Last week, pharmacy giant Walgreens Boots Alliance (WBA) made one of the worst possible announcements a company can make…
It said it will slash its dividend nearly in half.
For months, the market had been anticipating the cut. Shares of WBA were already down 30% over the past year.
The stock sank 5% on the day the news broke. And WBA could be in for more pain as investors move their money to better income-oriented plays.
If you’re an income investor, this news should concern you—even if you don’t own WBA.
In short, it’s a “canary in the coalmine” situation that hints we’re likely to see dividend cuts from a slew of other companies over the coming months.
Today, I’ll explain why income investors must be especially careful in 2024. And I’ll share three signs to watch for to help you avoid stocks likely to cut their dividends soon.
But first, let’s take a look at why dividend cuts are a huge red flag for any company.
Why dividend cuts are a death knell—and why more are coming in 2024
Companies will typically do anything to avoid cutting their dividend.
That’s because it sends a negative message to Wall Street. It indicates that the business is deteriorating sharply… to the point that the company can’t fulfill its obligations.
And when a company cuts its dividend, it usually sends its shares plunging.
Put simply, dividend cuts are a last resort for companies. In fact, some will even borrow money to keep their payout steady rather than cut it.
Data from McKinsey shows it’s extremely rare for a large, established company to cut its dividend without deteriorating conditions. According to McKinsey, from 1997 through 2021, just 29% of the 1,225 dividend-paying companies in the study cut their dividend. That works out to an average of 2% of companies per year.
Digging deeper, you’ll see that almost all of these cuts happened when a company saw a profit decline of at least 20%… an economic crisis… or both.
As you would expect, dividend cuts increase when the economy deteriorates. For example, during the recession of 2020, the number of dividend cuts/eliminations jumped to 16%—eight times higher than the 2% average.
These historical numbers are concerning to current investors…
It’s no secret that the economy is in a tough spot today. The Fed has spent almost two years trying to slow down the economy by raising interest rates. Below, you can see the huge surge in rates in a relatively short period.
As you can see from the chart, interest rates are well above their 20-year averages. As a result, borrowing costs are far higher than many companies—particularly those with weak growth prospects—can afford.
It’s an especially dangerous situation for companies that overestimated their growth prospects… overspent on acquisitions… or relied on debt to finance their operations or maintain their dividends.
And many will be forced to take the same (devastating) step that WBA took last week… by slashing their dividend.
The good news is that there are a few major warning signs investors can look for—to help avoid buying one of these troubled companies…
1. A payout ratio above 100%
The most important metric for income investors to watch is the dividend payout ratio.
In short, this number measures how much of a company’s profit is being used to pay its dividend.
Payout ratio = total dividends / net income.
Income investors want this ratio to be relatively low, since a lower number means the company has plenty of profit left after paying its dividend. By contrast, a higher number leaves the company with less room to raise its dividend or invest in new growth projects.
Simply put, the payout ratio measures whether a company can afford its dividends.
When the payout ratio exceeds 100%, it means the company is paying out more (in dividends) than it’s making in profits. Not surprisingly, that’s exactly the situation WBA ran into in recent years… as you can see on the chart below.
Be sure to keep an eye on the payout ratio of every dividend-paying stock in your portfolio. If this metric goes above 100% (or dips below 0% due to negative net income), it’s a major warning sign that the dividend is too high, compared to a company’s profits.
That brings us to our next red flag…
2. Declining profits
Sharply slowing—or, worse, declining—profits are another important warning sign to watch for.
Earnings are the lifeblood of a good income investment. If a company’s profits are heading in the wrong direction, it typically means it will have to cut expenses. And dividends are often the ultimate target.
For instance, Walgreens, which benefited significantly from COVID, started to struggle as the pandemic faded (as you can see below). Its net income went negative by the end of 2020… and dipped even further into the red by early 2023. Put simply, WBA’s dividend wasn’t sustainable after multiple quarters of losing money.
3. Worsening debt trends
The last red flag involves a company’s debt load…
In general, the more a company owes, the higher its interest payments… which add a nonnegotiable, long-term expense to its balance sheet.
Once again, Walgreen’s problems were easy to spot from its debt levels. As you can see below, the company’s long-term debt rose almost sixfold over the past decade… and more than doubled in the past five years.
The steady rise in debt was a clear warning sign for income investors.
Keep in mind, debt levels are especially important today, now that interest rates are at their highest levels in 16 years. Any new borrowing will mean higher interest payments… which leaves companies with less profits to fund their dividends.
The bottom line
A payout ratio above 100%… slowing or falling profits…or sharply higher debt are critical warning signs that a dividend cut could be coming soon.
If you rely on dividends as part of your income stream, it’s important to check your portfolio’s health often—and watch for these red flags.
(Or, you can let me do the legwork for you. At Unlimited Income, I’m constantly watching the latest moves in dividend stocks for the most reliable yields combined with the best growth stories. For instance, last week, I recommended a telecom giant that’s rapidly outpacing its peers thanks to two major industry trends… Better yet, it just issued a dividend that it plans to hike annually at an industry-beating pace.
You can get the pick—as well as the rest of the portfolio—when you join us at Unlimited Income… risk–free!)
