Spectra Energy One Of The Better Income Plays On The Market

May. 2.12 | About: Spectra Energy (SE)

In this article, let's evaluate the investment merits of Spectra Energy (NYSE:SE), as well as its dividend. We expect single-digit dividend growth at Spectra for some time to come.

Investment Considerations

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Return on Invested Capital

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Spectra Energy's Dividend

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Spectra Energy's dividend yield is above average, offering a 3.56% annual payout at recent price levels. For inclusion in our dividend portfolio we look for yields above 3%, so we're paying close attention to the firm.

We think the safety of Spectra Energy's dividend is good. 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 (read hiccups in operations), 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. For oil and gas pipeline firms, we make a few slight adjustments due to their business structures, 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 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 Spectra Energy, this score is 1.3, offering both a "cushion" and revealing some excess capacity for future dividend growth. The beauty of the Dividend Cushion is that it can be compared apples-to-apples across companies. For example, Wal-Mart (NYSE:WMT) scores a 1.4 on this measure. Also, for firms that have a score below 1 or that have a negative score, the risk of a dividend cut in the future is certainly elevated. In fact, the Valuentum Dividend Cushion caught all dividend cuts in our non-financial coverage universe, except for one, which subsequently raised its dividend above pre-cut levels (meaning it shouldn't have cut it in the first place).

Now on to the potential growth of Spectra 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. As such, 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 Spectra Energy. We rate the firm's future potential dividend growth as good.

By employing a matrix (in the image above), one can see above that Spectra Energy has a very solid dividend--the cross section of its good safety and good future potential growth scores. 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 Spectra Energy' case, we think the shares are fairly valued, so the risk of capital loss is medium. If we thought the shares were undervalued we'd rate the risk of capital loss as low.

All things considered, Spectra Energy stands out to us as one of the better income plays on the market today. We'd consider adding it to our dividend growth portfolio.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.