Dividend paying stocks like Sichuan Expressway Company Limited (HKG:107) 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.
In this case, Sichuan Expressway likely looks attractive to investors, given its 4.8% dividend yield and a payment history of over ten years. It would not be a surprise to discover that many investors buy it for the dividends. Before you buy any stock for its dividend however, you should always remember Warren Buffett's two rules: 1) Don't lose money, and 2) Remember rule #1. We'll run through some checks below to help with this.
SEHK:107 Historical Dividend Yield, January 26th 2020
Payout ratios
Dividends are typically paid from company earnings. If a company pays more in dividends than it earned, then the dividend might become unsustainable - hardly an ideal situation. 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. In the last year, Sichuan Expressway paid out 29% of its profit as dividends. 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.
Another important check we do is to see if the free cash flow generated is sufficient to pay the dividend. Sichuan Expressway paid out 99% of its free cash last year. Cash flows can be lumpy, but this dividend was not well covered by cash flow. While Sichuan Expressway's dividends were covered by the company's reported profits, free cash flow is somewhat more important, so it's not great to see that the company didn't generate enough cash to pay its dividend. Cash is king, as they say, and were Sichuan Expressway to repeatedly pay dividends that aren't well covered by cashflow, we would consider this a warning sign.
Is Sichuan Expressway's Balance Sheet Risky?
As Sichuan Expressway has a meaningful amount of debt, we need to check its balance sheet to see if the company might have debt risks. A quick check of its financial situation can be done with two ratios: net debt divided by EBITDA (earnings before interest, tax, depreciation and amortisation), and net interest cover. Net debt to EBITDA is a measure of a company's total debt. Net interest cover measures the ability to meet interest payments. Essentially we check that a) the company does not have too much debt, and b) that it can afford to pay the interest. With net debt of 4.47 times its EBITDA, investors are starting to take on a meaningful amount of risk, should the business enter a downturn.
We calculated its interest cover by measuring its earnings before interest and tax (EBIT), and dividing this by the company's net interest expense. With EBIT of 3.24 times its interest expense, Sichuan Expressway's interest cover is starting to look a bit thin.
Before buying a stock for its income, we want to see if the dividends have been stable in the past, and if the company has a track record of maintaining its dividend. For the purpose of this article, we only scrutinise the last decade of Sichuan Expressway's dividend payments. The dividend has been cut on at least one occasion historically. During the past ten-year period, the first annual payment was CN¥0.26 in 2010, compared to CN¥0.10 last year. The dividend has shrunk at around 9.1% a year during that period. Sichuan Expressway's dividend has been cut sharply at least once, so it hasn't fallen by 9.1% every year, but this is a decent approximation of the long term change.
We struggle to make a case for buying Sichuan Expressway for its dividend, given that payments have shrunk over the past ten years.
Dividend Growth Potential
With a relatively unstable dividend, and a poor history of shrinking dividends, it's even more important to see if EPS are growing. While there may be fluctuations in the past , Sichuan Expressway's earnings per share have basically not grown from where they were five years ago. Over the long term, steady earnings per share is a risk as the value of the dividends can be reduced by inflation. Sichuan Expressway is paying out less than half of its earnings, which we like. However, earnings per share are unfortunately not growing much. Might this suggest that the company should pay a higher dividend instead?
Conclusion
To summarise, shareholders should always check that Sichuan Expressway's dividends are affordable, that its dividend payments are relatively stable, and that it has decent prospects for growing its earnings and dividend. Firstly, the company has a conservative payout ratio, although we'd note that its cashflow in the past year was substantially lower than its reported profit. Second, earnings have been essentially flat, and its history of dividend payments is chequered - having cut its dividend at least once in the past. Ultimately, Sichuan Expressway comes up short on our dividend analysis. It's not that we think it is a bad company - just that there are likely more appealing dividend prospects out there on this analysis.
See if management have their own wealth at stake, by checking insider shareholdings in Sichuan Expressway stock.
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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