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Can This Stock Be a Four-Bagger?

Here’s why you should think long and hard before investing in commodity stocks. These stocks are roller-coaster rides that can make you tremendously wealthy, but more often than not could also make you lose your shirt when you’re caught on the wrong side of the trade.

When I last wrote about Peyto Exploration & Development (TSX:PEY) in December, I stated, “Peyto offers a 7.5% yield. However, it can cut its dividend if its earnings fall too low due to low commodity prices.” So, it makes sense not to rely on commodity stocks for safe dividends.

Peyto just cut its dividend by two-thirds. From the standpoint of the company, it’s a good thing because it can save up more capital for debt reduction, grow the business, or buy back stock. On the other hand, it’s bad news for its shareholders, at least in the short term, because they’ll now receive less income from the stock.

Peyto is profitable and generates lots of cash

In the last four reported quarters, Peyto reported revenue of $516 million and net income of $159 million. So, it was profitable with a net margin of 30.8%.

In the period, Peyto generated nearly $517.5 million of operating cash flow. After accounting for capital spending, it had $268.6 million of cash flow remaining. If you subtract the almost $151.7 million that it paid in dividends, the company was still left with nearly $117 million of free cash flow.

The dividend isn’t the priority.

Cutting the dividend was a managerial decision, asPeyto had enough cash flow to cover for the pre-cut dividend as shown in the previous section. Perhaps management determined it was a better use of capital to buy back stock — it announced a buyback of up to 10% of its public float late last month.

Low natural gas prices are affecting all Canadian natural gas producers — Peyto included. As a result, Peyto implemented a three-year plan last month to address the issue, including investing in longer-term initiatives, protecting the company’s balance sheet and implementing additional vertical integration efforts.

The dividend simply isn’t the priority, but it makes good sense for management to prioritize on the health of the balance sheet and future growth instead of paying out precious cash as dividends during such harsh times.

That said, as of writing, Peyto still offers a 3.18% yield. The payout ratio is expected to be about 11% of cash flow, which is quite low. Although the dividend is not a priority, in the past Peyto has increased its dividend when the operating environment improved.

Investor takeaway

Peyto has been a well-run, low-cost producer. However, the environment is just too harsh for natural gas producers right now. The company is improving its efficiency and investing for the future, which should be reflected in its bottom line or cash flow generation, especially if the operating environment improves.

Investors should note that at the peaks of cycles, Peyto has traded at more than $30 per share. So, it could be a four-bagger in the next peak from current levels, but admittedly, we’re currently inside a dark tunnel with no light in sight and a tremendous amount of patience is required.

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Fool contributor Kay Ng owns shares of PEYTO EXPLORATION AND DVLPMNT CORP.

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