A silver-colored pipeline.

Image source: TransCanada Corporation.

TransCanada (NYSE:TRP) pays an above average dividend, currently yielding 3.67%. Further, the company pledged to increase its payout by an 8% to 10% compound annual rate through 2020, fueled by growth projects currently under development. While it's one thing for a company to say it can deliver sustainable dividend growth, it is another to have the financial wherewithal to back it up. Here's a closer look at why TransCanada believes that investors can bank on the sustainability of its payout.

Considering the cash flow

The foundation of any dividend is a company's ability to generate steady cash flow. In TransCanada's case, its cash flow is more stable than most because long-term fee-based contracts or regulated assets support more than 90% of its earnings. In fact, that number is expected to increase to more than 95% after the company completes the sale of its merchant power business in the United States.

The percentage of TransCanada's cash flow from fee-based assets compares favorably to its peers. For example, 96% of the cash flow generated by fellow Canadian pipeline giant Enbridge (NYSE:ENB) will come from secure sources such as fee-based contracts once it completes the acquisition of Spectra Energy. Meanwhile, U.S. midstream giant Williams Partners (NYSE: WPZ) expects 97% of its gross margin to come from fee-based sources in the future, up from 93% at the start of last year. Like these peers, TransCanada has made a conscious effort to increase this percentage above 95% to improve the sustainability of its dividend.

Looking at the balance sheet

Another important factor driving long-term dividend sustainability is the strength of a company's finances. In TransCanada's case, it has a firm foundation thanks to its A-rated credit. That's a higher credit rating than Enbridge (BBB+/Baa2) and Williams Partners (BBB-/Baa3). One of the drivers of TransCanada's stronger credit rating is its conservative financing strategy. For example, from 2010 to 2015, the company placed more than 20 billion Canadian dollars' worth of assets into service. However, it only needed to complete C$10 billion of financing and kept its share count roughly flat by reinvesting a significant portion of its excess cash flow to finance these growth projects.

TransCanada's strong balance sheet has proved to be a competitive advantage during the recent oil market downturn because it has maintained open access to cheap capital. For example, last August the company issued $1.2 billion 60-year notes at a fixed rate of 5.875% for the first 10 years. Contrast this with the lower-rated Williams Partners, which sold $1 billion of 10-year notes in January of last year at a rate of 7.875%. TransCanada's lower borrowing rates mean it keeps more cash flow for dividends instead of sending it to creditors.

Drilling down into the coverage ratio

As mentioned, TransCanada retains a significant portion of its cash flow for reinvestment into growth project. As the chart on the right side of the following slide shows, the company's dividend payout ratio has consistently amounted to less than half of funds generated from operations over the past few years:

Chart showing that TransCanada's dividend payout ratio averaged less than 50% of funds from operations.

Source: TransCanada Corporation investor presentation.

That is one of the strongest dividend coverage ratios in the pipeline sector. For example, Enbridge expects its dividend to be between 50% to 60% of available cash flow from operations over the next few years. Meanwhile, Williams Partners anticipates paying out roughly 80% of distributable cash flow this year and as much as 90% in future years. That's even after the company recently reduced its distribution 29% so it could generate excess cash to finance growth projects. Most other pipeline companies pay out close to 100% of cash flow, which is why so many have had to reduce their payouts during the oil market downturn. Clearly, TransCanada's decision to maintain an industry leading coverage ratio enhances the long-term sustainability of its dividend.

Investor takeaway

TransCanada's dividend appears to be on solid ground. Not only does the company generate very stable cash flow but it has a top-rated balance sheet and a healthy coverage ratio. These factors should ensure that it continues paying a growing dividend for years to come.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.