Investing in dividend stocks and holding them for decades at a time can be a great way for investors to build wealth. The compounding returns of reinvested dividends can do wonders for a portfolio over a very long time horizon. This kind of investing only works, though, if a stock can reliably pay dividends for an extraordinarily long time. A significant payout cut, on the other hand, can erase years of returns in one fell swoop.
So when picking potential candidates for a dividend portfolio you plan to hold over the super long term, you want to avoid stocks for which the dividend payouts are uncertain. That's why, for now, Buckeye Partners (NYSE: BPL), Suburban Propane Partners (NYSE: SPH), and Covanta Holding (NYSE: CVA) don't look like the best dividend stock investments. Here's why.
Fewer options mean smaller chance to succeed
The reason most master limited partnerships are good investments is that they build big-ticket infrastructure projects that require little to no maintenance capital for decades and can, therefore, throw off lots of cash. To fund those projects, they have three avenues: issuing debt, issuing equity, or using excess cash from operations. A well-run master limited partnership will try to use all three of these options to fund growth because it gives management flexibility. Once one or two of those options get taken away, though, things start to get a little hairy.
As things stand today, it looks like Buckeye Partners' funding options are running thin. With a distribution yield of 11.9%, it's prohibitively expensive to issue new shares -- each new share gets a distribution in cash, so it's kind of like paying an 11.9% coupon rate. Also, the company ended 2017 with a distribution coverage ratio around 1, so every dollar coming in the door is pretty much going out in the form of distribution payments and little is retained for capital spending.
That leaves debt as the only viable option right now. While the company has relatively good debt metrics for a master limited partnership and an investment-grade credit rating, having to pay for a year of capital spending entirely with debt could seriously compromise its balance sheet.
Buckeye Partners did just absorb a major acquisition, which could boost cash flow in the coming quarters and allow this issue to blow over soon. Also, Buckeye has an impressive track record of maintaining capital discipline and rewarding shareholders with consistent dividend increases. However, we have seen this story play out with other master limited partnerships before, and few have been able to get through without a distribution cut. So until management can deliver higher cash flow and ease some of these funding concerns, it's best to shy away from this high-yield stock.
Is it just me, or is it getting warm in here?
The propane distribution business is a weird one. Selling propane to residential and commercial customers is a relatively simple business that has little to no commodity exposure, which is great if you want consistent revenue. There are a couple problems with this business, though. One is that fewer and fewer homeowners take propane or other heating fuel deliveries because they get hooked up to a line or elect for another form of heating. Large propane distributors like Suburban have historically been able to offset the loss of customers by making bolt-on acquisitions.
The other issue has been rising winter temperatures in Suburban's primary markets. Despite the short periods of extremely cold weather, winter temperatures as measured in degree heating days have been much higher than historical averages over the past few years. That means customers are using less propane and taking fewer deliveries in the winter months, when Suburban's business is strongest. The trouble Suburban faces is that a few poor winters have chewed through any extra cash on the books, which severely restricts management's ability to make those small acquisitions to grow the top line.
Suburban's management already cut its payout last year, but winter weather didn't really do the company any favors this past year, and it hasn't been able to trim down its debt load. Barring some weather anomalies, Suburban could be a headed for another distribution cut sooner rather than later.
If it works, great. If not...
Covanta Holding may be approaching a major inflection point in its business that could make or break its dividend. Its business -- handling waste -- has historically been conducive to generating returns. Also, since Covanta's waste facilities burn waste for electricity and recover recyclables from the waste stream, the company's land requirements for ultimate disposal are lower than those of conventional landfills. These qualities should make Covanta a great business.
Unfortunately, the company's promise so far hasn't translated into robust value delivered to shareholders. Like conventional waste handlers, it takes a lot of capital to get a new facility up and running, and the company's debt levels are a little too high for comfort. As it stands today, the company's interest expenses are equivalent to 64% of its annual EBITDA, and the company has been burning through cash for years as it builds new facilities, the largest of which is in Dublin, Ireland.
According to management, the completion of Dublin will significantly boost EBITDA in fiscal 2018 and its leverage metrics will come down to more reasonable levels. If that is that case, then perhaps the Covanta's leverage concerns will blow over and the company will turn into a great dividend investment. Any snags with Dublin, though, would be a significant blow to the company's earnings power and could make its dividend even more questionable than it is today.
There is a chance that Covanta could turn things around in 2018, but the company needs to prove over the next few quarters that Dublin is running smoothly and leverage ratios need to start dropping. Until then, you may want to sit on the sidelines with this dividend stock.
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