Whenever you see a stock with a high dividend yield, the first question to ask is whether the dividend is sustainable or not. In the cases of closed-end fund Guggenheim Strategic Opportunities Fund (GOF 0.68%)?and industrial conglomerate 3M (MMM 3.60%), I think there's a real risk that their dividends will be cut.
Anyone thinking of buying either of these two stocks purely as a dividend play needs to consider the case carefully.
1. Guggenheim Strategic Opportunities Fund
The Guggenheim Strategic Opportunities Fund invests in public equity and fixed-income markets across the globe. It specializes in finding securities or spreads between securities that deviate from their perceived fair value and/or historical norms.
The fund's stock currently yields nearly 18%. If that sounds unsustainable, then you will be even more concerned by the fact that its annualized monthly distribution of $0.1821 per share is equivalent to 18.4% of its per-share net asset value (NAV) of $11.82. As you can see below, the market continues to price the fund at a premium to its NAV.
As a closed-end fund, it's allowed to fund distributions by returning capital. That's a good thing for its distributions because the fund's net investment income from its investment operations hasn't covered its distributions over the last decade. In fact, net investment income was just $0.75 per share in the year ended May 31, when the yearly distribution was $2.19.
The fund makes up the difference by returning capital to investors, which puts pressure on NAV and is part of why its NAV has declined. In addition, the fund has ramped up borrowing in recent years. For example, in 2020, the fund had $649 million in assets compared to $19.3 million in total borrowings. Fast forward to 2023, and the fund has $1.47 billion in assets compared to $343.5 million in total borrowings. In other words, the ratio of assets to borrowings has gone from 33.6 times to just 4.3 times.
There's nothing wrong with returning capital from asset sales to investors; closed-end funds can use leverage to generate returns. Still, the decline in NAV and increasing leverage continue to pressure the fund's ability to make distributions.
Finally, looking at the credit quality in its fixed-income investments shows that the fund isn't holding high-quality assets. As you look at the chart below, you can think of anything below a BBB rating as being generally regarded as non-investment grade debt.
All told, the fund's declining NAV, increasing borrowing, substantive distribution as a share of NAV, and the quality of its fixed-income instruments in a volatile-rate environment are putting a lot of stress on its distribution. That spells risk and could eventually lead to a dividend cut.
2. 3M's dividend isn't a reason to buy the stock
With a current dividend yield of 6.2% and trading on just 10.5 times the midpoint of management's adjusted earnings-per-share guidance for 2023, industrial conglomerate 3M seems to be an income investor's dream. However, investing isn't as simple as screening for high-yield stocks and buying them accordingly. You have to believe in the sustainability of the yield, and there's reason to question that at 3M.
Look at 3M's free cash flow (FCF) and current dividend payout. Over the last 12 months, the company generated $4.85 billion in FCF, easily covering its $3.3 billion in dividends paid. For reference, Wall Street analysts expect FCF of $4.5 billion in 2023, then $4.2 billion in 2024, and $4.7 billion in 2025. These figures suggest that 3M will be comfortable at least meeting its current dividend payout.
However, there are two significant issues with 3M going forward that have not been factored into those FCF calculations.
The first issue involves two legal situations 3M is involved in. 3M, this year, reached settlements from class action suits alleging faulty military-grade earplugs and from environmental cleanup demands over PFAS chemicals manufactured and used by 3M.
CFO Monish Patolawala reminded investors of the matter at a recent investor conference. The $6 billion combat arms settlement ($5 billion in cash and $1 billion in stock) "is going to get paid over the next six to seven years," according to Patolawala. Meanwhile, the PFAS-related settlement is $10.5 billion to $12.5 billion with a payout that's going to be spread over 13 years.
While the timing of payments is unclear, 3M could end up paying $1.5 billion to $1.8 billion in cash a year over the medium term. Such figures would use up all of the FCF cover it currently has over its dividend.
The second issue is that 3M will spin off its healthcare business, Solventum, in the first half of 2024. The spinoff will raise a substantive amount of cash, and 3M plans to retain a 19.9% stake that could be sold off over time to generate cash. As such, 3M could use the cash to support its dividend or earmark it to pay for the legal settlements -- the result is the same.
Still, selling the healthcare business deprives 3M of its most stable business and leaves it with three cyclical segments (all three are set for sales declines this year). The volatility implied in the earnings of the remaining three segments and the loss of healthcare earnings (the segment contributed 25.6% of total earnings in the first nine months of 2023) means it probably makes sense to cut the dividend.
3M is not firing on all cylinders right now, and using the proceeds from the spinoff of the healthcare business to finance the dividend is a decision that management and the board will have to review very carefully. As such, 3M's dividend payment is probably at risk.