One of the messages I constantly preach is that investors need to exercise caution with high yields. As dividend cuts from the likes of Corus Entertainment Inc. and AltaGas Ltd. have demonstrated, an outsized yield can bite you if you aren’t careful.
A big yield doesn’t always signal danger, however.
Case in point: Inter Pipeline Ltd. (IPL).
The Calgary-based company – which operates oil sands and conventional pipelines, natural-gas processing plants and bulk liquids storage terminals – pays a monthly dividend of 14.25 cents, or $1.71 annually. Based on Tuesday’s closing price of $21, the shares yield a juicy 8.1 per cent.
Why so high? Well, the company has been raising its dividend annually, albeit at a modest rate recently. (The latest increase, announced in November, was about 1.8 per cent.) Combine that with a share price that has lost about one-quarter of its value over the past two years and – presto! – you have a yield in the high single digits.
Inter Pipeline’s stock has struggled for a couple of reasons. One is negative sentiment toward the energy industry. The other is a lack of near-term growth catalysts to drive the company’s earnings.
Inter Pipeline’s key growth project is the $3.5-billion Heartland Petrochemical Complex, which will convert locally sourced propane into polypropylene plastic used in packaging, textiles and other products. But the Alberta facility isn’t expected to come on stream until late 2021, and some investors would prefer not to hold a stock that requires them to wait two to three years to see a meaningful bump in cash flow.
Given the size of the Heartland project – which is the first of its kind in Canada – some investors are also wary of the execution risks involved.
For investors who can exercise patience, however, Inter Pipeline’s slumping share price offers an attractive entry point, some analysts say. The yield may look excessively high, but the dividend is “extremely low risk” and investors who “pocket the dividend and wait” will be ultimately be rewarded with a higher share price, analyst Elias Foscolos of Industrial Alliance Securities said in an interview.
Mr. Foscolos, who has a “strong buy” rating and target price of $26.50 on the shares, said dividend growth will likely be modest for the next few years but could accelerate once Heartland comes into service. In the meantime, the dividend is supported by a conservative payout ratio of about 60 per cent of Inter Pipeline’s 2018 funds from operations, according to the company. Using a more stringent calculation, Industrial Alliance puts the payout ratio at about 74 per cent, which still affords plenty of wiggle room.
Adding to the dividend’s safety, Inter Pipeline supports the payout with contractual cost-of-service and fee-based cash flows, which are insulated from swings in commodity prices and account for roughly two-thirds of the company’s earnings.
“We expect the contractual support will enable IPL to continue to grow its dividend at a conservative 2 per cent a year going forward,” AltaCorp Capital analyst Nate Heywood said in a recent note, in which he initiated coverage of the stock with an “outperform” rating and price target of $27.50.
Mr. Heywood also cited the company’s investment-grade credit rating, diversified business and future growth from Heartland. The company has said the project will generate an additional $450-million to $500-million of EBITDA (earnings before interest, taxes, depreciation and amortization) annually which, using the low estimate, would mark an increase of 36 per cent from 2018 adjusted EBITDA of $1.25-billion.
Heartland will benefit from low-cost propane feedstock in Alberta, but the project is not without risks. “Chemical businesses are notoriously cyclical and we worry the actual range of earnings could be much wider,” Odlum Brown analyst Cory O’Krainetz said in a note. Still, he rates Inter Pipeline a “buy” with a price target of $30.
Not all analysts are bullish on Inter Pipeline. Of 17 analysts surveyed by Refinitiv, there are nine buys, seven holds and one sell, and the average 12-month price target is $25.27. But for investors who want income now and are prepared to wait for growth, this high-yielding stock might be worth a closer look.