Even though I know that I certainly won’t make many new friends with this article, especially not from the ranks of dividend investors, it is a duty for me to address this topic. I also think, it’s no coincidence that my most popular article to date has been about looming dividend cuts. Simply put, it’s too important to be ignored.

Summary and key takeaways from today’s Weekly
– The danger of dividend cuts is real, but still rather underestimated, because the now dramatically higher interest rates only start to bite into corporate finances slowly, depending on the structure of debt.
– From my first article, I already had three hits: Intel, Newmont and Rio Tinto cut their dividends. I expect Intel finally to completely suspend its dividend, soon.
– With this article, I updated my thoughts and also replenished my list somewhat with more candidates.

What I could observe over the last years is that there are mainly two types of new investors that have entered the investing scene: more speculatively oriented on one side or pretty defensively positioned on the other.

Either extremely tilted to one or to the other side.

While the former predominantly was trying to hit the jackpot with technology stocks and make capital gains, the latter is clearly income-oriented and doesn’t care about the movements of stock prices, let alone of indexes.

This second group of “dividend investors” has a good approach and also the right mindset to withstand one or another storm, in my view. At least for so long as the dividends are being paid reliably.

But there is one problem I have.

There are lots of YouTubers, blogger colleagues and other similar (semi-)professional investors that publicly discuss their investments or at least their favorites. Many of the presented stocks often have been paying uninterrupted or even increasing dividends for yers and even decades.

But for some, this looking to the past blocks the view of the looming dangers.

From my observations, too many companies, respectively their managements, believed that interest rates would stay near zero forever – at least until their retirement. Hence, they not seldomly borrowed excessive amounts too pay dividends and finance stock buyback programs.

However, debt has to be paid back some day. The first companies have already started to react and are dialing back on shareholder returns. Many companies that bought back their stocks at higher prices than today, have already started to reduce their buyback programs significantly. Companies like Home Depot (ISIN: US4370761029, Ticker: HD) or Target (ISIN: US87612E1064, Ticker: TGT) come to my mind.

The other component is the dividend – the main motivation for many to invest and hold certain companies.

On 29 September 2022, I published my top ten companies for dividend cuts. Since then, two more quarterly earnings results, balance sheets and cash flow statements have come in. Today, I will update my most popular article so far and name a few more candidates that are standing on weak footing.

Let the numbers speak.

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How are my top ten “favorites” doing so far?

My most popular article so far is “Bargain or pain? Ten dividend darlings that face painful cuts” (see here). To be honest – as I am – I am somewhat surprised that this pretty old article – one of my first – has grabbed so much attention.

Even my two most popular articles have been about dividends. The second was about the “Dogs of the Dow” strategy (see here).

This clearly shows me that dividends are a key topic for many investors.

Not only that, but they are the cornerstone of their investment process and even mindset. Focus on the payouts, not on the daily price swings. Add to this thoughts like “what has been paid out to shareholders, cannot be spent on a private jet”.

Everything circles around dividends.

Myself, I like dividends, too. What’s not to like about being paid? I have no problem with that. I mention this, because there are also investors that view dividends as a waste of time due to interrupting the effect of compounding. Likewise, in most places dividends are taxed, i.e. a portion of the payout automatically is lost.

But where I have a big problem is assuming the safety of a dividend just by its past performance, ignoring the present and being blind to the future.

In that first article, I presented ten well-known and often favored companies that have been reliable dividend payers for a long time. As my readers know, I put much weight on the free cash flow generation of a business and judge from this ability about its prospects for future dividend payments.

What has changed now, as many investors only experienced the near zero interest rate environment, is that the circumstances for investments have changed massively.

It is no small adjustment that has taken place.

But the key is, it takes some time until the way higher interest rates bite into the financial statements of (leveraged) companies.

Reasons are that big parts of debts have fixed interest rates and long durations until maturity. But there are companies that already have the wall of dramatically more expensive refinancing directly in front of them. Likewise, there are also businesses that borrowed money on variable interest rates – ouch.

These are the most fragile to figure out and avoid.

But there are also companies where free cash flow generation is weakening. First cracks already started to appear.

As you know, a few weeks ago, the famous and allegedly infallible ex-“dividend king” V.F. Corp. (ISIN: US9182041080, Ticker: VCF) – after increasing its dividend 50x in a row over half a century – suddenly for many, cut its payout by 40%. You can read the whole story and why I don’t like these “dividend titles” in my article “Dividend Investing – high yield or high growth?” (see here).

Unfortunately for me, I didn’t have this company on my top ten list, though I was a critic of this company in my previous employment.

Now, let’s check the health of my top ten candidates for a dividend cut, again.

Altria (Ticker: MO; ISIN: US02209S1033)

When it comes to Altria, a few weeks ago, I wrote a separate and longer article about the decreasing well-being of the Marlboro-maker. The piece was “A king is falling – why Altria’s butt is burnt down” (see here).

In short, my main message was that Altria has exhausted its ability to increase prices disproportionately to balance massively shrinking volumes. To save revenues and cash flows, volumes were given less priority and thus felt, even rather dramatically.

This sacrifice is about to backfire as the price gap compared to discounted offerings has widened to up to 41%. In times of tight budgets, some smokers are giving up their brand loyalty and switch to more affordable products form competitors. The discount sector is growing in this overall shrinking sector – Altria’s volumes are falling rapidly.

So far, Altria is not in immediate danger of a dividend cut. I could even imagine that one or two puffs (read: symbolic dividend increases) are in the cards, but the prospects are not getting better.

Especially, should the until now unthinkable happen, a price war between the premium brands in order to rescue as much volume as possible until the alternative products – where Altria is lagging – are generating cash, instead of burning it.

IBM (Ticker: IBM; ISIN: US4592001014)

Regarding IBM, I warned that interest expenses were already consuming a big chunk of operating income (around 20%) and that cash generation has been rather sluggish and even declining in the past.

An alleged “transition into the cloud business” cannot be used forever as an excuse. There comes a time, when the numbers have to prove it.

In short, prior many software companies were selling one-time licenses and received upfront the full price. With cloud or subscription business models, the revenue is not realized fully upfront, anymore, but over a certain period of time – as long as the software is used. This leads to a transition where revenues (and cash flows) first fall, but then increase again and become even more stable.

That’s what some companies are hiding behind.

Over the last ten years, operating income of IBM has come down by two thirds, while at the same time interest expenses tripled, as the charts show:

What about cash flows and the dividend – for many the only reason to own the stock of “Big Blue”, as it is clearly not a growth story anymore?

In 2018, there was already a remarkable slowdown, as the quarterly dividend was only increased from 1.50 USD to 1.57 USD. Prior, the raises have been 10 cents or even sometimes 20 cents. What followed was once 5 cents and since then only a penny every year (three times in a row, now).

Coincidentally, diluted share count hasn’t gone down since 2018, either. IBM was once a “buyback machine” thanks to its strong cash flows. The total dividend still consumes nearly 6 bn. USD every year. However, free cash flow for the first time over the last ten years, has fallen below 10 bn. USD and reached only 8.5 bn. USD in 2022.

There is some buffer left.

I don’t see a cut coming immediately. But the penny-raises are a first warning sign.

Every year, very cheaply financed portions of debt become due:

If IBM doesn’t repay, but chooses to refinance, instead of 1.25% or 0.375%, you should rather expect 5% for the next bonds.

These are massive jumps!

If the business manages to keep free cash flows above 8 bn. USD per year, they could keep up or even continue to increase by a penny every year. But this is a big “if”.

Intel (Ticker: INTC; ISIN: US4581401001) 

My first bull’s eye.

Intel was doing an egg dance. What was – well not 100% clear, but at least likely – was that with its ambitious spending plans, the cyclical down move with massively falling revenues and margins, plus if this wasn’t enough, also problems to sell their chips with ballooning inventories, cash generation was under pressure.

Not only under pressure, but at the minimum for 2023, maybe even 2024, there will be NO free cash flow left for Intel to finance its dividend – assuming their strategic spending doesn’t get reduced.

0.365 USD per share didn’t sound like much, but in total, Intel was paying out nearly 6 bn. USD per year. The now 66% lower dividend of 0.125 USD per quarter, will still consume about 2 bn. USD per year while at the same time only being symbolic, as the current yield is just 2%. For those who bought Intel at a “cheap” single digit PE ratio at a share price of 50 USD or more, the new yield on cost can even be below 1%.

Prior to the cut, they commented as follows questions regarding the sustainability of the dividend:

• Q2 ’22: “we paid dividends of $1.5 billion, a 5% increase year-over-year and remain committed to growing the dividend over time“
• Q4 ’22: “we are committed to maintaining a competitive dividend“
• a few weeks later: The “competitive” dividend was slashed by 66%

You see, don’t judge management by what they are saying, but by what they are doing and by what the financials are telling you.

Capital has become expensive. Although Intel raised some more debt, they realistically had to chose between the dividend and their spending plans.

I could leave it with this.

But instead, now I’m really making myself unpopular with this guess: Intel will completely suspend the dividend and the stock will be thrown out of the Dow Jones index, because the weighting in this index is defined only by the share price.

Guess, which stock has the lowest weighting in the Dow Jones?

3M (Ticker: MMM; ISIN: US88579Y1010) 

3M is our next chronically-ill patient.

Nonetheless, it is still a darling of many. Saying something against it – like I am doing – borders on incitement and is akin to offending these people, who still believe in this company and its stock, personally.

3M has paid dividends without interruption for more 100 years.

It’s raised its dividend for 64 years in a row, although the last three raises were just by a penny. 3M is one of the few dividend kings.

These are remarkable, nearly unmatched achievements.

However, the dividend yield is now even higher than during the bottom of the Great Financial Crisis of 2008 / 2009. The free cash flow hasn’t grown over the last ten years and recently came down to 3.8 bn. USD. The dividend costs the company 3.4 bn. USD.

The series is in danger…

Buybacks that were conducted at higher prices (even more than double of the current level) and also at earnings multiples close to 30x, have more or less stopped. It is now about defending the dividend.

However, being forced into a defensive position is not a situation I personally favor.

In their freshly printed 10-K, 3M shows a few interesting points, regarding their debt.

First, look how the floating-rate debt evolved – not the total number outstanding (“carrying value”), but the interest rate behind it. It has jumped from just 1.43% to 5.70%! Debt is way more expensive now! Floating-rate debt – sometimes also called variable – reacts immediately.

The fixed-rate debt will be adjusted when due and refinancing has to be done.

Will 3M have to refinance? Well, with just less than 500 mn. USD left after the dividend, and 1.9 bn. USD due in 2023, 1.1 bn. USD in 2024, etc., I cannot see how the cost of debt will not rise for 3M.

Higher interest payments equals less earnings and less cash flows!

Concretely?

If they refinance the 1.9 bn. USD due in 2023 at let’s say 5% higher total interest rates than prior, the total interest payments will be up by 95 mn. USD on this sum.

After the dividend, only around 400 mn. USD have been left in 2022!

And no, this is not just a small or usual cyclical downturn at 3M.

The company’s operating income is on a ten year low, as is the stock price.

AT&T (Ticker: T; ISIN: US00206R1023)

AT&T is in so far special, as it already had cut its dividend as I was presenting it as a candidate. The reason is, like with Intel now, that another cut will likely be coming.

But AT&T has other reasons that Intel, because its balance sheet is massively over-leveraged. A point in favor of AT&T is that its business is way more recession-resistant as consumers are not giving up their mobile connections.

At the end of 2022, net debt stood at 132 bn. USD. AT&T pays more than 6 bn. USD for interest payments alone! Its free cash flow is around 12 bn. USD, while the (already reduced) dividend consumes around 8 bn. USD now.

We have 4 bn. USD left as a buffer.

During 2023, several bonds with interest rate between 1.05% and 2.75% become due. Current debt – to be paid in less than twelve months – is around 7.5 bn. USD with cash on hand of 3.7 bn. USD. Refinancing, here we come!

Assuming they refinance 5 bn. USD out of the 7 bn. USD at interest rates of 6% – which is rather an ideal scenario – then interest payments would increase from ca. 85 mn. USD (assuming a 1.7% mid-point interest rate) to 300 mn. USD – for this single one!

Over the next 36 months, 15 bn. USD will have to be paid back or refinanced and the two years after that again 15 bn. USD.

AT&T is not in immediate danger of a cut. But every year will be a nail-biter, as “unforeseen circumstances” can be forcing to do the unthinkable.

Management is in a difficult position. Many retail investors hold the stock only due to the dividend. A further cut would send the price of the stock into the basement. Hence, they have to manage to pay down as much debt as possible without touching the dividend. Some refinancing will be needed, i.e. interest expenses will rise.

Newmont (Ticker: NEM; ISIN: US6516391066)

A bull – but not a bull’s eye this time.

Newmont also cut its dividend of 0.55 USD per share and quarter, as lower gold prices didn’t allow for a high enough free cash flow generation to fully cover this dividend.

But, to fair, it was more of an adjustment. An adjustment that many resource companies have done.

They are now pursuing a variable dividend approach. This means, if commodity prices and thus corporate results are higher, then a higher special dividend – together with a lower base dividend – will be paid. This makes way more sense, as results are fluctuating much more at these types of businesses.

Prior, Newmont was holding and raising its dividend since 2014.

The new 0.40 USD dividend for the quarter is at the mid-point of the announced range (annualized 1.60 USD vs. an announced goal of 1.40–1.80 USD per year) and akin to an annualized yield of around 3.7%.

If gold prices go higher, so will the dividend.

Digital Realty Trust (Ticker: DLR; ISIN: US2538681030) 

DLR is a company with many fans. It is a leading operator of data centers, structured as a REIT, i.e. a property company that is loved for their dividends.

It has been raising its dividend every year, even strongly – until it didn’t! The last announcement should have brought the so far traditional yearly raise, but to the detriment of many investors, management kept the dividend flat.

A precursor to trouble? Some numbers first:

• DLR has net debt of 16 bn. USD – nearly 4x its revenues and 10x its operating cash flows (!)
• interest expenses (very low interest rates secured, due to using EUR-bonds!) of only 300 mn. USD – the average interest rate is just 1.9%; below they show higher rates
• nearly 20% of debt is variable (see the graphic below) – remember that variable / floating rates react immediately?
• its occupancy ratio is only 84% – strangely low for assets that are said to be “in high demand”
• operating cash flow is 1.6 bn. USD
• the dividend – due to a combination of a rising share count and a higher dividend per share – consumes nearly 1.5 bn. USD

This means that more or less the whole operating cash flow goes for the dividend.

Everything else is debt financed and debt will need to be refinanced at much higher interest rates.

The rest is counting down the quarters until the dividend-cable gets plugged.

It could come already during 2023, but in 2024 at the latest – that’s my guess.

Iron Mountain (Ticker: IRM; ISIN: US46284V1017) 

This is also a REIT, although an even more exotic one, as it is archiving documents and records of all sorts.

Iron Mountain hasn’t increased its dividend since 2019, as it is also a company plagued by debt-problems. Maybe “Debt Mountain” would be a more appropriate name?

Net debt is slightly more than 10 bn. USD. Luckily, short term debt is low and first bonds only start to mature in 2025. It has some time left.

The dividend costs 725 mn. USD per year. Operating cash flow has been somewhere between 800 mn. USD and 1 bn. USD over the last three years. This means, the dividend is sufficiently covered, although most of the cash flow is used for it.

IRM has around 20% of its debt outstanding in variable interest rates. The blended variable interest rate was 5.8% already. Total interest expenses were 488 mn. USD – 16% higher than in the both years before.

Luckily, there is some room to breathe and refinancing is not needed in the next months. But when it gets hard, here I am also expecting a cut to come some time in the future, though maybe not necessarily during 2023.

You shouldn’t expect any increases, either, as the focus will switch to handling the mountain of debt.

Omega Healthcare (Ticker: OHI; ISIN: US6819361006) 

The operator of care centers for the elderly, hasn’t increased its dividend per share since 2019. Prior, the increases have been penny-wise in most cases.

The debt situation will likely bring OHI into difficulties.

Net debt is around 5 bn. USD. The dividend consumes about 630 mn. USD, while operating cash flow has fallen from slightly over 700 mn. USD to even under the dividend sum in 2022.

This means that refinancing will be needed as there are no longer any financial resources left to effectively pay down debt. Bear in mind that in many cases the “customers” are not so financially strong either, or cannot be squeezed out ad infinitum by price increases.

The cash flow should quickly jump back above the dividend or otherwise it wouldn’t be even covered at all.

We see in the maturity overview above that in every year several hundred millions USD of debt will have to be refinanced.

Every year.

The dividend is already barely covered. How much time can we give OHI until it faces reality and “surprises” many of its loyal investors?

If I had to choose one company of this top ten list, I would pick OHI for the next cut.

Until then:

Rio Tinto (Ticker: RIO; ISIN: GB0007188757)

It was obvious that after lower iron ore prices, the record dividend of Rio Tinto likely wouldn’t be repeated. Hence, the more than 50% slash is not a surprise, but in line with cyclical and volatile commodity prices.

I wouldn’t expect shareholder returns to be increased massively to former heights, either, even if commodity prices were to come back. The reason is that RIO and its other big Australian competitor are starting to invest more into mining activities for critical resources like copper or nickel.

The money is needed somewhere else.

Here you see the price of iron ore. Notice the big swings and the overall higher level during 2021:

This way, we can keep it short at this stage.

Whom to add to this watchlist?

For example, I wrote a separate article about farmland stocks “Are farmland stocks a hedge against inflation?” (see here).

Especially the stock of Farmland Partners (ISIN: US31154R1095, Ticker: FPI) comes to my mind as there recent results were shocking from a debt / interest rare perspective.

They raised cash by selling stock at the open market and effectively paid down some of the high debt load. That’s fine so far. But the guidance for 2023 sees a rise of more than 30% for interest expenses that were already only tightly covered. FPI, as I wrote my farmland article, had variable debt of the magnitude of 20%.

In 2022, operating cash flow was 17 mn. USD. The dividend cost 11 mn. USD. But interest expenses are expected to rise by around 5 mn. USD.

Might be tight…

Other candidates I have on my radar:

• Easterly Government Properties (ISIN: US27616P1030, Ticker: DEA)
• Verizon Communications (ISIN: US92343V1044, Ticker: VZ)
• Northwest Healthcare Properties (ISIN: CA6674951059, Ticker: NWH)

I had a look at the first two in my article “Debt and high inflation – money for nothing or looming meltdown?” (see here). The latter was briefly discussed in “Zombie companies – The Walking Dead?” (see here).

Easterly Government Properties (DEA) is so far keeping its payout steady for the seventh consecutive quarter. But the outlook foresees lower operating results for 2023 than in 2022. And the sustainability of the dividend might be tested, because debt is also high. The good thing is that for 2023, there is no big amount of debt that has to be refinanced. It starts from 2024.

Share count is rising year after year, so the total dividend increases even without a formal increase per share. In 2022, more or less the whole operating cash flow was used for the dividend.

Verizon raised its divided last year slightly, but its debt problems aren’t solved.

More or less the entire free cash flow (after all recurring investments) is spent on the dividend. Cash on hand is low and high refinancings are coming with 10 bn. USD in short-term debt:

NorthWest Healthcare Properties has a very low interest coverage ratio, high debt to cash flows, a high portion in short-term and variable rate debt. Final 2022 numbers haven’t been released, yet.

Hence, here is what I wrote back then (excerpt):

With its most recent numbers as per Q3 2022, the interest coverage ratio – typically measured by EBITDA / interest payments at REITs – was only slightly a smidgen above 2x. 

Now comes the really interesting stuff. In 2023 alone, around a third of NWHs debt is due for refinancing. This alone will be interesting. Another thing is that two thirds (yes, 2/3) of total debt are financed with variable interest rates. This will be very interesting, to say the least.

“Zombie companies – The Walking Dead?” (see here)

Time is ticking here, too.

After three hits, now I have replenished my list with four additional candidates. Let’s see, how my “top eleven” develop over the next months.

Conclusion

The danger of dividend cuts is real, but still rather underestimated, because the now dramatically higher interest rates only start to bite into corporate finances slowly, depending on the structure of debt.

From my first article, I already had three hits: Intel, Newmont and Rio Tinto cut their dividends. I expect Intel finally to completely suspend its dividend, soon.

With this article, I updated my thoughts and also replenished my list somewhat with more candidates.

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