Equity investors interested in income often start the selection process by looking at companies with large dividend yields. This is a logical place to begin, but can miss an important aspect of dividend investing—growth in distributions. A static dividend distribution will, over time, lose ground to inflation.
A good way to think about dividend growth for an investment already in a portfolio is “yield based on purchase price.” This divides the current dividend by the original purchase price. A growing dividend distribution will result in a yield based on purchase price that is above the yield when the investment was purchased. And, over time, a stock with a fast growing dividend distribution can often provide shareholders more income than would be attained by purchasing a stock that had a higher yield, but little or no distribution growth.
Although this reframing of dividends is helpful for investments that are already in a portfolio, it can also be used to differentiate between potential investment candidates. Each week in the Index section of The Value Line Investment Survey a screen of stocks with the highest projected 3- to 5-year dividend yields is run. Using this list as a starting point can be helpful, but comparing this list to a list that simply looks at the highest yielding equities can highlight interesting differences.
We have chosen two rather different equities to highlight today: CVR Partners (UAN) and Transocean (RIG). Both have high dividend appreciation potential out to 2017-2019, but differ significantly beyond that. The first is a domestic producer of nitrogen fertilizers and a limited partnership, while the second is the world’s largest offshore oil and gas driller.
CVR Partners produces nitrogen-based fertilizers ammonia and urea ammonia nitrate in the U.S. Midwest, used largely to grow corn and wheat. The company‘s limited partnership units are 70% owned by its parent, CVR Energy, Inc. (CVI), which also owns the partnership’s general partner. It operates one plant, in Coffeyville, KS, which is the only nitrogen fertilizer facility in the United States that uses petroleum coke as a feedstock, rather than natural gas. The company obtains 70% of its pet coke from an affiliate located literally "across the street”, and it also owns rail cars and storage facilities in several places. UAN expanded its plant last year by around 50%.
Despite the plant expansion, which came on line in last year’s first quarter, unscheduled maintenance hurt results in the second and third quarters, as did lower fertilizer prices. This was caused, to some extent, by higher Chinese exports that were a result of that country using less coal for its industry, making more coal available for use as a fertilizer feedstock. The outlook for 2014 is a bit better, as capacity ought to rise by a few percent, thanks to improvements made in 2013. And in this year’s first half, a major capacity expansion for diesel exhaust fuel (DEF) ought to contribute. DEF carries higher margins than fertilizer and must be used from now on to reduce emissions in all diesel trucks.
As a limited partnership, CVR Partners distributes all “distributable cash flow”, which is basically net income plus depreciation, minus maintenance capital outlays and a small reserve. Due to factors cited above, cash distributions were just $1.745 per unit in 2013, down from $2.207 in 2012. But population growth, a need for more grain to increase meat supplies, and likely lower imports should boost U.S. nitrogen fertilizer demand at a decent pace. Too, CVR Partners’ products compete well with fertilizers produced from natural gas when the price of gas is a bit below where it is today. Likely higher gas prices, as the nation shifts from coal-fired power generation to less-polluting gas fired units, ought to help CVR. All told, we look for the units to yield around 8.0% in the 2017-2019 time frame.
Transocean, the world’s largest offshore oil and gas drilling company, operates 48 high-specification floating rigs (including 29 ultradeepwater rigs); 25 midwater floaters; and 9 jackup rigs. It works in all the major offshore oil fields and has a leading position in most of them, with the notable exception, for now, of Brazil. Its customers run the gamut of oil companies from the huge international outfits (ExxonMobil (XOM - Free ExxonMobil Stock Report), Royal Dutch Shell (RDS), Chevron (CVX - Free Chevron Stock Report); to sizable independents (Anadarko (APC), Murphy (MUR); and national oil companies, such as those of India, Norway, and Petroleos Brasileiros (PBR). At about $29 billion, its backlog is at a record. In recent years the company has upgraded its fleet, disposing of around $2 billion of older or lower-capacity rigs while bringing on line 11 large ones and several high-spec jackup rigs. It is contracted to take delivery of seven ultradeepwater rigs and five jackups over the next four years.
Earnings improved sequentially in 2013, thanks to better fleet utilization and revenue efficiency (revenues booked divided by total possible revenues under active contracts), bringing the September figure to $1.37 a share before items, compared with $1.40 in the prior-year period. The outlook for 2014 is somewhat mixed. While the great majority of Transocean’s rigs are committed for the year, the deepwater market remains soft and has put downward pressure on day-rates for not only deepwater rigs but ultradeepwater rigs, as well. On the other hand, overhead will very likely decline from the 2013 level as the company continues to implement a multi-year cost-cutting program, which has already entailed, to paraphrase the CEO, saying goodbye to some long-time colleagues. Longer-term, Transocean ought to get its share of increased ultradeep water drilling, which should grow faster than total demand for oil as land and shallow-water resources are depleted. The 12 new rigs, which are all contracted for, should help, and the company has options five more high-spec jackups.
Unlike our other selection today, however, Transocean is still facing possibly high payouts for the Macondo rig incident, in which 11 workers died when that rig exploded in the Gulf of Mexico in April 2010. The company has settled with the U.S. Department of Justice, for about $1.4 billion in fines, recoveries, and penalties, payable over the next four years, but still faces lawsuits from the Gulf Coast states and individuals. It says it is open to reasonable settlements. We think the total cost of this disaster will not crimp the company’s growth much.
That said, Transocean considers its prospects to be good enough to propose raising its dividend 34%, to $3.00 a share annually, starting in the second quarter of 2014; the increase is subject to approval at the annual meeting in May. Barring an unlikely adverse event, we think the dividend hike will sail through with a large majority. And management is committed to raising the dividend as earnings grow. Assuming the dividend hike goes through, RIG now yields a generous 7.0%.
At the time of its writing, the author held a position in ExxonMobil.