Fabrice Taylor, CFA, publishes the President’s Club investment letter. His letter and The Globe and Mail have a distribution agreement. You can get a free copy here.
Commodities routs are serious business and savvy investors know better than to think they’re immune from them because they don’t own resource stocks. When commodity prices collapse, it’s easy to get burned when you don’t expect it, because in this country the resource sector has long tentacles. The danger is compounded when there are dividends involved.
To illustrate the point, consider Wajax Corp., which sells and services industrial equipment and power systems such as generators through more than 100 locations across the country. It’s a well-run company and pays a nice dividend. The balance sheet is reasonable and the board seems to allocate the company’s money with care.
But there is nothing management and the board can do about commodity prices, even though I’m sure they wish they could.
Wajax posted a poor first quarter, with revenues down 6 per cent and earnings per share down 40 per cent. That monthly dividend? Slashed by a quarter.
What’s worse is that some analysts said out loud that they’d have preferred a bigger dividend cut given the bearish outlook for Wajax’s goods and services, which even management is beginning to share.
The trouble is that Wajax’s customers operate in the resource sectors, and with rapidly slowing demand for commodities, business is drying up. And here’s the bad news about slowing commodity demand: It’s not a one-quarter or one-year phenomenon. It builds momentum and does a lot of damage before it’s over.
For Wajax and its shareholders (the same can be said of companies such as Finning, Ritchie Bros. Auctioneers and others), the near- and medium-term outlook is pretty grim. Demand will continue to fall, which hurts revenues. But because capacity is difficult to reduce quickly, profit will fall even more as competitors get aggressive about maintaining market share by cutting prices.
The trick for investors is to dig into the numbers and find out exactly how bad things are.
With the stock still yielding 7.4 per cent despite a dividend cut, it’s easy to feel secure. That’s a mistake because dividend yields are a very effective way of papering over major problems, as we’ve seen time and time again with high-yield stocks like Yellow Media (which is not to compare Wajax to Yellow Media in terms of business outlook, but rather in terms of its risk or perceptions thereof).
So forget the yield for a moment and look at other numbers. EPS, as noted, fell off a cliff. But debt is also quietly climbing. It reached $220-million in the first quarter, up more than $40-million in those three months. Debt relative to earnings (before interest, taxes, depreciation and amortization) is also on the rise, moving from less than one times EBITDA five quarters ago to more than two times now. It’s manageable, but if earnings continue to weaken, as is most likely, it will become an issue and that dividend will start to look like a bad idea.
And here’s the standard arithmetic: The current payout represents about three-quarters of 2013 earnings. Should those earnings drop another 30 percentage points, and should the dividend be cut by the same, in order to preserve the payout ratio, and should investors suddenly decide that they need to earn a 9-cent-yield to justify the risk of holding the stock – all realistic assumptions well-substantiated by history – the stock price is going to get cut almost in half.
It doesn’t help that Wajax’s valuation is higher than many peer companies, which is likely due to retail investor interest arising from that dividend. If and when the payout is reduced, debt and relative valuation will take centre stage. It’s when the tide goes out that you see who’s been skinny dipping, as the old adage goes.
The Wajax story illustrates a perennial threat for Canadian investors: getting blinded by yield when your eyes should be peeled for the general health of a business.
Whether it’s Wajax or others, there are plenty of non-resource companies that will be bruised by the turn in the cycle. Dividends only serve to prolong the outcome, and make it more shocking when it finally happens.
|RBA-T Ritchie Bros Auctioneers Inc.||25.11||
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|FTT-T Finning International||31.59||
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|WJX-T Wajax Corp.||38.25||
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