Want to double your money in five years? Just invest in a dividend stock that yields 14.9%, and -- assuming the dividend stays the same during that time frame -- that's exactly what's going to happen. And of course, assuming a high dividend is going to remain as such is a pretty big assumption.
Canadian oil and gas production company Vermilion Energy (NYSE:VET) saw its yield hit that sweet 14.9% mark back in October. Currently, it's yielding about 14%: still a healthy sum. And it offers a monthly payout as opposed to the standard quarterly version.
But there's more to a dividend than just yield and frequency. Let's take a closer look at Vermilion to see if it's worth buying today.
First, the good news
Often, a high dividend is a result of a floundering share price. That's true here, too, unfortunately. As Vermilion's share price has declined this year, the yield has gone way up:
We'll get to why this is happening in a moment, but it's actually surprising how many of Vermilion's financial metrics are sound. The company's return on capital employed -- a measure of management's effectiveness -- sits at a solid 10.7%, which is not quite as good as the 18.5% of industry outperformer ConocoPhillips (NYSE:COP) but is much better than many other independent exploration and production companies (E&Ps).
Similarly, while the company's debt load of 1.4 times EBITDA is high, many other E&Ps have higher debt loads. Meanwhile, the company's price-to-earnings ratio and enterprise value-to-EBITDA ratio -- two standard valuation metrics -- are among the lowest in the industry. They're even lower than Conoco's, suggesting that Vermilion may currently be undervalued.
Many of Vermilion's key metrics don't look all that bad compared to those of its peers, but the share price has been falling anyway. Here's why.
The not-so-good news
Although Vermilion has a global footprint, 60% of its production comes from the U.S., where crude prices -- benchmark WTI crude in particular -- are comparatively low. Vermilion's share price was hit hard in August when WTI crude dropped to $51.14/barrel. Prices have since recovered but remain volatile. On the company's Q3 earnings call, Vermilion's management estimated it could cover its proposed 2020 capital expenses and its dividend payout with funds from operations (FFO) as long as WTI stayed at or above $55 per barrel.
Unfortunately, things may not go according to plan. After announcing Q3 results, Vermilion's shares got hammered again thanks to lower-than-expected production due to unplanned downtime, weather, and maintenance issues, which turned an expected quarterly profit into a loss. Hopefully, these are one-time problems, but they demonstrate how precarious Vermilion's position is.
Right now, WTI crude is trading at a comfortable $59 per barrel. But if the price falls again, or if Vermilion experiences more operational issues, that FFO number is almost certainly going down, too. Here's why that's such a big concern.
To cut or not to cut
Vermilion's FFO has exceeded the total of its capital expenditures and dividends paid for a decade. That means for 10 years, its total payout ratio has exceeded 100%. To make up the difference while maintaining its dividend, Vermilion has issued new shares -- which raise money but dilute existing shares' value -- and taken on debt.
Part of this discrepancy was thanks to the company's dividend reinvestment program, or DRIP. Since 2003, Vermilion has automatically reinvested shareholder dividends at preferred rates. It ended the preferred rates in 2018 and now says it will phase out the DRIP altogether by the end of 2020.
To its credit, since Vermilion started paying a dividend in 2003, it's never cut it, instead raising it four times -- most recently in 2018. Management has pointed out that so far in 2019, capital expenditures plus dividend spending barely exceed FFO:
If it didn't cut the dividend when its total payout ratio was 170%, the company reasons, why would it do so now at a payout ratio of 104%, with DRIP on the way out?
The snowball effect
Depending on how things shake out in the oil market, Vermilion may have no choice but to make cuts when it didn't need to before.
Back in 2009, Vermilion had almost no long-term debt; now it has $1.5 billion. It also had less than 80 million shares outstanding; today it has 155.3 million. The company's share price has fallen by about 60% since then, too. With shares worth less, Vermilion would have to issue more of them to raise the same amount of money, further diluting the value of existing shares and also increasing the total dividend payout. At a certain point, this cycle will become unsustainable.
Management certainly seems determined to avoid cutting the dividend at all costs, and to its credit, it hasn't done so yet. But there's a first time for everything. Witness the cautionary tale of the now-privately held Buckeye Partners, which sported a 15% yield and a high payout ratio in Q3 2018, but hadn't cut its distribution in 30 years and had "no plans" to do so. It cut its payout just one quarter later, with disastrous results.
If oil prices stay high enough, Vermilion should be able to execute its plans, get its payout ratio below 100%, and then begin the hard work of paying down some of the debt it's accrued. But remember, a payout ratio in the 90% to 95% range doesn't leave much margin for error. Another unforeseen production issue or sudden drop in oil prices could ruin the company's plans.
Ultimately, investors will have to decide for themselves whether the prospect of doubling their money in five years is worth the risk that in a couple of years, the dividend will get cut, causing the share price to plummet and leaving them with a net loss. There aren't many yields this high in the market, but there are plenty of less risky ones.