Here’s Why This Share With A 6.2% Dividend Yield May Be a Yield-Trap

Investors who are looking out for shares with attractive dividend yields right now may have come across oil & gas support services provider Pacific Radiance Ltd (SGX: T8V); at the company’s current share price of S$0.485, it has a yield of some 6.2% thanks to its annual dividend of S$0.03 per share in 2014.

That’s more than twice the 2.8% yield that’s offered by the SPDR STI ETF (SGX: ES3), an exchange-traded fund tracking the fundamentals of Singapore’s stock market barometer, the Straits Times Index (SGX: ^STI).

But, Pacific Radiance’s high yield does not necessarily mean that it’d make for a solid income share. In fact, there are signs that it may be a yield trap, a share with a high yield that ends up being a disappointing income investment as a result of having poor subsequent business performances.

Makings of a reliable dividend

Generally speaking, there are a few things that I like to dig into when I’m trying to assess how reliable a company’s dividend is:

  1. The company’s track record in growing and paying its dividend.

This criterion’s importance lies in the insight it can give investors about management’s commitment to reward shareholders as the business grows.

  1. The company’s ability to grow its free cash flow over time and generate it in excess of the dividends paid.

Ultimately, a company pays its dividends with the cash it has and that cash can from a few sources. A company can 1) take on debt, 2) issue new shares, 3) sell its assets, and/or 4) generate cash from its daily business activities.

There are always exceptions, but it’s generally more sustainable for a company to pay its dividends using the cash it has generated from its businesses.

It thus follows that investors should be keeping a close watch on a company’s free cash flow as it is the actual cash flow from operations that’s left after the firm has spent the necessary capital needed to maintain its businesses at their current state. The higher the company’s free cash flow can be over time, the larger the potential for growing dividends.

  1. The strength of the company’s balance sheet.

When a company has a weak balance sheet that’s laden with debt, its dividends can be at risk of being reduced or removed – either due to pressure from creditors or from a simple lack of cash – even at the slightest hiccup in the fortunes of its business.

On the other hand, a strong balance sheet that is flush with cash gives a company the resources to protect its dividends during the inevitable tough times that rolls along every now and then.

Falling short

Pacific Radiance only got listed in November 2013, so it has a very short financial track-record that we can assess. But, there are still useful clues that we can glean from the oil & gas outfit’s numbers. The chart below show how the company has fared against the three criteria discussed above:

Pacific Radiance's dividends per share (DPS), free cash flow (FCF), and balance sheet figures

Source: S&P Capital IQ

What’s striking here is that Pacific Radiance has failed to produce any free cash flow at all since 2010. In addition, the company’s balance sheet has remained weak (the amount of cash has consistently been much lower than the amount of borrowings) the whole time. These traits reduce the chances of Pacific Radiance being able to support its current level of dividends in the future as the firm simply does not have too much room for error.

Risks to the firm’s dividends are also exacerbated by the fact that the price of oil is currently still only slightly north of US$50 per barrel, a far cry from the price of more than US$100 per barrel seen in the middle of 2014. Pacific Radiance has already shown signs of stress in its business given that its revenue and profit had experienced year over year declines of 25% and 94% respectively in the first quarter of 2015.

A Fool’s take

Given what we’ve seen, it appears that the only thing to like about Pacific Radiance as an income stock is its high yield – it’s for this reason that it may be a yield trap. But all that being said, it’s still worth stressing that this look at the company’s historical financials is not a holistic overview of the entire picture.

Investors would still need to dig into the qualitative aspects of the oil & gas outfit’s business and consider if brighter days are ahead. A study of Pacific Radiance’s financial track record can be important and informative, but more work needs to be done beyond that before any investing decision can be made.

If you like what you've seen and would like more analyses on dividend investing and important updates about Singapore's stock market, sign up for The Motley Fool Singapore's free weekly investing newsletter, Take Stock Singapore. Written by David Kuo, it can help you grow your wealth in the years ahead.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any companies mentioned.