Dividend growth investing is lots of fun, especially if you have a systematic methodology to determine which companies' dividends are safe and which ones aren't. That is why we created a forward-looking assessment of dividend safety in our innovative, predictive dividend-cut indicator, the Valuentum Dividend Cushion™. In this article, let's evaluate the investment merits of Teekay (TGP), as well as its dividend under this unique but yet very straightforward framework. But first, let's look at some investment highlights:
• Teekay LNG Partners is one of the largest independent owners of LNG carriers. The firm is a publicly-traded MLP that provides LNG and crude oil marine transportation services. The firm boasts long-term, fixed-rate contracts that typically extend for 10-25 years and is well-positioned to capitalize on global demand for LNG.
• Although we don't think the firm's valuation indicates an attractive investment opportunity at this time, we'd take a closer look if the firm's share price fell below the low end of our fair value range (see full-page image below).
• Teekay's cash flow generation is robust, but its financial leverage could potentially be concerning down the road. If cash flows begin to weaken, we'd become more cautious on the firm's overall financial health.
• The Baltic Dry Index, or the shipping industry's pricing metric, is uncomfortably volatile. The BDI declined a whopping 94% in 2008 from a peak of 11,793 in May 2008 to a low of 663 in December 2008 and remained volatile during 2009. The BDI will continue to be volatile, and fixed contracts do not last forever. Such volatility is not a fun ride for investors, especially when BDI pricing is low and contracts are up for renewal.
Return on Invested Capital
Teekay's dividend yield is excellent, offering roughly a 7% annual payout at recent price levels. We prefer yields above 3% and don't include firms with yields below 2% in our dividend growth portfolio.
We think the safety of Teekay's distribution is very poor (please see our definitions at the bottom of this article). We measure the safety of the dividend payout in a unique but very straightforward fashion. As many know, earnings can fluctuate in any given year, so using the payout ratio in any given year has some limitations.
Plus, companies can often encounter unforeseen charges, which makes earnings an even less-than-predictable measure of the safety of the dividend in any given year. We know that companies won't cut the dividend just because earnings have declined or they had a restructuring charge that put them in the red for the quarter (year). As such, we think that assessing the cash flows of a business allows us to determine whether it has the capacity to continue paying these cash outlays well into the future.
That has led us to develop the forward-looking Valuentum Dividend Cushion™. The measure is a ratio that sums the existing cash a company has on hand plus its expected future free cash flows over the next five years and divides that sum by future expected dividends over the same time period. Basically, if the score is above 1, the company has the capacity to pay out its expected future dividends. As income investors, however, we'd like to see a score much larger than 1 for a couple reasons: 1) the higher the ratio, the more "cushion" the company has against unexpected earnings shortfalls, and 2) the higher the ratio, the greater capacity a dividend-payer has in boosting the dividend in the future.
For Teekay, this score is -0.6, revealing that on its current path the firm can't completely cover its future dividends with net cash on hand and future free cash flow. It will eventually have to issue new shares or issue new debt to preserve its payout, and such costs could be dilutive to existing shareholders. When factoring in expected future equity issuance (6% growth rate in diluted shares outstanding), the score jumps to 1.2 (still below a threshold of GOOD), but above 1. Importantly, however, the pace of future equity issuance is something that is very difficult to predict. We plan to publish Teekay's updated report taking into consideration our new methodology for MLPs on our website soon. We also use our dividend cushion as a key decision component in choosing companies for addition to the portfolio of our Dividend Growth Newsletter.
Now on to the potential growth of Teekay's dividend. As we mentioned above, we think the larger the "cushion" the larger capacity it has to raise the dividend. However, such dividend growth analysis is not complete until after considering management's willingness to increase the dividend. To do so, we evaluate the company's historical dividend track record. If there have been no dividend cuts in 10 years, the company has a nice growth rate, and a nice dividend cushion, its future potential dividend growth would be excellent, which is unfortunately not the case for Teekay. We'd rate the firm's future growth potential as very poor (please see the decline in the pace of growth in the image above).
And because capital preservation is also an important consideration, we assess the risk associated with the potential for capital loss (offering investors a complete picture). In Teekay's case, we currently think the shares are overvalued, so the risk of capital loss is high. If we thought the shares were fairly valued, the risk of capital loss would be medium. Remember, intrinsic value is based on the going-concern of a firm's future free cash flows long into the future. If Teekay renegotiates some of its contracts at poor rates, having long-term rates could become a negative.
All things considered, we're not tempted by Teekay's dividend at all. And we think the shares are overvalued. There are much better dividend risk/reward profiles out there, in our view. However, we note that we continue to update our forecasts, and we could become more optimistic about Teekay's dividend should 1) future free cash flows increase above our current expectations; 2) the company issues equity at a faster pace than we expect; or 3) the firm improves its capital structure.