High-yielding equities can make for attractive investments, especially for those looking to generate income. However, chasing yield is not a wise strategy and at times can lead to poor investment decisions.
It’s for this reason that investors should always triple check the safety of the dividend for high-yield stocks. Today, we take a look at Inter Pipeline (TSX:IPL) and its 7.60% yield.
Dividend growth
Inter Pipeline is a Canadian Dividend Aristocrat that’s raised dividends for 11 consecutive years. As an Aristocrat, this midstream company has established a certain level of trust with investors. After all, it has raised dividends for more than a decade.
Although this is a great start, investors should note that achieving Aristocrat status is no guarantee of future dividend growth. In 2019, there were 15 companies who either suspended, cut or kept their dividend steady and as such, lost their Aristocrat status.
Unfortunately, Inter Pipeline is “show-me” territory. Last year, the company did not raise dividends, but as it paid out more in 2019 than in 2018, it’s still a dividend growth stock in the eyes of income investors.
However, this is the first warning sign that the dividend may be at risk. Inter Pipeline has until the end of 2020 to increase its dividend or lose Aristocrat status.
Growth rates
An important and often overlooked aspect when analyzing the safety of the dividend is that of growth rates. Is the company growing revenue and earnings? Or is it suffering from contraction?
Logic dictates that a growing company will be better positioned to maintain a dividend than one experiencing a period of negative growth.
Over the past five years, this midstream company has grown earnings by approximately 5% annually. Unfortunately, the good news ends there. In 2020, revenue and earnings are expected to contract by 1.8% 17% respectively. This is warning sign number two.
Payout ratios
Finally, it’s important to know if the dividend is well covered by earnings and cash flow. Depending on the industry, a payout ratio as a percentage of cash flow is more important than that of earnings.
The midstream industry is an example of this. It is a good thing, as Inter Pipeline’s dividend accounts for ~118% of earnings.
Through the first nine months of 2019, Inter’s dividend accounted for 80% of cost-of-service and fee-based cash flows before sustaining capital. This is good news, as it means that the dividend is sustainable during times of normal operations.
The problem begins when it has a high level of new capital investments. Case in point – the Heartland Petrochemical Plant.
The first of its kind in Canada, the $3.5 billion project is the most ambitious in company history and has been a big drag on cash flows. The project is expected to enter commercialization by the end of 2021.
Of the $3.5 billion, the company is on the hook for another $1.3 billion in capital expenditures over the next two years ($900 million in 2020 and $400 million in 2021). Remember, this is over and above cash reserved for sustaining capital.
The good news is that the company has $1.2 billion available on its credit facility and generated $670 million in undistributed cash flow over the past two years.
By the company’s definition, undistributed cash flow is equal to funds from operations less sustaining capital and dividends. Between the two, it appears to have sufficient cash to see Heartland through to completion.
Foolish takeaway
Is the dividend safe? As an Inter Pipeline shareholder myself, it’s probably the one company in my portfolio in which the dividend is teetering on the edge.
It all boils down to the company’s ability to commission Heartland on time and on budget. Once operational, Heartland will generate approximately $450-500 million of average annual EBITDA. This implies massive growth potential for a company that generated ~$600 million in EBITDA in 2018.
Since the company kept its dividend steady last year, it recognizes that cash flow is tight and will be until Heartland is complete. Until then, the dividend can’t be considered 100% safe.
