In my opinion, analyst downgrades need to be taken with a dump truck's worth of salt, because most of the time "sell" advisories don't arrive until share prices have already cratered and other analysts have piled on with their own downgrades. In other words, most analysts have a bad case of short-term focus and a herd mentality, and oftentimes downgrades don't arrive until a stock is so beaten down it might actually represent a great long-term buying opportunity.
Take, for example, TransCanada Corporation (NYSE:TRP), which between Aug. 4 and Sept. 11 received one upgrade and three downgrades from analysts.
Since Aug. 4, TransCanada shares are down 15%, and many income investors might be nervous about the growth prospects of this gas and oil pipeline giant, especially with so many analysts downgrading the stock and the prospect of cheap energy prices potentially stretching on for years.
Let's take a systematic look at TransCanada's business model, growth plans, and most importantly its dividend growth profile, to see how risky it really is to buy shares at today's beaten-down price.
TransCanada at a glance
TransCanada earns its money by operating an enormous system of natural gas and oil pipelines and extracting tollbooth-like fees under long-term contracts. The mostly predictable cash flows this generates allows it to fund its dividend and help pay for its enormous growth backlog of future projects -- $46 billion of which are already secured by long-term commercial contracts.
TransCanada is also the general partner of TC PipeLines (NYSE:TCP), an MLP that is 28.2% owned by the company and serves as a source of funding via dropdown sales of assets. A perfect example of how this works is the company's recent dropdown sale of TransCanada's 30% stake in Gas Transmission Northwest to TC PipeLines for $457 million; $264 million of which was in cash, $98 million of assumption of debt, and $95 million in new Class B TCP units.
Basically, by selling its assets to its MLP, TransCanada gains cash and debt assumption to help offset the cost of building a project, and then the larger equity stake in TCP results in larger distributions to the general partner. This recurring and growing cash flow is joined by TransCanada's incentive distribution rights, or IDR fees, which currently grants it 15% of TC PipeLines's distributable cash flow.
Dividend profile: generous dividend with good growth prospects
TransCanada's current yield of 4.8% is generous, and management is guiding for 8% to 10% dividend growth through 2017.
Management expects the next three years' worth of dividend growth to come from the $12 billion in small to medium-sized projects it plans to put into service over the next 3.5 years.
To maintain that kind of impressive dividend growth long-term, TransCanada plans to rely on its $34 billion in large scale projects, such as its $12 billion Energy East project, $8 billion Keystone XL pipeline, and $5 billion Prince Rupert Gas Transmission project, or PRGT.
All told, the $46 billion in contracted growth projects are expected to add around $5.75 billion in annual EBITDA, basically doubling TransCanda's current earnings before interest, taxes, depreciation, and amortization.
All this talk of dividend growth is nice, but as important as future payout growth is, current dividend sustainability is more important. The best way to calculate that is with a distribution coverage ratio that compares distributable cash flow to the cost of the dividend.
However, TransCanada is a Canadian company, and because of a lack of maintenance capex data in its regulatory filings, calculating its DCF isn't possible, and so we're forced to rely on the dividend payout ratio, which compares the dividend to TransCanada's earnings per share.
This method isn't ideal because in a highly capital-intensive industry such as pipelines, non-cash charges can cause wild swings in EPS, something avoided when looking at DCF.
TransCanada's three- and six-month earnings payout ratios were 87% and 90%, respectively, indicating that the dividend should be sustainable, though to safely achieve the 8% to 10% growth target will require good execution of its large growth projects, which -- along with a rising U.S. dollar that's decreasing the dividend paid in U.S. dollars -- represents the biggest potential risk for income investors.
Bottom line: future payout growth faces risks mean analysts may be right in this case
While TransCanada's current dividend is probably safe, whether it can achieve its targeted dividend growth in the long term will depend on completing its large-scale projects such as Keystone XL and PRGT. That will require regulatory approval from the U.S. Congress, the government of British Columbia, and the federal government of Canada, respectively.
This regulatory risk is one reason that I think analysts may be right to be skeptical of TransCanada's long-term prospects, even should oil prices recover sharply over the next few years.
Adam Galas has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.