With Teekay (TGP) showing strength this year and the equity boasting a 7% yield, we wanted to take a close look at the firm's valuation and determine whether the dividend payout is sustainable.
Return on Invested Capital
We think Teekay is worth $27 per share, which represents a price-to-earnings (P/E) ratio of about 17.8 times last year's earnings and an implied EV/EBITDA multiple of about 13 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 5% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 7.7%. Our model reflects a 5-year projected average operating margin of 54.6%, which is above Teekay's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3.1% for the next 15 years and 3% in perpetuity. For Teekay, we use a 9.8% weighted average cost of capital to discount future free cash flows.
Teekay's dividend yield is well above average, offering just above a 7% annual payout at recent price levels. However, we think the safety of Teekay's dividend is VERY POOR (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 (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 Dividend Cushion™ to help financial advisors better assess the safety of a company's dividend. 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 (a negative 0.6), revealing that on its current path the firm may not have the capacity to pay out its expected future dividends, though flexibility remains. The beauty of the Dividend Cushion is that it can be compared apples-to-apples across companies. For example, Wal-Mart (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). The Dividend Cushion also caught the recent cuts by JC Penney (JCP) and SuperValu (SVU). We use our dividend cushion as a key decision component in choosing companies for addition to the portfolio of our Dividend Growth Newsletter (please see our links on the left sidebar for more information).
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. 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 not the case for Teekay. We rate the firm's future potential dividend growth as VERY POOR based primarily on its lack of excess capacity (in fact future dividend payments may overwhelm future cash flows after considering the firm's capital structure, namely debt).
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 think the shares are overvalued (please see our valuation section above), so the risk of capital loss HIGH. All things considered, we're not tempted by Teekay's dividend at all and believe there are much better dividend risk/reward profiles out there.