Dividend based income investing certainly has its attractions especially in this era of super-low deposit rates. However, rather than being drawn in by yields that are considerably higher than what you might get at the bank, investors need to consider what may happen if the dividend is cut. With the price of oil currently under pressure, this has become a pertinent question for dividend paying oil exploration and production companies such as Crescent Point Energy Corp. (TSX:CPG)(NYSE:CPG).
A relevant example of what can happen to a stock price when the dividend gets suspended occurred on Wednesday when the offshore oil and gas drilling contractor providing, Seadrill Ltd (NYSE:SDRL), suspended its dividend. Seadrill’s stock immediately dropped by 22%, despite sharp declines over the previous few months.
The Seadrill experience may be an indication of things to come from other dividend paying companies operating in the energy space. Investors in these companies, including Crescent Point, should assess a number of key indicators when considering the sustainability of the dividend:
A track record of consistent and growing dividend payments: Crescent Point has built a solid track record of paying dividends over the past 10 years although the last increase was in June 2008. Growth since 2004 has averaged 3.5% per year.
A rock-solid balance sheet: Crescent Point has a manageable amount of net debt which represents only 25% of equity while the interest coverage ratios are within reasonable limits. This should provide some degree of comfort that the dividend could be maintained even if the profitability of the company was under pressure for a period of time.
A pay-out ratio that leaves room for unforeseen events: Crescent Point has not been able to cover their dividend payments with free cash flow (that is operating cash flow minus capital expenditure) for several years which implies that the company had to raise additional debt or other capital to be able to pay the dividend. One reason for this situation is the ongoing high level of spending to sustain and expand the production capabilities. Capital expenditures for 2014 are expected to amount to $2.0 billion with a similar expenditure in 2015.
The company is faced with a volatile product price which can result in considerable swings in profitability thus impacting the ability to sustain the dividend. The crude oil price is currently about 25% below the average price achieved so far in 2014, which, if sustained will have a considerable impact on 2015 profits and cash flow.
Crescent Point’s share count has increased by 165% over the past 5 years resulting in a sharply higher dividend “cost”. The annual dividend currently amounts to around $1.2 billion which was in the past partly paid with equity issued in lieu of the cash dividend. This saved the company more than $1.22 billion in cash payments between 2012 – 2013. However, shareholders may in the future be less inclined to accept shares rather than cash given the declining stock price. This would place additional strain on cash flow.
Will Crescent Point be able to maintain the dividend payments?
Crescent Point has a solid track record of dividend payments, a declared willingness to continue with regular payments, a sound balance sheet and an active hedging program that will protect the cash flow to some extent against lower oil prices in 2015. On the other hand, because of all the shares its issued, cash dividend payments could be much higher in the future, capital expenditures are expected to remain high and lower oil prices will hurt profits and cash flow.
While it is likely that the company will continue to pay dividends for the foreseeable future, the uncertainty created by the sensitivity of the cash flow and profit to volatile and unpredictable oil prices makes this investment unsuitable for income seeking investors.
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This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.
Fool contributor Deon Vernooy, CFA has no position in any stocks mentioned.