Two of National Bank’s ‘dividend all-stars’ are able to fund their dividend hikes simply from free cash flow, says the bank’s managing director of research.
Considering the state of Canada’s energy sector, its stock markets, and energy-related stocks in particular, can investors expect to find any companies able to fund a dividend hike simply from free cash flow? Toronto-area equity analyst Greg Colman, as it turns out, answers with an emphatic “Yes”.
National Bank Financial, the capital markets arm of National Bank of Canada, has devised a portfolio of ‘dividend all-stars’ that it updates twice a year. Its selection of about 25 stocks (among the roughly 330 securities that the bank covers) is based on three main criteria: a dividend or distribution yield of four per cent or more, a low risk of the current payout proving unsustainable (dividend growth is ideal, unsurprisingly) and a generally positive bias regarding the prospects of the company and/or its share price.
Oil and gas stock generates high free cash flow
In late August, Mr. Colman, who has worked at National Bank Financial since 2005 and served as managing director of research there since 2014, added his latest candidate to the list (as well as the first of his ‘best buy’ picks), oil and gas stock Pason Systems Inc. (TSX—PSI).
The company caters to energy firms, providing specialized data management for their drilling rigs. Some of the functions they offer to clients include data acquisition, remote communications, and Internet-based information management, allowing workers at rigs to easily collaborate with colleagues at the office.
Mr. Colman says: “Concurrent with the release of (2019) second-quarter results, Pason announced a cent-a-share increase to the quarterly dividend which, based on the closing price, implies an attractive 4.8 per cent yield.” Following that increase, the dividend stands at $0.19 a share per quarter, or $0.76 on an annualized basis.
Expanding further on his selection, the analyst predicts that the company will achieve operating cash flow of just under $99 million in 2019, while it will spend $30 million on capital projects. Accordingly, he estimates the company will have around $69 million in cash available to fund a dividend that costs $65 million annually, following the increase.
Mr. Colman calculates a target price of $21 a share for Pason. However, he also points out that the company works in a sector carrying above-average risk.
“The energy services sub-sector is known to be highly volatile, and the current macroeconomic backdrop is hardly favourable given the uncertainty stemming from ongoing trade tensions between the United States and China and a lack of egress in Canada,” says Mr. Colman.
Nevertheless, he adds, “Despite our forecasts calling for a flat rig count in North America next year, we see Pason generating over $100 million in free cash flow in 2020, resulting in an estimated, roughly 60 per cent payout ratio, which we view as sustainable in the long run.”
In addition, if fortunes in the oil patch take a bad turn, Pason has some extra fat in its balance sheet to balance out the lean, the analyst argues.
“Pason is well-positioned to weather substantial sector volatility with zero debt and an enviable cash balance, which can be leaned on to support the dividend should industry conditions worsen substantially, which management has been comfortable with doing historically,” he says. As of the second quarter’s end, the company had $189 million in cash on hand.
The analyst concludes, “This high free cash flow generator is a responsible place to invest in the volatile oilfield services sector.”
Manufacturing stock has high cash flow yield
Mr. Colman highlights Pason’s fellow dividend all-star, farm machinery and equipment manufacturing stock Ag Growth International Inc. (TSX—AFN), as another ‘best buy’ selection.
Ag Growth designs and builds portable and stationary systems, structures, and equipment for handling fertilizer, seed, grain, feed and food in the agricultural industry. Some of its products include grain drying systems, storage bins and belt conveyors.
Mr. Colman sets a target price of $63 a share for the company.
At present, Ag Growth’s dividend yields about 5.7 per cent, matching the average among its peers in National Bank’s dividend portfolio.
In a report on the portfolio as a whole, the bank noted that Ag Growth was one of 10 companies that have an elevated, double-digit cash flow yield (13.9 per cent in Ag Growth’s case), suggesting potential for dividend increases.
(While the dividend payout ratio is simply the total amount paid out in dividends divided by total cash flow, cash flow yield is calculated by dividing total cash flow by the number of shares, then dividing again by the share price. The latter metric is useful for determining a company’s value.)
This is an edited version of an article that was originally published for subscribers in the October 18, 2019, issue of Investor’s Digest of Canada. You can profit from the award-winning advice subscribers receive regularly in Investor’s Digest of Canada.
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