If I offered you an investment that pays 3.5% a year, and one that pays 12% a year, which one would you choose?
All else being equal, we'd be fools not to take the 12% offer.
Of course, "all else" is rarely equal… especially in a rising interest-rate environment. "Growth," as you'll recall, is the new "income."
That's why we need to look well beyond yield to evaluate a dividend payer, and focus on total return.
The first company we'll look at today, for example, will pay you $12 a year for every $100 you invest in its stock. That certainly seems appealing.
But this second company – despite its lower payout – is a far better investment, for three reasons…
A Tale of Two Dividends
Let's look at two companies in the same sector, just to make sure we're comparing apples to apples…
Or, in this case, fertilizer to fertilizer ….
Rentech Nitrogen Partners LP (NYSE: RNF) is a mid-sized, $1.1 billion market cap, fertilizer company, structured as a Master Limited Partnership. That means they are designed to pay out to unitholders nearly all of their earnings as cash distributions.
Canada-based Agrium Inc. (USA) (NYSE: AGU) is the third-largest fertilizer company in North America, with a $12.7 billion market cap. Unlike Rentech, the much larger Agrium is structured as a corporation, which means it retains most of its earnings.
In the most recent quarter, Rentech paid out a cash distribution to unitholders of $0.85 per unit, or 2.96% (11.9% annualized).
That number trounces the payout made to shareholders by Agrium of $0.75 per share, or 0.87% (3.5% annualized).
But, this is a case where I think investors are much better served owning a 3.5% yield than a near-12% yield.
Simply put, Agrium is a much better investment to own than Rentech – even though Agrium's annualized dividend yield is far less than Rentech's.
Here are three reasons why.
- Growth Is Trending Upward
- The Payout Ratio Is Grounded in Reality
- The Price Is Right
Rentech's recent dividend payout trend is going in the wrong direction. In Q3 2012, the company payout was $1.17 per unit. The payout in Q3 of this year is down about 30%. Meanwhile, Agrium's dividend yield is trending higher. In the same quarter a year ago, the company paid a dividend of $0.50 per share. The most recent payout of $0.75 per share represents a 50% increase in payout, year over year.
Rentech's trailing 12-month EPS was $2.32, of which free cash flow was less than half. Yet the company is expected to pay out a $3.40 cash dividend at current payout rates. A free cash flow payout ratio of more than 300% almost certainly is unsustainable, and that means dividends will likely be cut sharply going forward. Agrium's trailing 12-month EPS was $9.02, of which free cash flow was nearly $6.00 per share. This is more than sufficient to sustain its current $3.00 per share dividend payout and near 50% payout ratio.
It's been a tough year for the fertilizer industry because of a sharp drop in fertilizer prices, rising natural gas prices, and the sordid break-up of the Russian fertilizer cartel this summer. The declines in the space now have Rentech earnings down by 30% and trading at a trailing 12-month PE of 12.3. Agrium earnings were down only 12% and the stock is almost a quarter cheaper at trailing 12-month PE of 9.6.
As you can see, Agrium wins on all three of the aforementioned measures. Moreover, I think Rentech is using unsustainably high dividends to lure investors – a situation known as a dividend trap, and one that savvy investors need to avoid at all costs.
The bottom line here is that Agrium with its 3.5% yield is clearly a superior holding than Rentech with its 12% yield.
You don't have to take my word for it, either. The market agrees with this assessment. Shares of Rentech are down some 20% over the past six months. At the same time, Agrium shares are down just 4%, despite all the trouble in the sector.
The smart money knows: Sometimes 3.5% is better than 12%.