2 Stocks With ~5% Dividend Yields Worth Avoiding

By Valuentum Analysts

The benefits of dividend growth investing are well-documented. Not only can dividend growth investors generate strong current income, but they also benefit from dividend reinvestment on a potentially appreciating stock over time. This dynamic can be even more powerful than compound interest.

But dividend growth investors have to be vigilant to avoid those companies that may cut their payouts. There are a few reasons why a company may cut its payout. First of all, dividends are paid from cash on the balance sheet, so an evaluation of the balance sheet as well as free cash flow is paramount.

What we’d like to see in a strong dividend growth entity is a solid net cash position on the balance sheet — total cash less total debt is positive — and a firm that is generating free cash flows far in excess of cash dividends paid. A framework that considers balance sheet health and future free cash flow coverage of the dividend has worked well as the Dividend Cushion ratio has shown.

There are a few other reasons that can punish a company’s dividend. For one, a secular decline in the company’s products could lead to a dividend cut, while contingent liabilities could potentially force management to pause growth or even cut the payout to conserve cash or allocate funds in its legal defense. A new strategic vision could also change the dividend policy at the company, or management could slash the payout to make it more in line with peers.

With all this said, sometimes the board could cut the payout unexpectedly, too, even if free cash flow is solid and the balance sheet is healthy. Perhaps they want to make a big acquisition or buy back lots of stock to leverage up the company. Whatever the reason, dividend growth investors need to pay close attention to the potential for a payout cut. In this note, let’s cover two companies potentially at risk of a dividend cut in the coming years.

First things first, for Intel, let’s look at the numbers. For the twelve months ended 2022, Intel generated cash flow from operations of $15.4 billion, but it added $23.7 billion in net property, plant and equipment, an absolutely staggering number that drove adjusted free cash flow firmly in the negative. After accounting for a few other items (‘payments on finance leases’ and ‘sale of equity investment’), adjusted free cash flow was a negative $4.1 billion on the year. That’s not good at all, especially considering that the firm paid out nearly $6 billion to shareholders in dividends over the same time period.

Looking at the balance sheet isn’t very encouraging either. At the end of 2022, the company had $37.7 billion in debt and $4.4 billion in short-term debt against cash of $11.1 billion and short-term investments of $17.2 billion, meaning Intel has a net debt position. Intel may have sufficient cash on the books to keep paying the dividend for the next couple of years, but that assumes the firm stops its cash burn pronto. The company plans to cut costs by $8-$10 billion by the end of 2025, and we view these cuts as absolutely necessary, considering that revenue is under considerable pressure.

Years ago, Intel was the leader with AMD (AMD) only hoping to follow, but the roles seemingly have switched. Intel is now in a world of trouble, and the company’s fourth-quarter results, released January 27, might mark the beginning of some very, very tough times for the chip giant. We’ll have to see how things shake out during 2023, but if Intel plans to continue to spend aggressively, we could see the company seek to shore up its balance sheet by cutting the dividend at some point. Intel’s outlook for the first quarter of 2023 came in far below consensus estimates, and investors have good reason to be concerned. Intel’s dividend could end up on the chopping block before we know it.

As we did with Intel, let’s first start with the numbers. During the full year 2022, operating cash flow fell 25%, to $5.6 billion, while the company generated $4.7 billion in adjusted free cash flow, which was also down 25% on a year-over-year basis. During the year, 3M covered its cash dividends paid of ~$3.4 billion. 3M is in much better shape than Intel in this regard, and the company expects adjusted operating cash flow to advance to the range of $5.8-$6.3 billion in 2023.

Though that’s a move in the right direction with respect to expected cash flow generation, 3M’s guidance with respect to full-year 2023 results wasn’t very encouraging. Management expects total sales to fall 2%-6%, with adjusted earnings per share to come in at $8.50-$9.00 versus $9.88 per share on a comparable basis last year. 3M expects free cash flow conversion to be 90% to 100%, but we’ll be monitoring the company’s success in this area as the year progresses.

The bigger threat with respect to 3M, in our view, is the contingent liabilities associated with its “forever chemicals” (PFAS products) and allegations that it sold the military faulty earplugs. The contingent liabilities associated with these types of missteps could be huge, and that’s why we think investors have punished shares of 3M, driving its dividend yield north of 5% at last check. Litigation risk is almost impossible to quantify, but it’s something dividend growth investors can’t ignore when it comes to 3M, in our view.

At the end of September (we’re still waiting for 3M’s 2022 Annual Report to be filed), the company held $13.8 billion in long-term debt and another $1.86 billion in short-term debt against a cash balance of $3.4 billion and $185 million in marketable securities. 3M has solid free cash flow coverage of its payout, but net debt on the balance sheet and the magnitude of potential contingent liabilities it could face down the road could eventually threaten its dividend. Its lofty yield speaks of this concern, in our view.

Concluding Thoughts

Dividend growth investing is a wonderful strategy, but it relies on forecasting dividend growth for many years to come. In the case of Intel, we’re mighty concerned about its payout health on the basis of its balance sheet and deteriorating free cash flow generation. 3M, on the other hand, can cover its dividend quite well with free cash flow, but its balance sheet and contingent liabilities leave us a bit concerned about the payout in the years to come. We think investors should heed caution when it comes to considering either Intel’s or 3M’s dividend payouts. Both could keep their dividends intact for a long time yet, but the risks to both have increased considerably during the past few years, in our view.

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