Danger Lurking in PPL Stock Dividend Payout Ratio Analysis?

Source: PPL.

Dividend investors gravitate to stocks that will provide them with the reliable income that they need in order to support their standard of living. Yet in order for a company to sustain its dividend payouts over the long run, it needs to make sure it earns enough money to cover them. In the case of utility company PPL (PPL -1.03%), which serves electricity customers in Pennsylvania, Kentucky, Virginia, and Tennessee as well as the U.K., nervous investors worry that the company actually pays more in dividends than it has earned over the past year. Are their concerns about PPL justified? Let's take a closer look at PPL by doing a dividend payout ratio analysis to see if its attractive dividend yield is sustainable.

Dividend Stats on PPL

Source: Yahoo! Finance.

Should PPL dividend investors worry?
When you look at PPL's recent earnings and dividends, it's easy to come to the conclusion that the utility might not be able to keep paying dividends at their current level. On a GAAP basis, PPL has earned substantially less than it paid out in dividends since this time last year, yet the utility company hasn't pulled back on the payments it has made to shareholders. Indeed, PPL raised its dividend early this year by about 1.4%, showing the inconsistency between the company's apparent optimism about its future ability to pay dividends and its shareholders' worries.

Yet the problem that often comes up with stocks that have high earnings-based payout ratios is that generally accepted accounting principles don't always show a complete picture of how a utility is performing. In PPL's case, a couple of things point to the utility's likely long-run success in sustaining its payout despite some short-term challenges.

Colstrip plant. Source: PPL.

The first has to do with a particular transaction that had a huge one-time impact on PPL's earnings. Last December, a PPL subsidiary terminated its operating lease agreements connected to a fractional stake in a coal-fired electrical generation plant in Colstrip, Montana. The subsidiary then purchased the fractional interests outright, paving the way for it to sell unrelated hydroelectric assets to Northwestern Energy. The accounting impact of the lease termination was a one-time charge of $697 million, or $413 million after tax. On a pre-tax basis, that charge reduced earnings by about $1.10 per share. Without the charge, PPL's earnings payout ratio would have looked a lot healthier.

The other thing to keep in mind is that as with many other utilities, PPL's cash flow tells a much different story than its net income. Notably, PPL has had more than $1.23 billion in depreciation and amortization charges over the past 12 months, and a host of other factors lift PPL's overall operating cash flow to $3.26 billion, more than triple its $944 million net income over the same period.

Still, the flip side of the cash flow argument is that PPL has aggressively ramped up the amount that it spends on capital expenditures, and that has actually left the company in a negative free cash flow situation over the past couple of years. In 2013, PPL spent more than $4.2 billion on capital expenditures, up from just $2.5 billion in 2011, and the utility is on pace to spend more than that in 2014.

Source: PPL.

Where PPL's dividends really come from
In order to make up its negative free cash flow, PPL has raised money by offering stock. Pursuant to equity units it sold in 2010 and 2011, investors were obligated to pay a set amount to buy PPL stock in 2013 and 2014, and the roughly $1.4 billion that PPL received from settling those equity units last year and the $1 billion it got this year has helped eliminate the cash flow gap.

Going forward, it's unclear whether PPL will continue needing those cash infusions. As long as PPL can avoid having restructuring charges recur, its long-term earnings outlook appears to be much more favorable. If PPL meets expectations in the years to come, then earnings payout ratios could fall back toward the 50%-70% range that PPL has generally seen. As with the entire utility sector, investors should keep an eye on PPL's debt to make sure that borrowing costs don't rise too much in coming years, but PPL's use of equity issuance has helped it avoid even greater reliance on debt, and that should help shareholders in the long run.