Seeking Alpha
Portfolio strategy, ETF investing, dividend growth investing
Profile| Send Message| ()  

One question that frequently arises with respect to dividend paying stocks is whether or not the company can afford to a) not only pay the current dividend, but b) is that dividend stream and growth sustainable? The standard measure for affordability is Payout Ratio, which is the ratio of dividends/share to earnings/share. While this metric is useable for a majority of companies, it is of little to no use for companies that choose to pay a large portion of their cash flow as dividends, as well as MLPs (Master Limited Partnerships) and REITs (Real Estate Investment Trusts), which are required by tax law to do so.

There is a simple solution to this problem, one tha is in use by some investors but not widely recognized by all. The best place to start is with the Cash Flow Sheet, which -- along with the Income Statement and Balance Sheet -- constitute Financial Statements that companies are required to file on a quarterly (and annual) basis. There are websites that provide this information; I use Money.MSN.com, showing five years of data (bottom of first column on Quote sheet (first screen displayed)).

The table below shows an example of a REIT top-level Cash Flow Sheet. It was selected to represent not a typical case, but a situation where nearly all available cash is paid out in dividends. The company, Omega Healthcare Investors (OHI), is in the business of providing "financing and capital to the long-term healthcare industry with particular focus on skilled nursing facilities located in the United States" (taken from its website). According to its profile on the Money.MSN.com website, "it finances investments through borrowing under its revolving credit facilities, private placements or public offerings of debt or equity securities, the assumption of secured indebtedness, or a combination of these methods." The facilities are managed by "third-party operators. It uses the term operator to refer to its tenants and mortgagees and their affiliates who manage and/or operate its properties."

Year

2011

2010

2009

2008

2007

Cash from Operating Activities

169.77

157.56

147.22

89.33

84.54

Cash from Investing Activities

(257.64)

(384.82)

(209.00)

(187.10)

(29.91)

Cash from Financing Activities

81.30

242.00

63.74

96.00

(53.39)

Net Cash Beginning Balance

6.92

2.17

0.21

1.98

0.73

Net Cash Ending Balance

0.35

6.92

2.17

0.21

1.98

Data in the table above are in $M.

This top-level view of cash flow is a snapshot in time of the year's money trail taken at the end of the year. The "checkbook" balances. If you take the beginning balance in any year and add (subtract) cash flows from the three activities, you get the ending balance. The details represent the movement of all funds in and out, facilitating the tracing of where monies come from and how they are spent. Never forget that cash flow is continuous, the reported data reflect its whereabouts only at predetermined points in time. It is not a random inspection process, leaving the door open for cover-up -- comparable to mutual fund "window dressing." We see here that, for the most part, cash from operating and financing activities goes into investing activities.

From this we can track where the money comes from to pay dividends, the task at hand. We particularly want to insure it doesn't come from Investing or Financing. Taking a closer look at Operating Activities:

Year

2011

2010

2009

2008

2007

Net Income

52.61

58.44

82.11

78.14

69.37

Depreciation

100.34

84.62

44.69

39.89

36.06

Non-Cash Items

36.66

20.78

6.91

1.25

2.3

Changes in Working Capital

(19.83)

(6.28)

13.51

(29.95)

(23.19)

Cash from Operating Activities

169.77

157.56

147.22

89.33

84.54

Data in the table above are in $M.

Again, details will add up to the bottom line. Note that in 2010 and 2011, net income was reduced which may cause concern -- "earnings are down." In this case, net income was reduced due to one-time adjustments that were taken in the Income Statement which lowered Net Income. This is reflected in the Non-Cash Items line where they are added back in. Sometimes these "adjustments" are shown on the Income Statement as Unusual Expenses and sometimes not. Unfortunately, details on the Income Statement from Gross Profit to Operating Expenses don't always add up, monies are taken out without specifics. In any event, the Cash Flow sheet should reflect "hard cash" profit, defined by the summation of Net Income, Depreciation (a non-cash item subtracted from income on the Income Statement), and Non-Cash Items. This appears in the table below along with Cash Dividends Paid (from Financing Activities).

Year

2011

2010

2009

2008

2007

'Hard Cash Profit'

189.61

163.84

133.71

119.28

107.73

Cash Dividends Paid

161.89

138.88

109.24

98.06

81.26

Ratio

0.85

0.85

0.82

0.82

0.75

Data in the table above are in $M.

REITs are required by law to distribute at least 90% of their taxable income to shareholders in the form of dividends, so this level of "payout" should come as no surprise. The above exercise shows that dividends paid were covered by Cash from Operations and not by added debt and/or public sale of stock. It is important to notice that for this analysis, all data were obtained from the Cash Flow Sheet where numbers add up. Doing this on a per-share basis only adds another variable to the mix and may be misleading. Besides, common stock shareholders are not the only recipients of dividends; in MLPs, General Partners get a portion. I am not sure, but possibly preferred stock holders also. In any event, doing the "payout" calculation using data obtained solely from the Cash Flow sheet should resolve the issue of dividend affordability for stocks, MLPs and REITs, all using the same formula.

To summarize: Affordability Ratio = Cash Dividends Paid / (Net Income + Depreciation + Non-Cash Items)

(Note: All data is taken from the Cash Flow Sheet.)

If you read the literature on this subject, you will find that (in general) maintenance capital expenditures should be subtracted from what I call hard-cash profit before dividends are paid. Maintenance capex are capital expenditures required to maintain the company's operations at their current level. These sums are not split out on financial statements and a wide variety of assumptions have been made as to their magnitude. Obviously, these will vary with industry and it is not clear exactly what they consist of. Since maintenance capex is not a line item on the cash flow sheet, it must be buried in one of the other entries. It is probably part of Acquisition of Fixed Assets in Investing Activities, if so it is/may not be financed solely from Operations. In which case, my tendency is to ignore it. It is only an issue in those instances where dividends consume nearly all available funds. No company, to my knowledge, saves the depreciation allotment into a special account to use when needed.

Now to the dividend sustainability issue, which is probably more art than science. Start with the company profile and gain a clear understanding of the company's products and business model. Visit the company's web-site. Use Financial Statements as a company resume to gain knowledge and understanding, particularly of trends in such metrics as revenue, earnings, depreciation, physical assets, debt, dividend growth. Just looking at the statements and trying to understand how money flows can go a ways in learning the company's business model. Expenditures in R&D indicate commitment to the future (not applicable in this case). Looking at dividend growth, the chart below shows dividends vs. time for OHI from 2004 to 2012:

Click to enlarge image.

The 2012 data assumes no additional increase in Q4 2012. The red curve reflects the dividend amounts. The green curve is a "best fit" to a straight line as described in "Measuring Dividend Growth, Part 2 - Linear Case." From there, a link to Part 1, Exponential (Compounding) Case for stocks with exponential dividend growth. Note that OHI dividend increases are not random but reflect a firm policy, good sign. Although it looks like the dividend was cut in 2009, actually it is 1 penny higher than 2008. Dividends were increased 1 cent Q2 2008 from $0.29 to $0.30 making total for the year $1.19. Dividends were held at that level through 2009 at $1.20. This kept dividend growth positive and retained OHI on David Fish's Challenger List. Dividends were increased three times in 2010 to get "back on track." I believe OHI was waiting out the financial crisis to see how it would affect their business. When things calmed down, it increased dividends more than normal in the next two years to regain its dividend flow. I call that management.

From the Cash from Operating Activities table above, both (Net Income + Non-Cash Items) and Depreciation are increasing over time, indicating a growing business. The table below shows revenue, also increasing nicely:

Year

2011

2010

2009

2008

2007

Revenue $M

292.20

258.32

197.44

193.76

159.56

The line item Property/Plant/Equipment on the Balance Sheet is also steadily increasing. In addition, OHI invests regularly in other long-term investments, listed under Assets on the Balance Sheet, that appear to provide income (designated as Other Revenue on the Income Statement). This is reflected in the revenue data above. It isn't indicated anywhere, but that looks like rainy-day funds -- a prudent hedge. No Goodwill on the Balance Sheet, that's good. Under Financing Activities (Cash Flow sheet), additional stock was sold in four of five years. This will dilute earnings/share unless earnings also increase, which it did. In 2011, shares were retired (re-purchased). Additional debt was incurred in three of five years, reduced in the other two (2007 and 2008) -- normal activity for this business line. It is difficult to determine when a dollar collected from Financing Activities contributes to Net Income. There has to be a time delay, possibly several years. The bump in Investing Activity in 2010 hasn't shown up (yet). Something to watch for, but not panic over -- the missing dollar. The current economy may have an impact here, no fault of the company. Who knows the collateral damage due to a) inability to sell homes and b) unemployed family members?

The ratio of Dividends to Hard Cash Profit does increase over the five years from 0.75 to 0.85, which could be a concern. It is not clear how much of an affect the current state of the economy has on OHI's business. In other stocks in my portfolio, there is a fairly widespread reduction in dividend growth; dividends are still growing, but not as rapidly as before. I call this a wait-and-see.

OHI is a small-cap company with a market cap of $2.59 billion. It has 24 employees. These may be a concern to some, but they are growing and, from what I can determine, appear to be a well-run company. Institutional ownership is 89.1%. Current yield (forward) is 7%, and current dividend growth is 7% -- hard to beat. With baby boomers retiring and eventually needing OHI's "product," market potential is there. Baby boomers will inherit copiously to pay the cost. Other than a) monitoring the Affordability Ratio for OHI to see that it doesn't keep increasing, and b) watching for the missing dollar, I see no reason to believe OHI cannot sustain its dividend growth. The best evidence that all is well is the fact that OHI has enough confidence in its future to raise dividends as it has. Even if it did cut back, with that yield it is still a good stock to own. I am long OHI, a whopping 1.4% of my portfolio. I could up that and not lose any (more) sleep.

Each of us has to assess risks as they apply to our situation; but remember, the only risk-free investment is 90-day Treasuries (by definition). There is potential risk in owning OHI (things "could" happen), but rewards (yield and increasing dividends) are larger -- and they are here and now.

This discussion may seem disjointed and it is to a degree. This is not a "plug in the numbers and turn the crank" process. Each set of Financial Statements is unique. Each has a story to tell. If you find it, you will have better insight as to whether you should buy/keep the stock or not. I do not maintain I am an expert in this, but like any other endeavor, practice improves your ability.

Some investors use several fundamental metrics to gauge stocks, in both buying and maintenance analyses. I tend to be very cautious in that arena; most of these metrics are industry sensitive, a fact usually overlooked. Stock screeners are worthless if used without taking industry effects into account. If you don't believe me, screen with your favorite metrics and see how many of your current portfolio holdings show up. Comparing stocks in different industries using fundamental metrics is playing on a non-level field. Case in point: Intel (INTC) has a Net Profit Margin of 22.7%, Yield of 3.3%, and Dividend Growth of 15%. Then, Target (TGT) has a Net Profit Margin of 4.1%, Yield of 2.0%, and Dividend Growth of 19%. On a yield/dividend growth basis, I would rank INTC a little higher (50/38), but not 5 times.

One currently popular fundamental metric is ROE (Return on Equity). It is defined by the following formula: ROE = Net Income / Shareholder Equity. Shareholder Equity is also Total Assets - Total Liabilities. Normally, a large part of Total Liabilities is Long-Term Debt. So to increase ROE, take on more debt. That is what the banks did to goose performance. ROE attempts to quantify that an increase in shareholder equity (balance sheet) transforms into income (income statement and cash flow sheet). One problem, as we saw above, is the time it takes for the process to play out.

It is more rewarding to use fundamental metrics year to year on each company separately, as was done here. Business processes are dynamic and taking multiple snapshots in time help in understanding. As a portion of my ongoing analytics, I perform the payout determination shown here (along with perusal of Financial Statements and calculations for a dividend growth chart) on all stocks in my portfolio every year and do likewise for stocks I am interested in buying. It works.

Source: Dividend Affordability And Sustainability