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Is This Succulent 11.4% Yield Safe?

High yield investing is best done on a case-by-case basis. For every seemingly safe double-digit yield, there are many other companies paying unsustainable payouts.

Investors can analyze a company paying an extra generous yield, but even that comes with risks. I’ve seen many instances of a company that can easily afford its succulent payout until earnings suddenly fall off a cliff.

Let’s take a closer look at one such stock, Vermilion Energy Inc. (TSX:VET)(NYSE:VET), which is currently paying an eye-popping 11.4% dividend. Can it afford the payout?

The skinny

Vermilion is an Alberta-based energy company with production assets spread across the globe. The company is currently drilling in Canada, the United States, across parts of Europe, and even in Australia.

Approximately 60% of 2019’s estimated production will come from North America, but higher Brent crude prices means that 50% of estimated funds from operations for the year will come from Vermilion’s international production.

Thanks to organic growth and various tuck-in acquisitions, Vermilion has increased production significantly over the last few years.

In 2016, the company averaged just over 60,000 barrels of oil production per day. 2019’s production is projected to exceed 100,000 barrels per day for the first time in its history. Vermilion has grown production by an average of 15% annualized since 2012.

From 2000 to 2014, Vermilion’s long-term growth was nothing short of extraordinary. The company increased its share price from $10 per share to an eventual peak of $80 per share, while paying generous dividends since 2003.

Then the bottom fell out of the energy market, sending shares plunging. The stock is currently just over $20 per share, a decline of some 70% from the peak.

Dividend analysis

Vermilion has paid a monthly dividend since 2003. Unlike many of its peers in the energy sector, it has never cut the payout. In fact, the company has slowly increased the distribution over the years.

After a few years of paying $0.17 per share each month, the company hiked the dividend in 2008, 2013, 2014, and then again in 2018. The current payout is $0.23 per share on a monthly basis.

A history of uninterrupted dividends bodes well for future payouts.

As Vermilion focuses on low-cost production with high netbacks, the company produces plenty of free cash flow. The company projects it’ll generate $6 per share in funds from operations in 2019.

After we deduct its capital expenditure program, it leaves us with approximately $2.50 per share in free cash flow.

Vermilion’s dividend, meanwhile, works out to $2.76 per share, giving us a payout ratio in the 110% range. This is obviously not ideal.

It’s not all bad news, however. The company just got a big boost from the recent jump in oil prices, and some analysts predict the commodity price will be higher for months while Saudi Arabia fixes its infrastructure.

Vermilion has also paid out more than it has earned a number of times in the past, most notably in 2015 when it spent 121% of its funds from operations on dividends and capital expenditures. Its balance sheet is in good shape too, meaning that it can easily afford to subsidize the payout for a while.

The bottom line

Ultimately, the health of Vermilion’s dividend depends on the overall health of the energy market. If you’re a bull on oil and that enthusiasm turns out to be right, you’ll be rewarded with both a generous dividend and a likely increase in Vermilion’s stock price.

For me, a dividend largely linked to the price of crude is too risky, but I can see how other investors would be attracted to this opportunity.

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Fool contributor Nelson Smith has no position in any of the stocks mentioned.

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