The dividend of Suncor Energy (NYSE:SU) has more than doubled since 2010. The most recent dividend hike came in at 9.5% early this year. For Q1 2014, the company delivered its best quarterly results in history, making many income investors believe that the healthy dividend growth trend can be sustained. In this article, I will provide readers some perspectives on Suncor's future cash flow and dividend trends.
I have performed free cash flow forecasts from 2014 to 2016 to gauge Suncor's capacity for future dividend growth. My free cash flow projections started with consensus revenue estimates which predict the top line to grow by 2.5% CAGR from $40.2B in 2014 to $42.2B in 2016. Suncor managed to maintain a fairly steady operating cash flow margin in the past 3 years as the figure trended within a tight range between 25% and 27%. To be fair, I assumed a 26% cash margin for 2014, which is consistent with its 3-year average. As some of Suncor's growth projects are expected to come online in the next few years and the company continues to direct capital spending toward new projects with high return and capital efficiency, I assumed a slight cash margin expansion of 100 bps from 2014 to 2016. In terms of capital expenditure, I used management's guidance of $7.8B for 2014 and assumed the figure to rise by 3% per annum through 2016. This is supported by my view that Suncor's existing production does not require significant capital investment to sustain and management's plan to improve capital efficiency should continue to reduce capex needs. Based on those assumptions, free cash flow was projected to grow by 8.7% CAGR from $2.6B in 2014 to $3.1B in 2016 (see chart below).
As Suncor is expected to pay out an annual dividend of $0.84 per share in 2014, total dividend spending in the year would be approximately $1.2B based on my share count estimate (discussed later). This represents a free cash flow dividend payout ratio of 47% which is higher than historical level in previous years. Given my forecasted free cash flow CAGR of 8.7%, Suncor can grow its annual dividend spending by a similar rate in 2015 and 2016 such that the free cash flow payout will trend steadily. I modeled 8.5% dividend spending growth in the next 2 years. In this case, the company would have about $1.4B-$1.6B excess free cash flow in each year (see chart above).
I then assumed that Suncor will spend 80% of the excess free cash flow on share repurchase. Based on a buyback price assumption of $42 for 2014 and an annual growth rate of 10%, I estimated that average share count will drop to 1.4B by 2016. Based on my dividend spending projections, dividend per share was forecasted to grow by 9.7% CAGR from $0.84 in 2014 to $1.01 in 2016. Compared with consensus EPS estimates, my dividend forecasts imply that earnings dividend payout ratio will grow from 23% in 2014 to 29% in 2016 (see chart below).
As the free cash flow payout ratio will trend steadily under my forecast scenario and the earnings payout ratio in 2016 will remain in line with its historical level in 2012 and 2013, I believe my forecasted CAGR of 9.7% for dividend per share over the next 2 years is completely achievable.
In terms of valuation, I believe the shares are reasonably valued right now. Based on current annualized dividend of $0.84 per share and 12% cost of equity, Gordon Growth Dividend Discount Model suggests that current share price has priced in a dividend growth rate of 9.5%-10.0%, which is in line with my expectation over the next few years (see chart below).
From a relative perspective, Suncor currently trades at 11.7x forward 2015 EPS estimate with a consensus long-term EPS growth estimate of 7%. This compares favorably with S&P 500's forward 2015 P/E multiple of 15.4x. As Suncor's long-term EPS growth potential is not significantly below S&P 500's average of 9% and the stock's dividend yield is in line with S&P 500's average of 1.9%, its 24% valuation discount to the market looks very reasonable.
In conclusion, Suncor would have sufficient capacity to sustain the current dividend growth pace. Given the stock's current reasonable valuation, income investors are recommended to buy the shares for healthy dividend growth over the next few years.
All charts are created by the author, and historical data used in the article and the charts is sourced from S&P Capital IQ, unless otherwise specified.
Disclosure: The author is long SU. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.