May 25, 2012

J.C. Penney May not be the Last Company to Suspend Dividends

by Sridharan Raman

J.C. Penney recently stunned its investors by announcing not only a much larger loss than analysts had been advising them to expect, but by unexpectedly suspending its dividend payments until future notice, in order to conserve cash that the company needs to complete its strategic overhaul. A new study using StarMine’s SmartRatios Credit Risk (SRCR) model, screening all North American companies with a market capitalization of $1 billion or more, reveals that another five large companies face similar financial constraints to those at J.C. Penney. These companies – most of them in the natural resources or utilities sector – may find, in their turn, that suspending or eliminating their own dividend makes sense.

Looking back at J.C. Penney, the retailer’s score of 24 on the StarMine SmartRatios Credit Risk (SRCR) model puts the company in the bottom quartile of companies in the Americas and could have warned investors early on that the company’s dividend might be in jeopardy. The SRCR model combines financial ratios and metrics that are predictive of credit risk into five components: profitability, leverage, debt coverage, liquidity, and growth. A look at the latest income statement shows that in the last three quarters the dividends paid exceed the net income. The interest expense was more than two thirds of the operating income. Finally the operating margins continued to fall further below the industry median (as depicted in the chart on the right).

Logically, our next question was whether there are other companies that have similar scores and whose financial statements provide similar clues. None of the other retailing stocks showed the same warning signals that preceded J.C. Penney’s move to suspend its dividend. Our screens did, however, identify five companies that have similar characteristics to those of J.C. Penney, that also may struggle to maintain their dividend payments to shareholders. Perhaps because of the high and increasing capital spending programs that they have embarked upon, those companies are clustered in the energy, materials and utility sectors. If commodity prices continue to languish at their current levels or decline still further, those hefty spending plans may not generate reasonable returns for the companies and their shareholders, making cutting or suspending their dividend payments a more attractive option.

Chesapeake Energy Corp. (CHK.N)
(Dividend yield – 2.3%)

Chesapeake – which, as we discussed previously, is mired in a corporate governance controversy as well as struggling to deal with its hefty debt load by selling assets – has a SRCR model score of only 17. In the just-ended first quarter, the company’s interest expense exceeded its operating income, and its capital spending consistently has exceeded its cash flow from operations. The company recently issued $2.5 billion of new long-term debt to help finance that spending program; interest payments on that debt represent another drain on its cash.

Edison International (EIX.N)
(Dividend yield – 2.9%)

The utility has the lowest possible score on StarMine’s SRCR model, of only 1, indicating a high probability that it will experience financial distress. Its interest expense represented two-thirds of its operating income in the quarter ended March 31, 2012. The operating income for the period was $318 million while the interest expense was $212 million. Although its long-term debt stands at a record $14 billion, the company has continued to issue more in eight of the last nine quarters. It’s possible that some of that debt was used to pay dividends, given that the company’s capital spending consistently exceeds its cash flow from operations.

Great Plains Energy Inc. (GXP.N)
(Dividend yield – 4.2%)

This energy exploration and production company, like several others on our list, has seen its capital spending consistently exceed the cash it generates from its operation. Its interest payments on its debt ($67 million in the quarter ended March 31, 2012) exceed its operating income ($49 million) and in only two quarters during the last five years has the company managed to generate positive free cash flow. The company’s dividend payment obligations have exceeded its net income in four of the last six quarters. The company scores only 4 on the StarMine SRCR.

M.D.C. Holdings (MDC.N)
(Dividend yield – 3.7%)

M.D.C. Holdings – the sole non-resources company on our list – has paid out more in the form of dividends to its shareholders than it has generated in net income in each of the last eight quarters; its free cash flow has been negative in each of the last six quarters. Futhermore, the company’s net operating income has been negative in the last eight quarters, giving it a negative net operating margin even while the rest of the industry enjoys an average operating margin of more than 6%. Not surprisingly perhaps, the home-builder’s SRCR model score is a relatively weak 19.

Arch Coal Inc. (ACI.N)
(Dividend yield – 6.0%)

Concerns about the balance sheets of coal mining stocks are in the news already, with news that Patriot Coal (PCX.N) is talking to advisors about a restructuring plan triggering a selloff earlier this week. Coal companies already are under pressure as demand for coal has dropped in light of an unseasonably warm winter, newly-cheap natural gas and new environmental regulations. At Arch Coal, the return on net operating assets has remained below the industry median in each of the last three quarters, while interest expense now consumes 60% of the company’s operating income. Arch Coal has an SRCR model score of only 2, reflecting those issues. That’s the same score as that of Patriot Coal, whose auditors have just voiced concerns about its viability; rating agencies recently slashed their ratings on Patriot’s debt to CCC as it negotiates with its lenders.

Dividend-yielding stocks have become an important part of investors’ portfolios in recent years, as the tax treatment of dividend income became more favorable while bond yields languished at near-record lows. But, as the news from J.C. Penney and the examples above remind us, not all dividends are created equal – and not all dividends are “safe”.

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