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Beware the risks behind Northland Power’s lofty yield

John Heinzl is the dividend investor for Globe Investor's Strategy Lab. Follow his contributions here. You can see his model portfolio here.

On the surface, Northland Power looks like a tempting investment.

The company produces electricity – something everyone needs. It has a healthy pipeline of solar, wind and hydro projects. And the stock sports a 6.9-per-cent yield – more than twice as high as the yield on the S&P/TSX composite index.

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But when a yield gets that high, you need to ask why. In Northland's case, there are several risks to keep in mind.

Dividend is high – but not growing

Perhaps the most troubling sign is that Northland hasn't raised its dividend – currently 9 cents a month – since August, 2006. Given the company's aggressive dividend payout ratio and future investment plans, don't hold your breath for an increase any time soon.

For fiscal 2013, Northland estimates that it will pay out 80 to 90 per cent of its free cash flow as dividends. But the company also acknowledged that the true payout ratio is actually much higher – 115 to 125 per cent – if you include dividends that are paid in shares, instead of cash, under the company's dividend reinvestment plan (DRIP).

Northland says the lofty payout ratio is largely a timing issue, reflecting "the level of spending on growth initiatives and payments of dividends on equity capital already raised for construction projects for which corresponding cash flows will not be received until future years."

But judging by the stock's 20-per-cent slide since early May, some investors are apparently losing patience.

Payout ratio could remain elevated

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When Northland released second-quarter results on Aug. 7, it said the board and management are committed to maintaining the current dividend of $1.08 annually. That's the good news. The bad news is that the payout ratio will probably have to remain above 100 per cent to keep those fat dividend cheques coming.

Northland had hoped to bring the payout ratio below 100 per cent in 2014, helped by a new natural gas-fired plant in North Battleford, Sask., that came into service in June. However, analysts say that if Northland proceeds with a proposed $400-million investment in the Gemini offshore wind development, located in the North Sea off the coast of the Netherlands, the payout ratio will likely exceed 100 per cent at least until the project's estimated completion in 2017.

Going ahead with Gemini would almost certainly put the kibosh on dividend hikes "for the foreseeable future," Nelson Ng, an analyst with RBC Dominion Securities, said in a recent note in which he cut his price target on Northland to $17 from $19. The shares closed Tuesday at $15.71 on the Toronto Stock Exchange.

Dividend not the only worry

Apart from the lack of dividend growth, investors are concerned about the perceived risks of developing offshore wind power, said Mr. Ng, who has a "sector perform" rating on the shares. Rising bond yields and delays faced by several of the company's wind, solar and hydro projects aren't helping the stock, either.

But one of the biggest uncertainties facing Northland is still years away – namely the expiration of long-term power purchase agreements (PPAs) at two Ontario gas-fired plants, in Iroquois Falls and Kingston.

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The PPAs, which were signed at a time of much higher power prices, together account for nearly one-third of Northland's estimated 2014 earnings before interest, taxes, depreciation and amortization, said Darryl McCoubrey, an analyst with Veritas Investment Research.

The expiration of the Iroquois Falls and Kingston PPAs in January, 2017, and December, 2021, respectively, "is the key risk factor underlying the [Northland Power] story," he said in a recent note. While Gemini "could more than compensate for the potential lost profit" if the Ontario plants renew their PPAs at lower rates, the move into offshore wind power – a new technology for Northland in a new jurisdiction – is "unsettling," he said.

Nontheless, Mr. McCoubrey maintained his "buy" rating on the shares, citing the company's strong management team and track record of developing new assets. As for the dividend, he doesn't see any "near-term risk" of a cut.

If you're tempted by Northland's juicy yield, just remember that it's high for a reason.

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