Here's a scenario we see all the time; you buy a company that looks great on paper, an analyst is predicting a 10% or 12% dividend yield over the next few years and now really all you need is for the share price to stay put and you've got yourself a 33% return over three years!
What actually happens though is that some companies will announce a profit downgrade, then they announce that they are going to restructure their management team, and then they realise that debt's too high and revenue is sliding too fast so dividends will have to be cut to reinvest in the business.
Beware!
The stories of STW Communications Group Ltd. (ASX: SGN), Metcash Limited (ASX: MTS), and QBE Insurance Group Ltd (ASX: QBE) are all great examples of the above process. Metcash shares are down 61% over the last 12 months, STW shares are down 54%, while QBE's issues started in 2010. The share price fell from $24 to $10 as management went through the above process.
Danger Sign 1: Industry fundamentals
Consider the industry fundamentals first and foremost. Is the company the best in the industry and does it have qualities that gives it protection from rivals? These qualities, known as moats by many investors, make it difficult for rivals to steal sales and ensure that the company can maintain profitability even in a market downturn.
All three companies above have limited 'moats' because their generic products can be sold by others at a cheaper price. QBE is a slight exception due to its size ($19 billion company), however investors need to step back and make sure that the industry is growing and the company remains strong within the industry. Competition is increasing in a major way for Metcash and STW and I can't see how they can escape it.
Danger Sign 2: Beware of unsustainable dividends
Investors always need to be wary of companies that target a large percentage payout of underlying net profit. The key issue here is that the company can end up paying out more than 100% of actual net profit, which CAN be fine, but as we've seen in the Metcash situation, sacrificing the potential to lower debt by paying out massive dividends can lead to big problems in the future.
In fact, this may be a large part of why STW is in the position it's in! Had STW targeted debt reduction over dividends in years gone by, perhaps its dividend would be increasing, rather than decreasing from 8.6 cents per share in 2013 to a forecast 6 cents this year.
Danger Sign 3: Beware of Management Restructure & Transformations
STW needs a management restructure. The company is an amalgamation of over 80 separately operating companies working under their own brands. The problem is that management restructures sound great on paper, and indeed having a structure that instils greater financial discipline on each part of the business is a good idea but there are risks!
What if management is taking power away from ex-business owners that demand the ability to manage their firms? What if all management are doing is increasing paperwork for each group within the network to 'apply' for funding? How well is this financial efficiency drive understood by the manager of each group?
Metcash is restructuring and QBE had to perform a massive restructure to make sure the 125 acquisitions it made over a 20-year period were working as a team! These reviews cost money and success isn't guaranteed.
Dividend Potential
As we've seen with Metcash, nominating a high dividend payout ratio is a great plan, as long as it's sustainable. I noted this exact issue with QBE Insurance earlier today.
The average analyst is now expecting STW Communications to deliver net profit of $44.6 million this financial year (ending December 31), down from $49.5 million in 2013 and $46.6 million in 2014. They expect net profit will rebound to nearly $47 million in 2016, which corresponds to an earnings per share of 10.8 cents this year and 11.4 cents next year- putting the company on a price to earnings ratio of just 5.6 this year and 5.3 next year.
Dividends are expected to be 5.7 cents per share both this year and next, but beware as analysts were also expecting that Metcash would be yielding over 12% this year. They've now ceased their dividend to pay down debt and restructure the business.
