On Wednesday, July 9, Potash Corp (NYSE:POT) goes ex-dividend. The company will pay its shareholders $0.35, which means around a 3.8% annual dividend yield based on current prices. With a yield that's around double the S&P 500, is this a company income investors should buy into?
The potash industry has seen more than its fair share of drama, which in 2013 caused potash prices to drop as much as 25%. However, investors, especially income investors, are more interested in cold, hard cash than drama. Let's drill down to see if Potash's dividend provides a stable foundation for future growth.
Potash has paid quarterly dividends since 1990, but until recently, the yields have hardly been a bumper harvest. In fact, most of the time, Potash offered dividend yields below market levels.
We can give Potash points for dividend longevity with quarterly payments for 24 years. But income investors want stocks that pay more than the S&P 500 (currently around 1.9%). The company only very recently started to return meaningful amounts of cash to investors through dividends.
Now that Potash offers above-market yields, what are its dividend sustainability and growth prospects?
The dividend payout ratio shows how Potash is able to deliver a market beating dividend yield. It upped the payout from a single-digit percent of earnings all the way up north of 70%. It gets full credit for focusing on dividends, but at the same time, payout ratios in the 70% neighborhood are worrisome. It's one thing for a company with steady earnings, like a utility, to pay a high payout ratio, but for a company like Potash, it's another story.
Here is a snapshot comparison of earnings per share for Potash versus utility Southern Company (NYSE:SO). There tends to be a much smaller range of outcomes at the utility.
There's nothing wrong with cyclical industries, per se, but the combination of a high payout ratio and cyclicality is cause for concern.
Turning to free cash flow, Potash's prospects for dividend sustainability and growth improve.
The company has a 5.1% free cash flow yield, which protects its 3.8% dividend yield. If the industry does not get embroiled in another price war or international scuffle, and the company continues to generate and grow free cash, then there's room for management to increase this payout.
Investors shouldn't expect a smooth ride. This is not a set it and forget it utility. With a yields near double the market average, protected by free cash flow, Potash makes a decent case for a spot in the higher-risk section of an income portfolio.
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Gunnar Peterson owns shares of PotashCorp. The Motley Fool recommends Southern Company. The Motley Fool owns shares of PotashCorp. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.