Dividends are an investor's best friend. According to Standard & Poor's, over the past several decades, about 40 per cent of the total return of the S&P 500 can be attributed to the reinvestment of dividends.
Case in point, over the past five years (ended Aug. 31), the S&P 500 had a simple return of 53.5 per cent. That number jumps up to nearly 88 per cent over the same period, if the dividends are consistently reinvested throughout.
In general, I believe investors should focus on the companies that use solid earnings to support consistent dividend growth. Several blue-chip names have raised their payout every year for the past few decades. As a rule of thumb, I like to see earnings that are at least twice as much as the annual dividend.
Even so, investors need to be cautious and not just chase the highest yields out there. If a security is yielding 8 per cent when the S&P 500 yields 2 per cent, there is added risk involved that should be understood before making any purchase.
With that in mind, I recently searched for outsized dividends that could be in danger. These payouts are either in peril of being cut, or the underlying stock may underperform the broader market and eliminate the benefit of the income.
In my opinion, Pitney Bowes is the poster child of a dividend in peril. The company, which is best known for its postage meters, actually has a rich history of paying dividends, having raised its payout every year since 1983.
That said, recent action in the stock suggests the market believes this streak could soon come to an end. The shares are down 24 per cent, year-to-date, and are currently changing hands around $14.14 (which works out to a 10.7 per cent dividend yield, based on the quarterly payment of $0.375 a share).
Pitney's 2012 consensus earnings estimate of $2.02 a will allow management to cover the annual dividend 1.3x. However, the company's earnings are expected to decline the next three years; which should come as little surprise to anyone who's been keeping up to date with the current financial state of the U.S. Postal Service.
In the meantime, Pitney has 7x more debt on the balance sheet than cash and $825-million of the borrowings coming due over the next two years. With few identifiable catalysts, I believe the action of the underlying stock will continue to deteriorate the benefit of the company's dividend, for as long as management can afford to pay it.
RR Donnelley is another stock who's 8.8 per cent dividend yield may not be as attractive as initial glance, after taking a closer look at the company's underlying fundamentals. At $11.82, the shares have fallen 18 per cent, year-to-date, more than offsetting any potential benefit of the dividend income.
Again, the story at RR Donnelley is similar to what it is at Pitney Bowes: a declining core business. In this case, the company operates in commercial printing, where both volume and pricing have been weak for several quarters.
RR Donnelley can currently cover its quarterly dividend of $0.26 a share at 1.7x of expected full-year earnings. However, the company's profit is expected to be flat at best over the next few years and the stock is not attracting many investors – even though it is trading at 6x expected full-year earnings. In the meantime, RR Donnelley has 10x more debt than cash on its balance sheet and its bonds have been designated with a Junk rating by S&P.
Declining earnings and a high debt load should be red flags for investors looking at stocks with above-average dividend yields. As a result, Pitney Bowes and RR Donnelley could soon find their payouts on the chopping block.
As part of TheStreet's partnership with Nightly Business Report, TheStreet's David Peltier will join NBR Monday (check local listings) to look at two dividend stocks to avoid.