Are These 17% and 15% Dividend Yields Too Good to be True?
Whenever you find a stock with a 15% dividend yield, remember the adage: "It's too good to be true."
This kind of ultra-high yield invariably means that most investors anticipate a major cut in the dividend. Otherwise, it would attract so much buying interest that the yield would get pushed sharply lower anyway.
But some of these high-yielders can present real bargains if you're willing to do some math. I've been looking at a pair of high-yield stocks that are actually undervalued, despite the likelihood of a dividend cut.
Here they are...
1. Inergy L.P. (Nasdaq: NRGY)
This propane distributor, which is structured as a master limited partnership (MLP), fell into a classic trap. Management grew addicted to a steady annual boost in the dividend, aiming to attract investors and provide them with extra income even as the company's operating fundamentals were deteriorating.
The slump in operating income can be chalked up to four factors. First, Inergy invested in a natural gas storage depot, known as Tres Palacios, where early returns have been weak because a glut of gas reduced profitability for storage facilities. (Many gas producers are selling on the spot market or lining up futures contracts because it doesn't pay to simply store gas.) Tres Palacios is currently at 71% of capacity, well below management's earlier targets.
Despite all of these challenges, Inergy is likely to still generate decent cash flow in coming years. Analysts project EBITDA of roughly $400 million in fiscal 2012, $420 million in fiscal 2013 and $440 million in fiscal 2014. These numbers could move up if Inergy's propane and natural gas markets start improve. Frankly, a more normal temperature range next winter would have a profound impact on Inergy's volumes and profits. (As I write this, my hometown in upstate New York is a balmy 70 degrees -- in March.)
Still, this would not be quite enough for Inergy to maintain its current dividend. The company announced an imminent dividend cut in late January, and analysts now forecast it to be about $1.80 a share in the current fiscal year and just $1.50 in fiscal 2013. Even using the lower $1.50 figure, that yield would be roughly 9.4% ($1.50 dividend / $15.82 stock price = 9.4%), which is still much higher than most other gas and propane MLPs. For example, rival AmeriGas Partners (NYSE: APU) sports a 6.7% yield, while the Alerian MLP ETF (Nasdaq: ALPS) carries a 5.9% yield.
But let's assume Inergy would eventually trade at a 7% yield when all of the current noise has abated. This means buyers would likely bid up the stock until the yield dropped from 9.4% to 7.0%. That's a 25.5% gain. Throw in the pro forma 9.4% yield, and you're looking at a 35% gain in the near-term, and a nearly double-digit yield in the long-term.
2. Two Harbors Investments (Nasdaq: TWO)
This is a real estate investment trust (REIT) that buys and sells residential mortgage-backed securities. Yup, these are the same bonds that got Wall Street into big trouble a few years ago.
But it's actually a far safer market these days. First, these bonds trade at a discount to par, reflecting the chance that some of the mortgages in the bonds could fail. And though the housing market is still unhealthy, the pace of new foreclosure activity appears to have markedly slowed. This gives this firm the chance to buy relatively safe bonds that sport ultra high yields.
The juicy 15.5% yield may well be maintained for a while to come, but will have to come down eventually. Conditions are favorable right now, but ultimately as the housing market rebounds, the bond market will no longer be quite so skittish, and this firm's investment managers won't find such high-yield bargains.
Two Harbors boosted its dividend from $1.48 a share in 2010 to $1.60 in 2011, and it could stay at this level during this year and next. Assume that reduced bond yield pushes the dividend figure down to $1 a share by 2014, and the stock would still sport a yield of nearly 10%. As is the case with Inergy, Two Harbors' shares may also modestly appreciate as the 10% "safer" yield attracts fresh investors.
Risks to Consider: As the U.S. economy continues to rebound, interest rates are bound to move up. This could affect the relative appeal of income-producing stocks as bonds ever-higher yields.
Action to Take --> A double-digit yield often means there's something amiss. But it doesn't necessarily the stock is in trouble. Do the math to see what the yield will look like after current or future challenges have been taken into consideration. The two stocks mentioned above have such high yields that even if they cut dividends, investors would still benefit from generous high yields of 9% or more.
[Note: If you haven't heard about this unique opportunity, then I want to tell you about it now. StreetAuthority has staked me with $100,000 of real money to invest in my absolute best ideas. For a limited time, you'll be able to follow along with me completely free. Go here to learn more.]
StreetAuthority LLC does not hold positions in any securities mentioned in this article.