Stocks with high dividend yields can be tempting for cautious investors seeking steady payouts. But they also often come with caveats.

Take the newly public

Babcock & Brown Air

(FLY) - Get Report


The Ireland-based aircraft-leasing firm went public last week at $23 per share, and has said it plans to pay a quarterly dividend of 50 cents starting in 2008. That amounts to an 8.7% dividend yield based on share price, which has stayed around $23 since the initial public offering.

The relatively high yield is enticing. So is the fact that global demand is fueling a boom in the aircraft-leasing market.

But the fine details of Babcock & Brown's lengthy prospectus show several reasons for investors to be wary.

The biggest issue is that the company is set to pay out nearly all of its earnings through dividends, according to calculations by

. In fact, it appears that Babcock & Brown's payouts could far exceed what it earns next year.

The other issue of concern is that U.S. investors cannot take advantage of the reduced dividend tax when buying the stock, because it is a passive foreign investment company. In some instances, investors could see increased taxes.

Moreover, because Babcock & Brown operates in a capital-intensive business, its high dividend payout ratio is questionable. The company owns airplanes that it leases to aircraft operators -- a business that requires substantial capital expenditures for maintenance and eventual replacement of aging airplanes.

So how bad is the problem?

The company's IPO prospectus shows "pro forma" earnings of $11.7 million, or 35 cents a share, for the first half of 2007.

Double that number and you get $23.4 million of net income for 2007, and 70 cents of EPS. Assuming the quarterly dividend of 50 cents in 2008 holds, then the annual dividend would be $2 next year.

Babcock & Brown has not given any future earnings guidance. Unless the company is able to triple its earnings per share from this year, it likely will be paying out far more than it is earning in 2008.

That's not unusual for aircraft-leasing firms. The companies instead argue that their cash earnings (which add back noncash charges such as depreciation to net income) cover their dividends.

Babcock & Brown spokesman Matt Dallas reiterated this policy to

: "We expect to pay out dividends from our distributable cash flow, which is the revenue generated from our aircraft portfolio, less all related cash expenses."

Nonetheless, that poses issues for investors.

Based on its 33.6 million-share count, Babcock & Brown would pay $67.2 million in dividends next year, based on the $2 dividend.

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According to Babcock & Brown's prospectus, the company's first-half 2007 "pro forma" operating cash flow was $44.6 million. That would have covered the dividend payment, which, based on the above calculations, would have been $33.6 million for a half year.

That results in the company paying out 75% of its cash earnings in the form of dividends.

As is typical, Babcock & Brown's operating cash flow number is higher than its net income number because it adds back $20 million of depreciation, which is a noncash charge.

That operating cash flow, however, doesn't take into account future capital expenditures. So it doesn't account for how much the company would need to spend to maintain its existing earnings capacity.

That's why people look at free cash flow, which is operating cash flow minus capital expenditures.

Capital expenditures show up in the investing section of a cash flow statement, and then eventually make their way through the income statement as assets are depreciated, in order to smooth out earnings.

When Dallas was asked why the company believes it is prudent to pay out more than GAAP earnings, he simply pointed out that other aircraft-leasing firms also followed this policy.

Indeed, competitors


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Genesis Lease

( GLS) follow a similar policy of paying out more than they earn.

However, Aircastle and Genesis Lease both pay out about 50% to 60% of their cash earnings, lower than Babcock & Brown's 75% effective cash-earnings payout this year.

At some point in the future, Babcock & Brown will have to replace aging planes. Even if depreciation is a noncash charge today (because it represents past cash outflows from previous capital expenditures), the depreciation charges point to a future cash outflow in the form of additional capital expenditures to replace the existing planes. And these are not capital expenditures to fuel growth, but are simply to maintain the existing capacity.

That means the company likely is not generating enough cash from operations to pay its dividend in the long run while also maintaining its business.

As the company warns in the prospectus: "Our operational costs will increase as our aircraft age, which will adversely affect the amounts available to pay dividends." Today, the average age of the company's aircrafts is 5.7 years, but some planes were manufactured as far back as 1989.

In order to grow cash flows, Babcock & Brown plans to buy additional airplanes to boost lease revenue. It expects to retain a portion of its operating cash flow to fund this growth. The rest of this acquisition-based growth strategy relies on continued tapping of the capital markets.

So long as the underlying business of leasing aircrafts remains fine and the company can expand operations at a rapid rate, it may be able to keep its current dividend level, or even grow it. In fact, several analysts point to a bull market for aircraft leasing firms today.

But what happens if the economy slows and buying new airplanes for future growth no longer makes sense? In such an instance, the sustainability of the dividend becomes much more questionable, especially if an economic slowdown comes at a time when older planes need to be replaced, pressuring cash flows.

Investors also should consider that Babcock & Brown is domiciled in Bermuda and pays corporate taxes in Ireland.

This results in the company being treated as a passive foreign investment company, or PFIC. U.S. investors who own the stock cannot take advantage of the reduced dividend tax rate for normal domestic stocks.

PFIC rules also require U.S. investors to pay additional taxes in certain instances. The company said in its prospectus that there are ways to mitigate the hit from PFIC rules, while also admitting the overall PFIC process is complex.

Given these numerous issues, investors should tread carefully with this stock and its seemingly enticing yield.