise was not as dramatic with “only” roughly doubling, but leverage compared to EBITDA is way higher now, with the figure having surpassed 5x recently (AWR ~4x), which is worrisome for a cyclical business.

Let’s now look at cash flow and investments.

SWK is not such a capital intensive business, so free cash flow generation is positive and it also covers the dividend, as you can see below the blue columns almost always have been bigger than the black ones representing the dividend payment.

Where do I see problems now?

First of all, SWK has 2.2 bn. USD in financial debt maturing in less than twelve months. As cash is only less than 0.5 bn. USD and they likely want to continue with their dividend payment, more expensive refinancing will be needed, increasing costs and impacting cash flows negatively.

Then according to their annual report (see here, p. 44), in 2025–2026 as well as 2027–2028 first 1.4 bn. USD and then 1 bn. USD will mature. This is unlikely to be repaid in full, too.

The above are ~ half of their financial debt maturing in less than five years.

On the other hand, recent cash flows were strongly boosted by inventory clean ups. In a cyclical business, this can happen from time to time. There are periods where cash flows are tied to working capital and ones where cash flows rise.

But cash flow cannot be boosted every year this way.

Below, you can see in blue the operating cash flow and in black the inventory movements. I like to see periods with high blue bars and small black ones. When black is too big, it strongly influences cash flows which should be taken into account.

To confirm, respectively double-check this, I looked at some inventory-specific metrics which indicate that the business has been having issues for years. Blue is average days inventory outstanding (how long does inventory stay in stock) and black inventory turnover (how often is the complete inventory sold and replenished in a year).

Both are trending in the wrong direction, indicating that the business is losing demand for its products and services.

What’s the bottom line?

The dividend costs SWK ~485 mn. USD p.a. With the last earnings announcement, management confirmed its guidance for 2024 to achieve 0.6–0.8 bn. USD in FCF.

That covers the dividend with a payout ratio of 58–80% rather comfortably.

But for example, sales growth was negative with 2% in the first quarter already. The company has also sold some of its business to reduce debt, but selling a business is also shrinking future income.

Refinancing the maturing debt of 2 bn. USD, will cost them 20 mn. USD p.a. more for every 1% in higher interest rates. This can quickly squeeze the buffer if they were to refinance at 3% or 4% higher interest rates than before.

While I do not expect an immediate cut like I do not do so with AWR, we are basically having here likewise a bet on lower interest rates. Plus in the case of SWK, we are dealing with a cyclical business where demand can plummet with a weakening economy. Compressed margins have been indicating SWK is losing competitiveness.

History does not ensure dividend growth in the future and it does not protect you from cuts.

I do not care that AWR has increased its dividend for 69 years and SWK for 57 years.

Their balance sheets are stretched / levered and both businesses are not flourishing, respectively in the case of SWK even struggling.

I’d be very cautious here, even if dividends could be held up and even increased one or two times before reality hits them. It was the same with the examples from the intro, when 3M even earlier in the year hiked its dividend and V.F. Corp increased it, despite a huge debt load, for a 50th time, before axing it twice.

High risk for little to gain is not my approach.

Conclusion

Dividend titles sound nice, but it is investing based on past performance.

Titles like kings are highly praised in the dividend bubble, but they are by no means prone from painful dividend cuts as several examples have shown.

Today, I am looking at two more candidates with deteriorating fundamentals.

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