Dividend paying stocks like Waste Connections, Inc. (NYSE:WCN) 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. Yet sometimes, investors buy a popular dividend stock because of its yield, and then lose money if the company’s dividend doesn’t live up to expectations.
With only a three-year payment history, and a 0.8% yield, investors probably think Waste Connections is not much of a dividend stock. 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. 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.
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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. 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, Waste Connections paid out 30% of its profit as dividends. This is a middling range that strikes a nice balance between paying dividends to shareholders, and retaining enough earnings to invest in future growth. Plus, there is room to increase the payout ratio over time.
We also measure dividends paid against a company’s levered free cash flow, to see if enough cash was generated to cover the dividend. Waste Connections’s cash payout ratio last year was 18%, 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 Waste Connections’s Balance Sheet Risky?
As Waste Connections 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 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). Waste Connections has net debt of 2.33 times its EBITDA. Using debt can accelerate business growth, but also increases the risks.
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 6.63 times its interest expense appears reasonable for Waste Connections, although we’re conscious that even high interest cover doesn’t make a company bulletproof.
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$0.39 in 2016, compared to US$0.74 last year. This works out to be a compound annual growth rate (CAGR) of approximately 24% a year over that time.
We’re not overly excited about the relatively short history of dividend payments, however the dividend is growing at a nice rate and we might take a closer look.
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. Strong earnings per share (EPS) growth might encourage our interest in the company despite fluctuating dividends, which is why it’s great to see Waste Connections has grown its earnings per share at 15% per annum over the past five years. A company paying out less than a quarter of its earnings as dividends, and growing earnings at more than 10% per annum, looks to be right in the cusp of its growth phase. At the right price, we might be interested.
Conclusion
When we look at a dividend stock, we need to form a judgement on whether the dividend will grow, if the company is able to maintain it in a wide range of economic circumstances, and if the dividend payout is sustainable. Firstly, we like that Waste Connections has low and conservative payout ratios. Next, earnings growth has been good, but unfortunately the company has not been paying dividends as long as we’d like. All things considered, Waste Connections looks like a strong prospect. At the right valuation, it could be something special.
Earnings growth generally bodes well for the future value of company dividend payments. See if the 15 Waste Connections analysts we track are forecasting continued growth with our free report on analyst estimates for the company.
If you are a dividend investor, you might also want to look at our curated list of dividend stocks yielding above 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.
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