Ensco's Dividends May Not Last Forever

Whether you're a beginning investor or a near-retiree, the importance of purchasing stocks that pay dividends cannot be overstated. Not only do companies that have quarterly or annual payouts provide you with a steady stream of income, but they also have the potential for capital appreciation. Simply put, dividend stocks can you give your portfolio what almost no other investment can -- both income and growth.

At The Motley Fool, we're avid fans of dividends -- and not just because we like that steady stream of cash. Studies have shown that from 1972 to 2006, stocks in the S&P 500 that don't pay dividends have earned an average annual return of 4.1%; dividend stocks, however, have averaged a whopping 10.1% per year. That is an incredible difference -- one that you'd be crazy to not take advantage of!

But investing in dividends can be dangerous -- companies can cut, slash, or suspend dividends at any time, often without notice. Fortunately, there are several warnings signs that may alert you, and these red flags could be the crucial factor in determining whether or not a company is likely to continue paying its dividend. Today, let's drill beneath the surface and check out Ensco (NYSE: ESV  ) .

What's on the surface?
Ensco, which operates in the oil and gas drilling industry, currently pays a dividend of 2.97%. That's certainly nothing to sneeze at, as the average dividend payer in the S&P 500, in 2009, sported a yield of 2%.

But  more important than the dividend itself is Ensco's ability to keep that cash rolling. The first thing to look at is the company's reported dividends versus its reported earnings. If you happen to see dividend payments that are growing faster than earnings per share, it may be an initial signal that something just isn't right. Check out the graph below for details of the past five years:

Source: Capital IQ, a division of Standard & Poor's.

Source: Capital IQ, a division of Standard & Poor's.

Clearly, there doesn't seem to be a problem here. Ensco has been able to boost its earnings at an adequate pace and keep its dividends in check at the same time.

The more secure, the better
One of the most common metrics that investors use to judge the safety of a dividend is the payout ratio. This number tells you what percentage of net income is paid out to investors in the form of a dividend. Normally, anything above 50% is cause to look a bit further. According to the most recent data, Ensco's payout ratio is 16.34%. It's obvious that, at least on the surface, there aren't any problems with Ensco generating enough income to support that nice dividend of 2.97%.

More important than checking out the payout ratio may be simply taking a peek at Ensco's cash flow. Free cash flow -- all the cash left over after subtracting out capital expenditures -- is used by firms to make acquisitions, develop new products, and of course, pay dividends! We can use a simple metric called the cash flow coverage ratio, which is cash flow per share divided by dividends per share. Normally, anything above 1.2 should make you feel comfortable; anything less, and you may have a problem on your hands. Ensco's coverage ratio is -1.04, which isn't enough to make me feel comfortable as an investor. There could be a number of reasons the number is so low -- maybe it's typical for the industry, maybe there's a significant amount of debt coming due, or maybe Ensco is simply less than stellar at managing its assets.

Either way, it's always beneficial to compare an investment with its most immediate competitors, so in the chart below, I've included the above metrics with those of Ensco's closest competitors. In addition, I've included the five-year dividend growth rate, which is also a very important indicator. If Ensco can illustrate that it's grown dividends over the past five years then there's a good chance that it will continue to put shareholders first in the future. Check out how Ensco stacks up below:

Company

Dividend

Yield

Payout

Ratio

Coverage Ratio

5-Year Compounded Dividend Growth Rate

Ensco 2.97% 16.34% -1.04 49.63%
Noble (NYSE: NE  ) 1.52% 18.44% 4.22 77.60%
Helmerich & Payne (NYSE: HP  ) 0.58% 16.97% 5.83 4.94%

Source: Capital IQ, a division of Standard & Poor's.

The Foolish bottom line
Only you can decide what numbers you're comfortable with in the end; sometimes a higher yield and a higher reward means additional risk. However, when we look at Ensco's payout ratio compared to its peer average, we see that it is a lower percentage, which illustrates that its dividend could be more sustainable (although the negative free cash flow is certainly worth noting). The bottom line, however, is to make sure that with anything -- whether it be a dividend, a share repurchase, or an ordinary earnings report -- you do your own due diligence. Looking at all of the numbers in the best context possible is just the best place to start.

Jordan DiPietro owns shares of Noble. The Fool owns shares of Ensco and Noble. 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.


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  • Report this Comment On October 30, 2010, at 2:09 AM, itconsultant wrote:

    I am not sure where you are getting the numbers for free cash flow.

    In FY 2009, ESV had operating cash flow of $1.2 billion. It used $240 milion in maintenance capex and another $623 million in growth capex ( on the buildout of new deep water rigs that are under construction). Even after you subtract both capex, you are left with $340 million in Free cash flow.

    In 2009, only $14 million was paid in dividends and $6 million in share repurchases.

    ESV raised the dividend from $0.1/share annual to $1.4/share this year. With 141 million shares outstanding that works out to about $200 million. So, FCF / Dividend = 340 / 200 = 1.7!!! ( assuming free cash flow stays at this level).

    Also, if you dig into the 10-k you will see that ESV is towards the end of a $3 billion capex cycle that goes towards building 7 deep water rigs. The last 3 rigs are under construction now. The growth capex starts to taper off in 2011 and 2012 at $320 million per year. After that the free cash flow should increase as capex would be down to maiteance capex ( assuming no new rigs are built but we will work on facts and not speculate on future actions).

    These rigs that are being built will add significant revenues and free cash flow to ESV. ( the daily rate on such rigs is north of $400k / day)

    Finally, the balance sheet of ESV had over $900 million in cash and only $250 million in long term debt!. ESV has enough means to support the dividend from free cash flows and can dip into the balance sheet if needed.

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