Shanghai Prime Machinery Company Limited's (HKG:2345) Attractive Combination: Does It Earn A Place In Your Dividend Portfolio?
Simply Wall St
Dividend paying stocks like Shanghai Prime Machinery Company Limited (HKG:2345) tend to be popular with investors, and for good reason - some research suggests a significant amount of all stock market returns come from reinvested dividends. Unfortunately, it's common for investors to be enticed in by the seemingly attractive yield, and lose money when the company has to cut its dividend payments.
A high yield and a long history of paying dividends is an appealing combination for Shanghai Prime Machinery. It would not be a surprise to discover that many investors buy it for the dividends. There are a few simple ways to reduce the risks of buying Shanghai Prime Machinery for its dividend, and we'll go through these below.
SEHK:2345 Historical Dividend Yield, January 14th 2020
Payout ratios
Companies (usually) pay dividends out of their earnings. If a company is paying more than it earns, the dividend might have to be cut. As a result, we should always investigate whether a company can afford its dividend, measured as a percentage of a company's net income after tax. Shanghai Prime Machinery paid out 31% of its profit as dividends, over the trailing twelve month period. This is a medium payout level that leaves enough capital in the business to fund opportunities that might arise, while also rewarding shareholders. One of the risks is that management reinvests the retained capital poorly instead of paying a higher dividend.
In addition to comparing dividends against profits, we should inspect whether the company generated enough cash to pay its dividend. Shanghai Prime Machinery paid out 0.005% of its free cash flow as dividends last year, which is conservative and suggests the dividend is sustainable. It's encouraging to see that the dividend is covered by both profit and cash flow. This generally suggests the dividend is sustainable, as long as earnings don't drop precipitously.
Is Shanghai Prime Machinery's Balance Sheet Risky?
As Shanghai Prime Machinery has a meaningful amount of debt, we need to check its balance sheet to see if the company might have debt risks. A rough way to check this is with these two simple ratios: a) net debt divided by EBITDA (earnings before interest, tax, depreciation and amortisation), and b) net interest cover. Net debt to EBITDA measures total debt load relative to company earnings (lower = less debt), while net interest cover measures the ability to pay interest on the debt (higher = greater ability to pay interest costs). Shanghai Prime Machinery has net debt of 1.88 times its EBITDA, which is generally an okay level of debt for most companies.
Net interest cover can be calculated by dividing earnings before interest and tax (EBIT) by the company's net interest expense. Interest cover of 3.07 times its interest expense is starting to become a concern for Shanghai Prime Machinery, and be aware that lenders may place additional restrictions on the company as well.
From the perspective of an income investor who wants to earn dividends for many years, there is not much point buying a stock if its dividend is regularly cut or is not reliable. Shanghai Prime Machinery has been paying dividends for a long time, but for the purpose of this analysis, we only examine the past 10 years of payments. The dividend has been cut on at least one occasion historically. During the past ten-year period, the first annual payment was CN¥0.048 in 2010, compared to CN¥0.041 last year. The dividend has shrunk at around 1.6% a year during that period. Shanghai Prime Machinery's dividend has been cut sharply at least once, so it hasn't fallen by 1.6% every year, but this is a decent approximation of the long term change.
We struggle to make a case for buying Shanghai Prime Machinery for its dividend, given that payments have shrunk over the past ten years.
Dividend Growth Potential
Given that the dividend has been cut in the past, we need to check if earnings are growing and if that might lead to stronger dividends in the future. It's good to see Shanghai Prime Machinery has been growing its earnings per share at 24% a year over the past five years. Earnings per share have rocketed in recent times, and we like that the company is retaining more than half of its earnings to reinvest. However, always remember that very few companies can grow at double digit rates forever.
We'd also point out that Shanghai Prime Machinery issued a meaningful number of new shares in the past year. Regularly issuing new shares can be detrimental - it's hard to grow dividends per share when new shares are regularly being created.
Conclusion
To summarise, shareholders should always check that Shanghai Prime Machinery's dividends are affordable, that its dividend payments are relatively stable, and that it has decent prospects for growing its earnings and dividend. First, we like that the company's dividend payments appear well covered, although the retained capital also needs to be effectively reinvested. We were also glad to see it growing earnings, but it was concerning to see the dividend has been cut at least once in the past. Overall we think Shanghai Prime Machinery scores well on our analysis. It's not quite perfect, but we'd definitely be keen to take a closer look.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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