Dividend Cut Alert: Double-Digit Yields That Could Soon Be Slashed

No one likes a dividend cut:

• They reduce the income stream that many retirees rely on for funding their retirement lifestyle.
• They often trigger a negative market response, leading to steep stock price declines. This typically adds insult to injury by adding steep capital losses on top of the steep decline in income, limiting investors’ ability to recycle the capital into another investment in an attempt to recoup their lost income.

Some companies are forced to cut their dividends due to macroeconomic events, such as many investment grade companies like Simon Property Group (SPG) and Energy Transfer (ET) did due to economic fallout from the COVID-19 lockdowns. However, many times dividend cuts come as a result of poor balance sheet management. AT&T (T) is a classic example of this, as they had to slash their dividend in an attempt to offload cumbersome debt and retain more cash to deleverage more aggressively after burning billions of dollars on ill-fated acquisitions.

In this article, we will look at two double-digit yielding stocks that we think may soon be forced to cut their dividends in response to management overleveraging their balance sheets.

#1. Medical Properties Trust Stock (MPW)

MPW – a REIT (VNQ) that focuses on for-profit hospitals in locations like the U.S., Europe, and Australia – recently posted solid Q3 results with FFO results and guidance that beat consensus expectations but has seen its stock price continue to crater since then anyway:

MPW’s problems began as a result of its aggressive spending on growth investments, particularly via acquiring numerous hospitals in its bid to continue its strong growth rate.

However, COVID-19 sent several of its hospital tenants into a tailspin due to significant cost increases that were not sufficiently offset by income growth Moreover, interest rates have risen sharply, which is now stressing its heavily leveraged balance sheet. As a result, management has been laser-focused on paying down its debt in a bid to shore up its balance sheet.

As part of this effort, they slashed their dividend by nearly 50% to retain more cash flow with which to pay down debt. They also have been selling assets aggressively, including an Australian hospital portfolio for over $300 million that it plans to use to reduce debt.

That being said, while it seemed for a while like MPW might be on its way out of the woods, conditions have recently deteriorated for its largest tenant Steward Health, which is having to defer rent payments and receive additional financial support from MPW due to its balance sheet issues.

In addition to the fact that MPW generates a lot of its revenue from Steward, it also has invested a considerable amount of money into Steward via both equity and debt structures in recent years as part of its efforts to keep the operator afloat and hopefully help it get through current industry headwinds. Should Steward go bankrupt, it would likely lead to a double hit to MPW in which both its revenues and balance sheet would suffer.

As a result, we think that MPW will likely have to reduce its dividend to the bare minimum in the near future in order to maximize its financial flexibility as it strives to continue paying down debt aggressively while also trying to keep Steward afloat.

#2. NextEra Energy Partners Stock (NEP)

NEP’s distribution is well-covered by CAFD and – unlike MPW – its underlying business model is quite stable. Nearly all of NEP’s cash flow comes from lengthy power purchase agreements (with a weighted average term to maturity of well over a decade) on its wind and solar farms with mostly utility (XLU) counterparties whose weighted average credit rating is BBB+. As a result, while there is some cash flow variance that comes with changing wind and sun patterns, there are very few reasons why NEP would experience a sudden sharp decline in cash flow.

Moreover, its large portfolio and operating expertise give it numerous repowering opportunities that enjoy very high returns on investment and typically involve low risk. This gives NEP an impressive organic growth profile that can also be largely self-funded through leveraging the cash flows on the assets themselves, including the monetization of related tax credits.

Last, but not least, NEP has an impressive track record of growing its payouts very aggressively and – despite recently halving its distribution growth outlook – is still guiding for a 5-8% distribution per unit CAGR through 2026 at least.

That being said, NEP still has some major challenges confronting it. To finance this aggressive growth over the past decade, the company stretched its balance sheet beyond its limits and is now having to play catch up given that its cost of capital has soared due to rising interest rates. In addition to piling on a considerable amount of project-level debt, NEP took on considerable corporate-level debt and also used CEPFs (a form of equity financing that must be paid back by some contractually established date or the assets purchased with that funding will largely go to the investors in the CEPFs).

Unfortunately for NEP, its CEPFs were nearly all scheduled to come due beginning in 2023, which just happened to be when interest rates reached heights not seen in quite some time. As a result, while it was likely planning on redeeming these CEPFs with a combination of attractively priced equity and cheap debt (or potentially even new CEPFs), suddenly any kind of equity financing was off the table and its options for debt financing were also increasingly limited. Instead, management was forced to pivot to selling off its non-core pipeline assets to raise the equity proceeds needed to redeem its CEPFs maturing through 2025 and then leaned on a major favor from its parent and largest shareholder – NextEra Energy (NEE) – to get its IDR fees suspended through 2026 in order to offset the lost cash flow from its pipeline assets. This should – in theory – enable it to sustain its distribution and even continue to grow it moving forward.

However, NEP is far from out of the woods. Management forecasts that it will have a 90%+ payout ratio over the next several years and it still has considerable risk that comes from:

• Needing to sell its Meade Pipeline asset at a good valuation
• Needing to successfully execute its repowering projects and generate the expected returns
• Needing to find a meaningfully sized attractively priced and financed acquisition by 2025 to continue fueling its growth and offset the loss of cash flow from the Meade Pipeline sale and the expense of having to fund its CEPFs in 2026 and beyond.

Given that it still faces these uncertainties, has considerable leverage on its balance sheet, has an elevated payout ratio, and interest rates remain fairly high, it is quite surprising that management continues to guide for a 5-8% distribution CAGR through 2026. While the distribution is certainly manageable if one of the aforementioned maneuvers does not work out as planned, NEP could be forced to slash its distribution.

Note that we are bullish on NEP as a speculative investment as we think that the stock is undervalued and the 12%+ yield is sufficient compensation for the risk involved. However, we also wanted to make clear to investors that this company’s distribution is far from safe and could very possibly be cut in the coming years if NEP fails to perfectly navigate its balance sheet minefield.

Investor Takeaway

Dividend cuts are the bane of the dividend investor’s existence and are particularly common among high-yield stocks. This is because high-yield stocks typically have at least one of the following two traits (and many times have both):

1. They have high payout ratios.
2. Their business models and/or balance sheets are facing significant challenges, leading the market to price in a dividend cut.

In the case of MPW, its payout ratio is not very high, but its business model and balance sheet are facing serious challenges. NEP, meanwhile, has a fairly high payout ratio and its balance sheet is also challenged, though its business model remains in solid shape. We are actually bullish on NEP because we believe that its stock is meaningfully undervalued right now and will ultimately deliver solid long-term returns for investors even if it does have to cut its distribution at some point. However, we are steering clear of MPW because we think its business model is on very shaky ground and bankruptcy is a distinct possibility if it fails to keep Steward alive.