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Yield-thirsty investors could win with risky Penn West

There is a line, somewhere, that dividend-paying companies cross when their payouts go from juicy to unsustainable. And Penn West Petroleum Ltd ., with an 8 per cent yield that's the biggest in the S&P/TSX 60, seems to have made that journey.

But the news isn't all grim. Even if the company cuts its dividend – which it may well do, given its balance sheet and earnings – its share price may well be at or near its floor. If it manages to surprise a deeply skeptical Bay Street, it will deliver a big win to investors who embrace risk along with their thirst for yield.

The Calgary-based company is a former income trust with a record of managing its energy properties with an eye to passing along the profits to shareholders.

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Its recent history, however, is of a debt-laden firm with falling production numbers and a dwindling dividend trying to reinvent itself as a growth-oriented exploration and production company.

"The transition story," Deutsche Bank analyst Stephen Richardson says, "has disappointed."

Indeed, investors looking for a company with a steady dividend track record should look elsewhere. Penn West, in its trust days, paid $4.08 in dividends in calendar 2008. By that year's end, the share price had fallen to about $13, pushing the trailing dividend yield to around 30 per cent.

That was a clear signal that things would change, and Penn West's dividend has never been the same, falling from 34 cents per month, to 23, to 15, to 9 cents. The company went to quarterly payments in 2011 upon its conversion to a corporation and now pays 27 cents a quarter.

Over the course of 2012, however, the company's shares have fallen by nearly a third to around $13, driving the yield above 8 per cent, into that red-flag territory.

There are very real concerns about another dividend cut as the current yield gobbles up most, if not all, of the company's earnings.

The company defines its payout ratio as a proportion of "funds flow," and says it comes in at just 33 per cent for the first half of 2012.

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But on a net income basis, which takes depreciation of its assets into account, Penn West has paid out two-thirds of its profits so far this year, and more than 100 per cent of earnings over the last 12 months.

Analysts' forecasts of 25 cents in 2012 basic earnings per share, according to Standard & Poor's Capital IQ, imply net losses for the second half of this year. And the estimate for 2013 is 21 cents per share – implying a payout rate of 500 per cent of profits.

Let's say the analysts are right about Penn West, helmed since 2008 by Murray Nunns. Penn West has no cash on the balance sheet and $3.7-billion in debt. To maintain the dividend, Penn West will have to sell assets, something it plans to do, as it says it envisions $1-billion to $1.5-billion in asset sales in the coming months.

Or, it can borrow more, as it has room on its line of credit. Either way, the payouts to investors won't likely come from the ongoing operations of the company.

You might think all this adds up to a stinkeroo of an investment. But here's a few thoughts about what could happen if you buy now. The company could maintain the dividend as it transforms itself into the producer it aims to be. Or, it could cut it by, say, half – which would still be a yield of 4 per cent on your investment.

Would the share price drop from Friday's close of $13.22 on the announcement of a cut? Quite possibly. But the company's tangible book value – its hard assets, minus its liabilities, is more than $15 per share.

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Even some analysts with "hold" or "sell" ratings have target prices or fair-value estimates above current levels. Mr. Richardson, who has a "hold" rating, uses a net asset value model to place a $20 target on the shares. Robert Bellinski of Morningstar Equity Research places a $16 "fair value" on the company. Sam La Bell of Veritas Research Corp., who has a "sell" rating and a $15.50 intrinsic value estimate, says he's "wait[ing] for signs that the company has its house in order."

Prudent investors, particularly those who need stable levels of dividend income, will wait to buy. Those who leap in, however, seem to have a couple of ways to win with a limited amount to lose.

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