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Is This 7.3% Yield Too Good to Be True?

Income investors love dividends, but when the share price of a stock declines so much that it yields north of 7%, they start questioning if a dividend cut is on the horizon.

The share price of Alaris Royalty Corp. (TSX:AD) has dropped 18% in the last year, and the company now offers a giant yield of 7.3%.

If Alaris’s dividend is sustainable, it may be a great opportunity to buy shares at a juicy yield after a year-long pullback.

Before discussing if Alaris’s dividend is sustainable, let’s first see if it’s the right business for you.

The business

Alaris offers capital to private businesses that wish to maintain the ownership in their companies. These partners have a history of generating strong cash flows, and Alaris receives monthly cash distributions from them.

Alaris has 70% of its investments in the United States and 30% in Canada. By industry, roughly 35% of its invested dollars are exposed to business and professional services, 34% are exposed to industrials, 22% are exposed to health care, and 9% are exposed to consumer discretionary.

question mark

Is Alaris’s dividend sustainable?

Historically, its growing cash flow per share allowed it to grow its dividend per share at an average annualized rate of 14% over five years.

However, since the summer of 2015 Alaris’s monthly dividend has stayed at 13.5 cents per share. This has prompted questions about whether its dividend is safe or not, as a growing dividend is perceived to be safer than a stagnant one.

Due to deferred distributions from selective revenue streams, Alaris’s payout ratio is expected to be about 101% this year.

That said, there are multiple events that can reduce its payout ratio, including debt reduction to lower interest costs, one or more of its problematic streams start making distributions again, and new capital deployment to increase cash flow.

Using a reasonable assumption that Alaris could deploy $79 million this year (whereas its average capital deployment per year since 2011 has been $120 million and as low as $77 million in a single year), Alaris’s payout ratio can be reduced to less than 92%.

Indeed, Alaris has $80 million available to invest. The company could also receive up to $120 million from its partners via expected exit events or repayment of short-term capital over the next year.

Investor takeaway

Right now, Alaris’s payout ratio is unsustainable. However, it’s likely that it can reduce its payout ratio to about 92% over the year. Still, that payout ratio may be cutting it too close for conservative income investors.

Since the shares aren’t dirt cheap, it’s probably wise to stay away. If they fall to $18-20, adventurous investors can consider picking up some shares.

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Fool contributor Kay Ng owns shares of ALARIS ROYALTY CORP.

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