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EV Energy's (NASDAQ:EVEP) yield is excellent, offering just under a 8% 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. EV Energy fits our criteria thus far, but what about the future growth and safety of its distribution? Let's take a look in this article.

Structure of the Oil And Gas Pipeline Industry

Firms in the oil and gas pipeline industry own or operate thousands of miles of pipelines and terminals -- assets that are nearly impossible/uneconomical to replicate. Most companies act as a toll road and receive a fee for transporting natural gas, crude oil and other refined products (and generally avoid commodity price risk). Though there is much to like, most constituents operate as master limited partnerships and pay out hefty distributions that can stretch their balance sheets. Additional unit issuance (dilution) has become common, and capital-market dependence is a key risk.

EV Energy's Investment Considerations

EV Energy is a limited partnership engaged in the acquisition, development and production of oil and natural gas properties. Its properties are located in the Barnett Shale, the Appalachian Basin (Utica Shale), the Mid-Continent areas in Oklahoma and Texas,
among others.

EV Energy's primary business objective is to manage its oil/natural gas assets for the purpose of generating
cash flows and providing stability and growth of distributions per unit.

EV Energy's Return on Invested Capital

EV Energy's Distribution

(click to enlarge)

We think the safety of EV Energy's dividend is excellent (please see our definitions at the bottom of this article). We measure the safety of the dividend 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. We make some adjustments for MLPs -- adding back cash from future equity issuance to the numerator -- but the concept is the same. 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 of 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 EV Energy, this score is 3.1, revealing that on its current path the firm can cover its future dividends with net cash on hand and future free cash flow roughly 3 times.

Now on to the potential growth of EV Energy'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 not the case for EV Energy. We have them rated as having good growth potential, as the pace of growth in the past two years has been meager (though there has been growth nonetheless).

And because capital preservation is also an important consideration for dividend growth investors, we assess the risk associated with the potential for capital loss (offering investors a complete picture). In EV Energy's case, we currently think the shares are fairly valued, so the risk of capital loss is medium. If we thought the shares were undervalued, the risk of capital loss would be low. All things considered, we like the potential growth and safety of EV Energy's dividend, and we're looking for growth to pick up in coming years.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Evaluating EV Energy's Lofty Distribution