Is This 16% Yield for Real?

I constantly scan the Web for profitable special situations. Today, I've found a recent IPO that yields a remarkable 16%. Seriously.

Investors love setups like this. No one knows a new small-cap IPO, so fewer investors push the price up and the yield lower. And this company's dividend won't appear on public finance sites for months. Check your broker's site and even it probably won't register an IPO's dividend, let alone a 16% whopper like this. You have to dig into the filings to discover it, something dividend screens can never find.

But as with all stocks yielding double digits, you have to be extra careful. Continue reading, and I'll let you in on this high yielder.

Double-digit yield
When you see a double-digit yield, the first question you should ask yourself is, "Why is the market giving me this yield?" Mr. Market's not in the habit of giving you great risk-free deals. If you can't find a good reason, the deal may be too good to be true. Portfolios can be devastated by investors who act like yield pigs, chasing whatever high-dividend stock shows up on their screen.

That's been the case with recent investors in Frontier Communications (Nasdaq: FTR  ) . The telecom had been yielding as much as 18%, as its stock cratered to around $4 per share early this year. That yield was a sign that the market didn't think Frontier's $0.75 annual payout was sustainable. And in mid-February, Frontier finally did cut its dividend to $0.40 per year.

It's the same story with mortgage real estate investment trusts Annaly Capital (NYSE: NLY  ) , American Capital Agency (Nasdaq: AGNC  ) , and Armour Residential (NYSE: ARR  ) . Each offers a double-digit yield -- the very reason investors have clamored for these names. Is that sustainable for the long term? The market's pricing offers a resounding "no!"

And we may already be seeing the cracks. In their latest quarter, all of these companies have reported declining interest rate spreads sequentially, hurting their profitability. That's reflected in declining dividends for the first quarter. Armour dropped its monthly payout by 10%, from $0.11 to $0.10, while Annaly notched its divvie down by $0.02 to $0.55. A more ominous sign comes from American Capital, which lowered its $1.40 quarterly payout -- consistently paid for 10 straight quarters -- to $1.25. When the credit market returns to normal, you can be sure the yields on these stocks will come down.

So what about this 16% yield I promised you?

A new high-yield IPO
The new company out of the gate is Whiting USA Trust II (NYSE: WHZ  ) . It's not really a company, but rather a royalty trust, which owns a 90% net profit interest in some of Whiting Petroleum's oil and gas properties in the Rocky Mountains, Mid-Continent, Gulf Coast, and Permian Basin.

The trust's properties include 1,300 gross producing wells in 49 mostly mature fields with well-known production rates. About 96% of the wells are proved developed producing reserves, meaning they're pumping resources now. Their production consists of 72% oil, 25% gas, and 3% natural gas liquids. Given the importance and high price of oil, it's good to see oil's predominance here.

Whiting USA Trust II is structured like many such trusts. It has a definite lifetime, either Dec. 31, 2021, or when 11.79 million barrels of oil equivalent have been pumped from its wells, whichever comes later. Investors have some potential upside if Whiting pumps out more oil and gas before the termination date.

The other source of upside is rising resource prices. The trust has hedged about half its oil production from April 1, 2012, to year-end 2014. Using a costless hedge, the trust will not receive less than $80 per barrel nor more than $122.50 on its hedged oil production. Its gas production will remain unhedged through its lifetime.

While unhedged production sounds great when prices are rising, it nevertheless exposes investors to the explosive volatility of commodities markets. The expected yield could fluctuate drastically from quarter to quarter, sending the stock price all over the place, something many dividend investors don't want.

The trust projects a 2012 payout of $4.02 per share. And at Friday's closing price of $24.46, that comes to about 16%. But before you hit that "buy" button, remember:

  • The trust will exist for about 10 years, after which investors are entitled to nothing.
  • Production is estimated to decline at an average of 8.4% per year from 2012 until 2021.
  • Cash returns to shareholders may decline at a faster rate because of the fixed costs associated with the underlying properties.
  • The payout is partially a return of capital, and thus not a true dividend from earnings.

As a rough calculation, to avoid a declining payout, realized resource prices would need to go up more than 8% per year. That's tough, and volatile commodity prices don't help matters.

So you can now see why this 16% yield exists. In other high-dividend stocks, this type of initial yield could mean capital gains of 50% to 100%. While the stock may rise in the short term, as the yield pigs rush in, the trust's declining production and finite life mean a decreasing share price over time. To win here, you have to play "the greater fool" game, selling in the short term to someone who is less educated about this situation. Hold too long, and you will get burned.  That doesn't offer the long-term certainty that I want in an investment.

Foolish bottom line
Now, I do think this IPO has a good probability of climbing over the next year, as investors become aware of the high dividend. But as a dividend investor, I much prefer set-it-and-forget-it stocks with every probability of long-term success. If you're looking for high-yielding stocks that can grow their dividends indefinitely, consider the nine names from a brand new, free report from Motley Fool's expert analysts called "Secure Your Future With 9 Rock-Solid Dividend Stocks." To get instant access to the names of these nine high yielders, simply click here -- it's free.

Jim Royal, Ph.D., owns shares of Annaly and Frontier. The Motley Fool owns shares of Annaly. Motley Fool newsletter services have recommended buying shares of Annaly. 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.


Read/Post Comments (7) | Recommend This Article (62)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 26, 2012, at 8:35 PM, mrmoneyguru wrote:

    Out of your picks, I own American Capital Agency (AGNC)

  • Report this Comment On March 27, 2012, at 5:11 PM, StarWitchDoctor wrote:

    mrmoneyguru.

    what article are you responding to?

    there were no picks here.

    Scott

  • Report this Comment On March 27, 2012, at 5:21 PM, mikecart1 wrote:

    Your discussion of REITs is flawed. Whereas regular stocks dividends depend on revenues and what the company decides based on its ability to pay dividends or not pay, REITs pay 90% of their revenue to shareholders. Therefore a drop is not permanent and goes up and down. Especially for NLY. Not sure why NLY is discussed with other REITs as one that is going to 'fail' in the future. NLY has been around and even if its dividend drops in half, it is still better than 90% of all other dividend stocks.

    :)

  • Report this Comment On March 27, 2012, at 10:05 PM, derekrv wrote:

    Everything depends on your assumptions, I guess....

    If you take the dividend payouts over 10 years, and reduce them by 10% a year (instead of 8.4% - to keep the math easy), you get a declining series, looking out into the future:

    4.02 / 3.60 / 3.24 / 2.92 / 2.63 / 2.37 / 2.14 / 1.93 / 1.74 / 1.57

    Add those 10 up, and you come back to $26.67 - especially since this model doesn't take the time value of money into account. Definitely not a good deal for the buyer.

    It'll be interesting to see what the stock does in the next few months....

  • Report this Comment On March 28, 2012, at 3:52 AM, bryndun wrote:

    I have been following analyses of Annaly on 'seekingalpha.com' especially that institutions and fund-like Magellan- are holders of over 54% of NLY. Should that mean that they somehow have a higher regard of its sustainability?

  • Report this Comment On March 28, 2012, at 6:58 AM, The1MAGE wrote:

    I have AGNC, and NLY. And I do expect their dividend to drop. But I don't see the big drop happening until 2013 since the FED said they would hold rates steady until then. (Last I heard. They could change their minds any time.) I am holding them until later this year, probably late summer to early fall. I won't dump them completely though, just cut back significantly on what I own, and probably a third sold each month over 3 months.

  • Report this Comment On March 28, 2012, at 9:49 PM, cmbourne wrote:

    So now FTR pays "only" about 10%, after the cutback, but is now stable. maybe it is time to buy

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