Cherokee (NasdaqGS: CHKE), a licensor of apparel brand names and trademarks, made an important announcement yesterday (Jan. 31st ). Before I tell you what the announcement was about, let’s look at Cherokee’s financials:
- 57% return on equity
- Debt-free
- Current ratio (current assets divided by current liabilities) = 2.5
- Free cash flow positive for the past ten consecutive years
- Earnings per share positive for the past ten consecutive years
- Free cash flow greater than earnings for five of the past six years, including the last two years.
Based on these extremely healthy-looking financial figures, I wouldn’t blame you for guessing that the news was good. Perhaps a takeover offer, a better-than-expected earnings report, or a dividend boost.
You’d be wrong.
In fact, Cherokee announced that it was cutting its dividend almost in half, from a quarterly rate of $0.38 to $0.20. The company’s hid the bombshell news in the seventh paragraph of an eight-paragraph press release, and its explanation for the dividend cut was cryptic:
The Board has decided to reduce the dividend from previous quarters in order to support its existing brands, as well as any newly acquired brands, and enable the Company to execute on its growth strategy.
The company’s stock dropped 11.7% on the news, its worst one-day decline in years. Obviously, given the price reaction, Cherokee’s investors were very surprised by the dividend cut, probably because they also felt secure knowing that the company had posted the healthy financial figures outlined above. Prior to yesterday’s cut, Cherokee’s dividend yield had been a mouth-watering 8.4%, and many shareholders that rely on dividends to meet their daily expenses owned the stock because of its high yield. It must have been quite a shock to wake up Monday morning and read that their monthly lifeline had been cut in half. Ouch.
The real reason for the dividend cut is simple and should never be forgotten. Regardless of how profitable a company is on a percentage basis, a dividend is unsustainable if it is larger than the cash flow supporting it. In Cherokee’s case, its annual dividend has been larger than its free cash flow for the past four years (payout ratio greater than 100%):
Since Cherokee doesn’t need manufacturing facilities and just deals in brand names and trademarks, it has an “asset light” capital structure that Warren Buffett says is the ideal business model (see Berkshire’s 2009 shareholder letter, p.9). In Cherokee’s case, this means that it has no cost of goods sold (i.e., revenues equal gross profit) and requires neither to incur debt nor make capital expenditures.
The problem is that Cherokee’s licensing business has not been growing; revenues and earnings are in decline. Since 2008, the company had already cut its dividend twice to combat this cash flow shortfall before yesterday’s third mega-cut. As I wrote in Dividend Time Bombs, previous dividend cuts are a warning sign that more dividend cuts are on the way.
Cherokee continues to be very profitable on a percentage of equity basis, but its equity and asset bases are shrinking. I’d rather make a 20% profit on a large, growing pie than 55% on a small, shrinking one. How about you?
I know how Cherokee’s investors are answering that question this morning.
Big Yield Hunting, the high-yield investment service from Roger Conrad and
High yields without strong businesses behind them will be at perpetual risk of devastating dividend cuts. And they have no chance of growing either, so they’re guaranteed losers if inflation emerges.
In contrast, only growing and healthy companies will continue to pay their distributions. If we see more inflation, growth is our best chance of keeping pace. Adopting an “income-plus” strategy won’t save your portfolio from all volatility if credit or inflation conditions worsen. But it remains the best approach.
An “income plus” investment standard disqualifies many high-yield companies (such as Cherokee) from Roger and David’s consideration. So far, Big Yield Hunting has recommended two Canadian income trusts, three telecommunications companies, and a master limited partnership (MLP). All of these top-notch stocks sport very high yields that are stable and sustainable.
Give Big Yield Hunting a try today!
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