As for the other four components that contribute to our quality grades, we’ve expanded the range of quantitative and qualitative factors that we consider to gain a holistic view of each company’s health.
Trends in a company’s payout ratio remain an important indicator of dividend sustainability and business strength. However, we must also consider management’s recent guidance, the aggressiveness of the assumptions that underpin these expectations and the company’s track record for delivering the goods.
Effectively judging the sustainability of a company’s revenue stream requires more than analyzing recent trends; we must also consider the points of potential weakness embedded in its business mix—details that management teams tend to downplay or ignore in their press releases and earnings calls.
For example, Crestwood Equity Partners LP’s (NYSE: CEQP) recent earnings calls focus almost exclusively on the partnership’s growth opportunities, with nary a mention of its significant exposure to declining production volumes in the Barnett Shale and Fayetteville Shale—output that will be displaced by other basins.
Whereas Crestwood Equity Partners likely faces a permanent impairment on some of its assets, AES Corp’s (NYSE: AES) exposure to Brazil and other hard-hit emerging markets has weighed heavily on the stock even though the company’s earnings have remained solid.
We also keep an eye out for diversification into unrelated business lines that could threaten the sustainability of future cash flow—rooftop solar power remains at the top of this list.
Income investors need to focus on how the dividend gets paid, instead of assuming that a high-yielding name will maintain its payout in perpetuity. Past performance during recessions or periods of industry weakness likewise provides insight into which names might be at risk.
Relations between utilities and regulators remain sanguine in most states (see map), largely because the industry has shored up its balance sheets and eschewed excessive risk since the Enron debacle. We prefer to avoid utilities operating in California and other states where relations with regulators are strained.
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