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A Good Payout Ratio May Not Be a Guarantee for Dividend Security

With low yields globally, the U.S. stock market offers plenty of securities with attractive dividend yields. At a quick glance, the world's largest regional theme park operator, Six Flags Entertainment Corp. (NYSE:SIX), offers one of the juiciest dividend yields out there. The Grand Prairie,Texas-based theme park operator can easily be part of a growth-income portfolio until close scrutiny of its cash flow is considered.

Meanwhile, missing two consecutive quarters did not help Six Flag's stock as it has maintained a downward path so far this year. Shares are down 22.4% year to date. A brutal drop of 12% happened just recently when the company's CEO said it is not in discussion or negotiations for a merger or acquisition. This was after its competitor, Cedar Fair LP (NYSE:FUN), rejected the former's $4 billion bid earlier this month.

Setting aside the company's difficulty in the mergers and acquisitions field, Six Flags appears to have a very attractive dividend yield of 7.6%. The company also demonstrates the capacity to cover for this high dividend payout so far this year. It handed out $209 million in dividends while having generated $230.97 million in profits--a 90% payout ratio--in the past nine months.

With growing revenue despite the earnings miss and a high payout ratio, Six Flags seems to be a good fit for a dividend income portfolio. However, a closer look at the company's balance sheet and free cash flow payout ratio may simply turn off more conservative investors.

For the recent quarter, the company reported a negative book value (more liabilities than assets) of $635 million compared to negative $643 million last December. Six Flags also registered a free cash flow payout ratio of 96% year to date, similar to its 2018 figure.

In review, a good payout ratio derived by dividing dividend payouts by its profit in a certain period of time can simply indicate a reliable dividend payer. While a free cash flow payout ratio--dividend payout divided by free cash flow--may be a more stringent metric for better scrutinizing a company's capability of maintaining and growing its payouts.

For clarification, there is no chance that Six Flags will have any difficulty covering its juicy dividend payouts for the time being. The company also has an admirable eight-year track record of growing its dividend payout and it would be very much disliked by its investors if it started to not grow or even cut its dividend for some unforeseen reason.

The point being made here is that with a negative equity and the growing probability of recession in the near future may push the company's management to conserve cash when the calamity finally hits and rationally choose and allocate its resources in maintaining its unique business operations rather than provide handouts to shareholders. In addition, the company may already have learned its lesson on operating with a leveraged balance sheet when, a little more than a decade ago, it tumbled on its debt amidst the Great Recession and had to file for bankruptcy.

Disclosure: No shares in Six Flags.

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This article first appeared on GuruFocus.