Does Alliance Data Systems Corporation (NYSE:ADS) Have A Place In Your Dividend Portfolio?

Today we'll take a closer look at Alliance Data Systems Corporation (NYSE:ADS) from a dividend investor's perspective. Owning a strong business and reinvesting the dividends is widely seen as an attractive way of growing your wealth. Yet sometimes, investors buy a stock for its dividend and lose money because the share price falls by more than they earned in dividend payments.

So you may wish to consider our analysis of Alliance Data Systems's financial health, here.

Some readers mightn't know much about Alliance Data Systems's 2.5% dividend, as it has only been paying distributions for the last three years. Many of the best dividend stocks typically start out paying a low yield, so we wouldn't automatically cut it from our list of prospects. The company also bought back stock during the year, equivalent to approximately 26% of the company's market capitalisation at the time. When buying stocks for their dividends, you should always run through the checks below, to see if the dividend looks sustainable.

Explore this interactive chart for our latest analysis on Alliance Data Systems!

Payout ratios

Dividends are usually paid out of company earnings. If a company is paying more than it earns, then the dividend might become unsustainable - hardly an ideal situation. So we need to form a view on if a company's dividend is sustainable, relative to its net profit after tax. Alliance Data Systems paid out 18% of its profit as dividends, over the trailing twelve month period. We'd say its dividends are thoroughly covered by earnings.

Another important check we do is to see if the free cash flow generated is sufficient to pay the dividend. Alliance Data Systems's cash payout ratio last year was 6.1%, which is quite low and suggests that the dividend was thoroughly covered by cash flow. 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 Alliance Data Systems's Balance Sheet Risky?

As Alliance Data Systems 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 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 a net debt to EBITDA ratio of 10.36 times, Alliance Data Systems is very highly levered. While this debt might be serviceable, we would still say it carries substantial risk for the investor who hopes to live on the dividend.

We calculated its interest cover by measuring its earnings before interest and tax (EBIT), and dividing this by the company's net interest expense. Net interest cover of 5.09 times its interest expense appears reasonable for Alliance Data Systems, although we're conscious that even high interest cover doesn't make a company bulletproof. Adequate interest cover may make the debt look safe, relative to companies with a lower interest cover ratio. However with such a large mountain of debt overall, we're cautious of what could happen if interest rates rise.

Dividend Volatility

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. The dividend has not fluctuated much, but with a relatively short payment history, we can't be sure this is sustainable across a full market cycle. During the past three-year period, the first annual payment was US$2.08 in 2016, compared to US$2.52 last year. This works out to be a compound annual growth rate (CAGR) of approximately 6.6% a year over that time.

Alliance Data Systems has been growing its dividend at a decent rate, and the payments have been stable despite the short payment history. This is a positive start.

Dividend Growth Potential

Dividend payments have been consistent over the past few years, but we should always check if earnings per share (EPS) are growing, as this will help maintain the purchasing power of the dividend. Alliance Data Systems has grown its earnings per share at 6.1% per annum over the past five years. A low payout ratio and strong historical earnings growth suggests Alliance Data Systems has been effectively reinvesting in its business. We think this generally bodes well for its dividend prospects.

Conclusion

Dividend investors should always want to know if a) a company's dividends are affordable, b) if there is a track record of consistent payments, and c) if the dividend is capable of growing. It's great to see that Alliance Data Systems is paying out a low percentage of its earnings and cash flow. Second, earnings growth has been ordinary, and its history of dividend payments is shorter than we'd like. Overall we think Alliance Data Systems is an interesting dividend stock, although it could be better.

Earnings growth generally bodes well for the future value of company dividend payments. See if the 17 Alliance Data Systems analysts we track are forecasting continued growth with our free report on analyst estimates for the company.

We have also put together a list of global stocks with a market capitalisation above $1bn and yielding more 3%.

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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.