After A Dividend Freeze, Follow These Steps

I hate to sell a stock. When I buy a stock, my intention is to hold it forever and enjoy its ever-growing dividend income. Unfortunately, it doesn't always work that way. Sometimes a stock changes and no longer fits in my income portfolio. It could be a company that cuts its dividend or in some cases freezes its dividend. Let's take a look at a two-step process designed to help us determine if we should sell a stock after a dividend freeze.

I. Does The Stock Still Meet Our Investment Criteria?

Dividend investing is about about building a reliable income stream that increases each year. When an investment stops raising its dividend it is no longer providing the future income growth required by my dividend portfolio. The stock may still be a good value, but my dividend portfolio’s primary objective is ever-increasing dividend income, not capital gains.

Obviously, the company's future prospects would play into a decision to keep or sell. Can the company raise its dividend, albeit late, and still preserve a year-over-year increase? Will the future earnings provide sufficient free cash flow to pay a dividend? What other obligations, such as debt, might absorb future cash flows? Is management committed to the dividend? Would you buy this stock today as an income investment? This step determines if the stock is a candidate for a sale.

II. Are There Better Alternatives Available?

Once the stock has been identified as a candidate for a sale, the question then becomes is there something out there that is better? Don't forget in determining the market value of a stock, the market considers any known "bad news" about about a company. So after the bad news is out and the company freezes the dividend, the price may drop and increase the effective yield on the stock. Yield on cost is not relevant when considering a sale.

The current price and current yield are what you will receive and give up when selling a stock. With the cash received is there another stock that would be an "upgrade" from the one you are selling? What does its future prospects look like? Will the new stock replace the dividend income lost from the one sold? What does its debt and cash flow look like? Will it continue to grow its dividend in the future? Is it a more riskier stock?

If in answering these questions you determine the stock should be sold, then you pass step two. At this point, you should sell the stock that froze its dividend and purchase the one you identified in step two.

A Real-World Example

I am holding three stocks with frozen dividends. Last week I spent some time analyzing one of them - Home Depot (HD). Its quarterly dividend has been frozen at $0.225/share since November 2006. Let's run it through the two-step process and see what happens.

I. Does The Stock Still Meet Our Investment Criteria? - Home Depot (HD)

• Can the company raise its dividend, albeit late, and still preserve a year-over-year increase? No, the annual dividend was $0.90/share in 2007 and 2008.


• Will the future earnings provide sufficient free cash flow to pay a dividend? Not easily. HD's 2008 free cash flow was $2.2 billion while it dividend was $1.7 billion.


• What other obligations, such as debt, might absorb future cash flows? HD has been increasing its debt over the last several years. In 2006, HD's total debt was $4.1 billion. At the end of 2008, HD's debt has nearly tripled to $11.4 billon.


• Is management committed to the dividend? This is subjective, but given the above it will be hard to increase the dividend in the near-term.


• Would you buy this stock today as an income investment? Definitely not!
  

Based on Step I, HD is a candidate for a sale. Let's take it through step 2.

II. Are There Better Alternatives Available? - Home Depot (HD)

On the day I was evaluating HD, its current yield was 3.52%. Good, but not great when compared to companies with a similar yield and growing their dividends. So the question is, "If I sold HD, is there another stock that would be an upgrade?" Over the last several weeks I have looked at three companies the piqued my interest. Let's compare them to HD:

1. Genuine Parts Co. (GPC) - [Recent Analysis]

• What does its future prospects look like? The economic downturn has left GPC struggling in some areas, but its management has done an excellent job managing the company for cash.


• Will the new stock replace the dividend income lost from the one sold? With a current yield in excess of 4.5%, GPC could more than replace HD's lost income.


• What does its debt and cash flow look like? GPC ended 2008 with a low debt to capital of 17.7%. Its 2008 free cash flow of $425 million was down from the 2007 record level of $526 million, but with little debt, the $425 is more than adequate to cover the annual $252 million dividend.


• Is it a more riskier stock? With its strong balance sheet and cash flows, GPC is less risky.


• Will it continue to grow its dividend in the future? For the 53rd consecutive year, GPC raised its dividend in March 2009. It appears to have the financial ability to sustain increases going forward.
  

2. General Dynamics Corp. (GD) - [Recent Analysis]

• What does its future prospects look like? Much of GD's work is tied to long-term defense contracts. Its business jet segment has suffered some.


• Will the new stock replace the dividend income lost from the one sold? With a current yield of 3.27%, GD's income will be slightly less than HD's, but with a dividend growth rate of 11% it could surpass HD in one year.


• What does its debt and cash flow look like? GD ended 2008 with $3.1 billion in debt, up from the $2.8 billion in 2007. Its 2008 free cash flow of $2.6 billion was at a record level and is more than adequate to cover the annual $533 million dividend.


• Is it a more riskier stock? No, with its strong cash flows and debt to capital of 24%, GD is better positioned than HD to weather the downturn.


• Will it continue to grow its dividend in the future? No reason to believe it won't.
  

3. Abbott Laboratories (ABT) - [Recent Analysis]

• What does its future prospects look like? Like all pharmaceutical companies, ABT is facing challenges to their branded patents, drug development and regulatory issues. However, they have a good pipeline and have diversified their business, thus they appear to be in a better position than most of their peers. Near-term, the economic downturn should affect them less than HD.


• Will the new stock replace the dividend income lost from the one sold? With a current yield in excess of 3.6%, ABT will replace HD'd lost income.


• What does its debt and cash flow look like? At 40% ABT's debt to total capital is a little higher than the 35% I like to see. However, it is moving in the right direction. ABT ended 2008 with $11.4 billion in debt, down from the $12.2 billion in 2007. Its record 2008 free cash flow of $6.1 billion was up $2.5 billion from 2007, and is more than adequate to cover the annual $2.2 million dividend.


• Is it a more riskier stock? No. ABT with its strong cash flows should be able to pay its dividend and pay down debt with the cash left over. I consider ABT's near-term prospects better than HD's.


• Will it continue to grow its dividend in the future? No reason to believe it won't.
  

In answering the above questions, I was confident that either GD or ABT would be an excellent replacement for HD. Going into April, GPC was my favorite, but it was disqualified based on its valuation.

I had pegged GPC as a stock to purchase in April. I opted to defer a month and wait until their earnings release on April 16th. Last week GPC reported 11% lower sales and 28% lower income. So why did their stock jump nearly 10% that day? First, they beat analysts prediction by $0.07/share. Secondly, and more importantly to me, they increased free cash flow by $10.6 million, or 8.6%. Management judiciously managed working capital and watched capital spending - signs of good management. Unfortunately, after its run-up, GPC's stock price was was trading well in excess of my buy price of $31.06. For now, I will leave GPC on my watch list.

Taking into account all the above, I sold HD and purchased ABT.

Full Disclosure: Long ABT


Related Articles:

• Should You Sell A Dividend Stock After A Dividend Freeze?
• What To Do With A Dividend Freeze?
• Early Warning Signs of a Dividend Cut
• 21 Suggestions for Success
• Measuring Dividend Stocks Investment Risk Profile