Are Dividend Investors Making A Mistake With Costa Group Holdings Limited (ASX:CGC)?

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Is Costa Group Holdings Limited (ASX:CGC) a good dividend stock? How would you know? Dividend paying companies with growing earnings can be highly rewarding in the long term. 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.

Costa Group Holdings pays a 3.5% dividend yield, and has been paying dividends for the past three years. It’s certainly an attractive yield, but readers are likely curious about its staying power. The company also bought back stock equivalent to around 0.7% of market capitalisation this year. Some simple analysis can offer a lot of insights when buying a company for its dividend, and we’ll go through this below.

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ASX:CGC Historical Dividend Yield, June 19th 2019
ASX:CGC Historical Dividend Yield, June 19th 2019

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. Looking at the data, we can see that 370% of Costa Group Holdings’s profits were paid out as dividends in the last 12 months. Unless there are extenuating circumstances, from the perspective of an investor who hopes to own the company for many years, a payout ratio of above 100% is definitely a concern.

In addition to comparing dividends against profits, we should inspect whether the company generated enough cash to pay its dividend. Last year, Costa Group Holdings paid a dividend while reporting negative free cash flow. While there may be an explanation, we think this behaviour is generally not sustainable. It’s disappointing to see that the dividend was not covered by profits, but cash is more important from a dividend sustainability perspective, and Costa Group Holdings fortunately did generate enough cash to fund its dividend. Still, if the company repeatedly paid a dividend greater than its profits, we’d be concerned. Very few companies are able to sustainably pay dividends larger than their reported earnings.

Is Costa Group Holdings’s Balance Sheet Risky?

As Costa Group Holdings’s dividend was not well covered by earnings, we need to check its balance sheet for signs of financial distress. A quick way to check a company’s financial situation uses these two ratios: net debt divided by EBITDA (earnings before interest, tax, depreciation and amortisation), and net interest cover. Net debt to EBITDA measures a company’s total debt load relative to its earnings (lower = less debt), while net interest cover measures the company’s ability to pay the interest on its debt (higher = greater ability to pay interest costs). With net debt of above 3x 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. Interest cover of less than 5x its interest expense is starting to become a concern for Costa Group Holdings, and be aware that lenders may place additional restrictions on the company as well.

We update our data on Costa Group Holdings every 24 hours, so you can always get our latest analysis of its financial health, here.

Dividend Volatility

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. This company’s dividend has been unstable, and with a relatively short history, we think it’s a little soon to draw strong conclusions about its long term dividend potential. During the past three-year period, the first annual payment was AU$0.06 in 2016, compared to AU$0.14 last year. This works out to be a compound annual growth rate (CAGR) of approximately 31% a year over that time. The dividends haven’t grown at precisely 31% every year, but this is a useful way to average out the historical rate of growth.

Costa Group Holdings has grown distributions at a rapid rate despite cutting the dividend at least once in the past. Companies that cut once often cut again, but it might be worth considering if the business has turned a corner.

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. Strong earnings per share (EPS) growth might encourage our interest in the company despite fluctuating dividends, which is why it’s great to see Costa Group Holdings has grown its earnings per share at 65% per annum over the past five years. The company has been growing its EPS at a very rapid rate, while paying out virtually all of its income as dividends. Generally, a company that is growing rapidly while paying out a majority of its earnings, is seeing its debt burden increase. We’d be conscious of any extra risk added by this practice.

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 a concern to see that the company paid out such a high percentage of its earnings and cashflow as dividends. 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. With this information in mind, we think Costa Group Holdings may not be an ideal dividend stock.

Earnings growth generally bodes well for the future value of company dividend payments. See if the 8 Costa Group Holdings analysts we track are forecasting continued growth with our free report on analyst estimates for the company.

Looking for more high-yielding dividend ideas? Try our curated list of dividend stocks with a yield above 3%.

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.

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. Thank you for reading.