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Are Dividend Investors Getting More Than They Bargained For With K-Bro Linen Inc.'s (TSE:KBL) Dividend?

Simply Wall St

Dividend paying stocks like K-Bro Linen Inc. (TSE:KBL) tend to be popular with investors, and for good reason - some research suggests a significant amount of all stock market returns come from reinvested dividends. If you are hoping to live on the income from dividends, it's important to be a lot more stringent with your investments than the average punter.

With K-Bro Linen yielding 3.9% and having paid a dividend for over 10 years, many investors likely find the company quite interesting. It would not be a surprise to discover that many investors buy it for the dividends. When buying stocks for their dividends, you should always run through the checks below, to see if the dividend looks sustainable.

Explore this interactive chart for our latest analysis on K-Bro Linen!

TSX:KBL Historical Dividend Yield, December 4th 2019

Payout ratios

Dividends are typically paid from company earnings. If a company pays more in dividends than it earned, then the dividend might become unsustainable - hardly an ideal situation. Comparing dividend payments to a company's net profit after tax is a simple way of reality-checking whether a dividend is sustainable. K-Bro Linen paid out 129% of its profit as dividends, over the trailing twelve month period. A payout ratio above 100% is definitely an item of concern, unless there are some other circumstances that would justify it.

We also measure dividends paid against a company's levered free cash flow, to see if enough cash was generated to cover the dividend. K-Bro Linen paid out 51% of its free cash flow last year, which is acceptable, but is starting to limit the amount of earnings that can be reinvested into the business. It's disappointing to see that the dividend was not covered by profits, but cash is more important from a dividend sustainability perspective, and K-Bro Linen fortunately did generate enough cash to fund its dividend. If executives were to continue paying more in dividends than the company reported in profits, we'd view this as a warning sign. Extraordinarily few companies are capable of persistently paying a dividend that is greater than their profits.

Is K-Bro Linen's Balance Sheet Risky?

As K-Bro Linen's dividend was not well covered by earnings, we need to check its balance sheet for signs of financial distress. A quick check of its financial situation can be done with two ratios: net debt divided by EBITDA (earnings before interest, tax, depreciation and amortisation), and net interest cover. Net debt to EBITDA measures total debt load relative to company earnings (lower = less debt), while net interest cover measures the ability to pay interest on the debt (higher = greater ability to pay interest costs). K-Bro Linen has net debt of 1.44 times its EBITDA, which we think is not too troublesome.

Net interest cover can be calculated by dividing earnings before interest and tax (EBIT) by the company's net interest expense. Interest cover of 3.40 times its interest expense is starting to become a concern for K-Bro Linen, and be aware that lenders may place additional restrictions on the company as well.

We update our data on K-Bro Linen every 24 hours, so you can always get our latest analysis of its financial health, here.

Dividend Volatility

One of the major risks of relying on dividend income, is the potential for a company to struggle financially and cut its dividend. Not only is your income cut, but the value of your investment declines as well - nasty. For the purpose of this article, we only scrutinise the last decade of K-Bro Linen's dividend payments. The dividend has been cut by more than 20% on at least one occasion historically. During the past ten-year period, the first annual payment was CA$1.10 in 2009, compared to CA$1.58 last year. This works out to be a compound annual growth rate (CAGR) of approximately 3.7% a year over that time. The dividends haven't grown at precisely 3.7% every year, but this is a useful way to average out the historical rate of growth.

Modest growth in the dividend is good to see, but we think this is offset by historical cuts to the payments. It is hard to live on a dividend income if the company's earnings are not consistent.

Dividend Growth Potential

With a relatively unstable dividend, it's even more important to evaluate if earnings per share (EPS) are growing - it's not worth taking the risk on a dividend getting cut, unless you might be rewarded with larger dividends in future. Over the past five years, it looks as though K-Bro Linen's EPS have declined at around 8.8% a year. Declining earnings per share over a number of years is not a great sign for the dividend investor. Without some improvement, this does not bode well for the long term value of a company's dividend.

We'd also point out that K-Bro Linen issued a meaningful number of new shares in the past year. Regularly issuing new shares can be detrimental - it's hard to grow dividends per share when new shares are regularly being created.

Conclusion

When we look at a dividend stock, we need to form a judgement on whether the dividend will grow, if the company is able to maintain it in a wide range of economic circumstances, and if the dividend payout is sustainable. We're a bit uncomfortable with its high payout ratio, although at least the dividend was covered by free cash flow. Earnings per share are down, and K-Bro Linen's dividend has been cut at least once in the past, which is disappointing. In this analysis, K-Bro Linen doesn't shape up too well as a dividend stock. We'd find it hard to look past the flaws, and would not be inclined to think of it as a reliable dividend-payer.

Given that earnings are not growing, the dividend does not look nearly so attractive. Businesses can change though, and we think it would make sense to see what analysts are forecasting for the company.

We have also put together a list of global stocks with a market capitalisation above $1bn and yielding more 3%.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.