Regular readers of my work will be well aware of my affinity for dividends. When investing for yield, it is important to make sure the dividend is safe and paid from profits generated from real earnings. Utility stocks come to my mind when I think of safe dividends in a stable industry that is almost guaranteed to profit.
Always be careful about what you think you know
The three businesses remaining my list after eye-balling stock screen results were Entergy Corporation (NYSE:ETR), American Electric Power Company, Inc. (NYSE:AEP), and FirstEnergy Corp. (NYSE:FE). Among these three I found the geographic distribution of services that I was hoping for and I thought that, since these were “safe” utility companies, this would be a quick exercise. I was not careful enough about what I thought I knew. When conducting due diligence, always work through the entire process prior to reaching a conclusion.
Three utilities with a common thread
However, when I looked at the cash flow statement, I noticed that over the last five years, subtracting capital expenditures from the cash from operations produced a positive result of $1.494 billion but the company paid out $3.036 billion in dividends and issued $2.402 billion in debt to cover the shortfall. Not my idea of a safe dividend.
American Electric Power Company, Inc. (NYSE:AEP) has power distribution operations in 11 states from Virginia to Texas and a very attractive dividend yield of 4.01%. It also exhibits some other favorable numbers with a current year P/E ratio of 15.38, right in line with the broader market and a very reasonable price to book ratio of 1.54. When these numbers were combined with a modest price to cash flow ratio of 8, I thought I had a real find.
Unfortunately, a review of the cash flow statement revealed some problems. Over the past five years, this business spent $518 million more on capital expenditures than was generated by cash from operations. It paid $4.073 billion in dividends to shareholders. Where did it get the money to spend more than it earned? It borrowed, to the tune of $4.59 billion between new debt sold and new stock issued to the public. As much as I like the dividend, these figures are hard to ignore.
The third business that survived my initial screening was FirstEnergy Corp. (NYSE:FE), a power provider in Pennsylvania, Ohio, New Jersey, West Virginia, Maryland and New York. Once again, the initial numbers looked promising with a 5.13% dividend yield and a current P/E ratio of 14.27 times 2013 earnings. The price to cash flow appeared to be a reasonable but unexciting 10 and the price to book value is only 1.38, which is quite reasonable.
Once again, when I started to review the cash flow statements for the past five years, I found that while the cash from operations less capital expenditures produced a positive cash result of $734 million, the amount of cash required to pay the handsome dividend was $3.812 billion and the difference was mostly funded with $2.083 billion of net debt issued during that time. The remainder was covered from existing cash on the books but the business still borrow over 50% of the money required to fund the dividend payout.
Foolish conclusions are not always funny
These businesses have not changed my view on dividend investing nor soured me on finding excellent opportunities in the utility sector. What it has done is display the need to dig deep when investing for dividend yield — and to avoid these three stocks.
The article Three Stocks to Avoid When Buying for Dividend Yield originally appeared on Fool.com and is written by Ken McGaha.
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