Deep Dive: Watch out for dividend-stock ‘yield traps’ during the coronavirus crisis

The sharp and fast decline of stock prices during the coronavirus outbreak means dividend yields have risen considerably. Meanwhile, the flight to quality and Federal Reserve policy have pushed down U.S. Treasury bond rates.

Taken together, these factors point to dividend stocks as attractive income plays. However, you need to be more focused on your own research to avoid yield traps.

B. Riley FBR analyst Eric Wold looked at 11 dividend-paying companies in the media, entertainment and outdoor-leisure industries and rated their likelihood of dividend cuts from “none” to “high.” We’ll start with this list and then consider potential large-cap yield traps lower down.

What is a yield trap?

A potential yield trap is a stock of a dividend-paying company that has fallen more quickly than the company’s earnings have fallen, making the shares appear attractive on a price-to-earnings basis and on a yield basis. No matter how much the share price has fallen before you buy, if the company subsequently cuts the dividend, the shares can be crushed, and your investment value along with it — and you lose part or all of the dividend that drew you to the shares.

And as far as earnings go, they cannot be predicted at this point — we’re too early in the financial crisis. So price-to-earnings ratios are essentially meaningless for the time being.

The B. Riley FBR list

Wold looked at 11 small-cap media, entertainment and outdoor-leisure companies and assigned dividend-cut probabilities of “none,” “low,” “medium” and “high.”

Let’s accentuate the positive and begin with two companies whose likelihood of cutting dividends on common shares is “none” according to Wold, who has “buy” ratings on both:

• Wold believes Dolby Laboratories US:DLB  can “push through any potential spending slowdown” because its Dolby Vision and Dolby Atmos systems have become “de facto standards” as the company has achieved an “annual doubling of volumes” for the past three years.

• “Keep in mind that ~90% of [InterDigital’s US:IDCC ] license revenues are derived from fixed-fee license agreements — mainly with Apple, Samsung and LG — that are not impacted by unit volumes or timing,” Wold wrote.

Here are three companies Wold believes have a “low” risk of cutting dividends. He has a neutral rating on Marcus MCS, +1.36%, but “buy” ratings for Xperi XPER, +1.25% and Brunswick  BC, +0.87% :

• Marcus has closed all its theaters so it isn’t generating any revenue. But the company owns 62% of its theaters,giving it an advantage over competitors, according to Wold. He sees “a low risk to the dividend being cut given the significant flexibility in cap-ex spending with the company’s owned theaters (that could make the annual cash flow shortfall minimum).”

• For Xperi, Wold sees “multiple upside scenarios,” and also wrote that B. Riley FBR’s free cash flow projections are “well ahead” of where they need to be to cover annual dividend payments.

• Brunswick has suspended production of boats and engines, but has continued to produce parts and accessories. Wold sees little risk to the dividend because of the company’s efforts to reduce debt and cut expenses before the coronavirus crisis, and also because his free cash flow projections for 2020 and 2021 are well above the dividend.

Here are four companies that Wold believes are at “medium risk” for cutting dividends; he has neutral ratings on all of them except for his “buy” rating for National CineMedia:

• Cinemark Holdings US:CNK  is another theater operator with no revenue as long as its theaters are closed. B. Riley FBR estimates the company’s 2020 free cash flow won’t cover its dividend.

• National CineMedia US:NCMI  produces pre-show advertisements used in movie theaters, so it is earning no revenue as theaters remain closed. B. Riley FBR estimates the company’s free cash flow this year will be less than its dividend payout.

• Marine Products US:MPX  hasn’t cut production, but B. Riley FBR expects a 15% decline in sales over the next 12 months, and another 10% decline over the subsequent 12-month period. The firm expects free cash flow to cover the dividend this year and next year. However, “a potential recession could drive the company’s board to take another look at the dividend,” Wold wrote.

Here are the two companies Wold covers that he believes are at “high” risk of cutting dividends. He has neutral ratings for both:

• AMC Entertainment Holdings US:AMC   cut its dividend by 85% last month. But B. Riley FBR projects that free cash flow will still not cover this year’s remaining payout.

• Cedar Fair’s US:FUN  theme parks are closed, which means there’s no revenue. Even if the company is able to reopen theme parks in mid-May, B. Riley FBR projects its 2020 free cash flow will only cover half the dividend.

Financial crisis

As identified COVID-19 cases in the U.S. rise rapidly, and a frightening death toll mounting, we appear still to be in an early state of the health crisis. But we are probably at an even earlier stage in the financial crisis. The S&P 500 Index SPX, +3.35%  hit its record high on Feb. 19 — the forward-looking stock market was more than halfway through the first quarter. Unemployment claims rose dramatically for the week ended March 21. The number of new claims may remain at a similarly elevated level for several weeks.

A potential place for dividend traps

Consider one industry: energy. The decision of Saudi Arabia and Russia to fight an oil price war by increasing production at this time is really an attack on the U.S. shale oil industry, with its massive production but relatively high expenses. The West Texas Intermediate (WTI) crude oil CL00, +7.42%  continuous contract quote was down 65% for 2020 to $21.51 a barrel on March 27.

On March 30, Jack Allardyce, an oil and gas analyst at Cantor Fitzgerald Europe, said: “With major producers pumping barrels freely and the IEA (International Energy Agency) suggesting that short-term demand could fall by a fifth due to travel restrictions, global storage is likely to hit capacity over the next two to three months. This is likely to be particularly damaging for U.S. crude, with prices in the Permian region potentially hitting single digits.” The italics are mine.

This means we are likely to see a tremendous wave of additional unemployment claims as domestic oil producers try to cut production as quickly as possible. Many energy companies have already made moves to build up and preserve cash — drawing credit lines, cutting capital expenditures, suspending share buybacks and lowering or suspending dividends.

Yes, it’s obvious that the weaker energy players will cut their dividends. But what about the old standbys?

Among large-cap stocks, Exxon XOM, +1.49%  and Chevron CVX, +4.61%  have traditionally been considered safe-and-steady dividend payers. But Exxon’s dividend yield had shot up to 9.42% at the close on March 27, after its shares had declined 55% from the end of 2019. Chevron’s dividend yield was 7.50%, with its shares also down 55% for 2020. In a market environment with such low interest rates, these very high yields indicate a lack of confidence among a good proportion of investors that even these dividends are at risk.

Both companies are components of the S&P 500 Dividend Aristocrats Index SP50DIV, +7.09% and held by the ProShares S&P 500 Dividend Aristocrats ETF NOBL, +3.48%, because they have increased annual regular dividend payouts for at least 25 consecutive years. Both continued to raise their annual dividends through the 2008-2009 financial crisis. Both managed to do the same when oil pries crashed 67%, from a high (for that cycle) of $107.68 on June 13, 2014 through a cycle bottom of $26.05 on Feb. 11, 2016.

Can they do so again during this cycle, with oil prices already dropping through the 2016 low? Can they do it if the Saudi and Russian governments continue to refuse to play ball and we hit the single digits? Might they be tempted not only to cut capital expenditures and stop buying back shares to shore up their balance sheets and possibly limit layoffs, but to also cut dividend payouts as well? After all, Exxon paid $14.65 billion in dividends during 2019, while Chevron paid out $8.96 billion.

In fairness, Exxon and Chevron are probably the safest dividend-payers in the oil patch. Chevron was included on a list of stocks that analysts at Jefferies said investors could be “practically stealing” at discounted prices because of the companies’ high quality. Pavel Molchanov, an analyst with Raymond James, said two weeks ago that it would be “virtually unthinkable” for either company to cut their dividend.

But the COVID-19 outbreak, paired with an increase in oil production by Saudi Arabia while global demand is dropping so dramatically, was also “unthinkable” only a few months ago.

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