Do Investors Have Good Reason To Be Wary Of Southern Cross Electrical Engineering Limited's (ASX:SXE) 7.2% Dividend Yield?

Today we'll take a closer look at Southern Cross Electrical Engineering Limited (ASX:SXE) from a dividend investor's perspective. Owning a strong business and reinvesting the dividends is widely seen as an attractive way of growing your wealth. Yet sometimes, investors buy a popular dividend stock because of its yield, and then lose money if the company's dividend doesn't live up to expectations.

With Southern Cross Electrical Engineering yielding 7.2% 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. There are a few simple ways to reduce the risks of buying Southern Cross Electrical Engineering for its dividend, and we'll go through these below.

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Payout ratios

Dividends are usually paid out of company earnings. If a company is paying more than it earns, then the dividend might become unsustainable - hardly an ideal situation. So we need to form a view on if a company's dividend is sustainable, relative to its net profit after tax. Southern Cross Electrical Engineering paid out 52% of its profit as dividends, over the trailing twelve month period. This is a healthy payout ratio, and while it does limit the amount of earnings that can be reinvested in the business, there is also some room to lift the payout ratio over time.

Another important check we do is to see if the free cash flow generated is sufficient to pay the dividend. Southern Cross Electrical Engineering paid out 159% of its free cash flow last year, suggesting the dividend is poorly covered by cash flow. Paying out more than 100% of your free cash flow in dividends is generally not a long-term, sustainable state of affairs, so we think shareholders should watch this metric closely. Southern Cross Electrical Engineering paid out less in dividends than it reported in profits, but unfortunately it didn't generate enough free cash flow to cover the dividend. Cash is king, as they say, and were Southern Cross Electrical Engineering to repeatedly pay dividends that aren't well covered by cashflow, we would consider this a warning sign.

With a strong net cash balance, Southern Cross Electrical Engineering investors may not have much to worry about in the near term from a dividend perspective.

Remember, you can always get a snapshot of Southern Cross Electrical Engineering's latest financial position, by checking our visualisation of its financial health.

Dividend Volatility

From the perspective of an income investor who wants to earn dividends for many years, there is not much point buying a stock if its dividend is regularly cut or is not reliable. For the purpose of this article, we only scrutinise the last decade of Southern Cross Electrical Engineering's dividend payments. This dividend has been unstable, which we define as having been cut one or more times over this time. During the past 10-year period, the first annual payment was AU$0.07 in 2010, compared to AU$0.03 last year. This works out to be a decline of approximately 7.4% per year over that time. Southern Cross Electrical Engineering's dividend hasn't shrunk linearly at 7.4% per annum, but the CAGR is a useful estimate of the historical rate of change.

We struggle to make a case for buying Southern Cross Electrical Engineering for its dividend, given that payments have shrunk over the past 10 years.

Dividend Growth Potential

Given that dividend payments have been shrinking like a glacier in a warming world, we need to check if there are some bright spots on the horizon. Earnings have grown at around 4.0% a year for the past five years, which is better than seeing them shrink! 4.0% per annum is not a particularly high rate of growth, which we find curious. When a business is not growing, it often makes more sense to pay higher dividends to shareholders rather than retain the cash with no way to utilise it.

We'd also point out that Southern Cross Electrical Engineering issued a meaningful number of new shares in the past year. Trying to grow the dividend when issuing new shares reminds us of the ancient Greek tale of Sisyphus - perpetually pushing a boulder uphill. Companies that consistently issue new shares are often suboptimal from a dividend perspective.

Conclusion

To summarise, shareholders should always check that Southern Cross Electrical Engineering's dividends are affordable, that its dividend payments are relatively stable, and that it has decent prospects for growing its earnings and dividend. First, the company has a payout ratio that was within an average range for most dividend stocks, but it paid out virtually all of its generated cash flow. Unfortunately, earnings growth has also been mediocre, and the company has cut its dividend at least once in the past. Overall, Southern Cross Electrical Engineering falls short in several key areas here. Unless the investor has strong grounds for an alternative conclusion, we find it hard to get interested in a dividend stock with these characteristics.

Market movements attest to how highly valued a consistent dividend policy is compared to one which is more unpredictable. Still, investors need to consider a host of other factors, apart from dividend payments, when analysing a company. For example, we've picked out 3 warning signs for Southern Cross Electrical Engineering that investors should know about before committing capital to this stock.

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

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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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