Eyebrows have been raised recently about the sustainability of dividends in the energy sector as more and more companies adopt a dividend paying model, be it Master Limited Partnerships (MLPs) or traditional equities that pay dividends. Some believe exploration and production (E&P) companies may be adopting a dividend-paying structure simply to increase their stock price. While this assumption may be a bit aggressive, it is important to note that capital often becomes more accessible for dividend paying equities. Caution must be exercised in dividend investing to avoid the downward spiral of a dividend cut or even elimination.
One of the most important fundamental drivers when analyzing the sustainability of a company’s dividend is internally generated, truly distributable cash flow. Internally generated cash flow for these E&P companies is a combination of production and the “cash netback” (think of this as the cash margin per single barrel of oil after all costs are taken into account). Netbacks can be affected by many different factors and we are not just looking for the highest netback on an absolute basis. For example, companies who produce a lighter blend of oil will most likely have a higher netback as the realized price is greater than that of heavy crude, so comparing the two on an absolute basis could show a substantial difference. Netbacks are also affected by costs such as operating, transportation, royalties and interest on debt. Not only does high interest expense decrease the cash netback, it also means higher leverage, potentially introducing more volatility (risk). As we analyze potential dividend paying equities, we look for companies with low leverage, as they likely have the ability to grow by raising outside debt capital, as well as those producing more current operating cash flow via higher cash netbacks. We prefer companies who have a competitive advantage embedded somewhere in their netback, which may include, but not limited to, operational efficiencies, easy access to transportation and/or favorable hedging strategies.
So once we have analyzed and are comfortable with internally generated cash flow, how can we be comfortable with the current dividend? The main ratio we look at is called the sustainability ratio (or total payout ratio) which is calculated as (capital expenditures plus dividends)/ cash flow from operating activities. This ratio displays the company’s ability to fund the dividends from its operating cash flow, while still being able to develop its asset base via capital expenditures. We are looking for this ratio to be under 100%, which means the dividend and capital program are funded from operating cash flow, giving us a sustainable business model.
If a company has a DRIP program (dividend reinvestment program, whereby shareholders are paid out via more shares rather than cash), we also need to be aware of the percentage of shareholders making use of the program. The higher the percentage of shareholders reinvesting their dividends, the less actual cash distribution. While positive from a cash standpoint, we also need to see if the bulk of the dividend is being paid in non-cash form and if that is actually sustainable if the DRIP election were to change. Therefore when we are looking at sustainability ratios net of DRIP, for example, (capital expenditures plus dividends less DRIP)/ cash flow from operating activities, we must also run the ratio excluding the DRIP program as if the dividend was 100% cash-pay. While a DRIP program is by no means a negative sign, a company without a DRIP program shows conservative corporate governance and the fact that management is not overstretching to fund a dividend. Analyzing the simple payout ratio (dividends/ cash flow from operating activities) is also key as it shows how much flexibility the company has in its capital program.