Is This Stock With A 10.4% Yield A Good Dividend Investment?

Dividend investors often want to fill up their portfolios with stocks that carry high dividend yields. But, it’s worth noting that a stock’s yield alone tells us nothing about what’s really important – the company’s ability to sustain or raise its dividends.

With this in mind, what should dividend investors make of Nam Cheong Ltd (SGX: N4E)? At its current price of S$0.144, the builder of offshore support vessels has a really enticing dividend yield of 10.4% thanks to its annual dividend of S$0.015 in 2014.

For perspective, the SDPR STI ETF (SGX: ES3) – an exchange-traded fund which tracks Singapore’s market barometer, the Straits Times Index (SGX: ^STI) – has a yield of ‘only’ 3.3% at the moment.

The foundations for a strong yield

The following’s not an exhaustive list for sure, but it contains some of the important things that I like to look at when I’m trying to assess a company’s ability to maintain or grow its payouts in the years ahead:

  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.

Dividends are ultimately paid using the cash that a company has and that can come 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.

In addition, it enables the firm to go on the offensive during a downturn and reinvest for growth even as its financially weaker competitors have to batten down the hatches; this plants the seeds for potentially higher dividends in the future.

Nam Cheong’s dividends: Yay or Nay

Let’s see from the chart below how Nam Cheong’s dividends and free cash flow has fared against the first two criteria:

Nam Cheong's total dividends (ordinary + special) and free cash flow (FCF) per share

Source: S&P Capital IQ

Nam Cheong became a listed company in Singapore’s stock market by virtue of a reverse takeover in 2011. Since its listing, it has consistently raised its dividends. This deserves a pat on the back.

But, the same chart also shows that Nam Cheong has had trouble generating fee cash flow. If Nam Cheong can’t generate regular free cash flow in the future, it will likely struggle to pay its dividends.

Nam Cheong's balance sheet figures

Source: S&P Capital IQ

The chart just above plots the changes in Nam Cheong’s balance sheet since end-2011. I trust it’s obvious to see that Nam Cheong’s balance sheet has been consistently weak with the amount of borrowings coming in far higher than cash.

The offshore support vessels builder has also seen its balance sheet deteriorate markedly over the years with its level of debt growing far faster than cash; to that point, Nam Cheong’s net-debt position of RM323 million at the end of 2011 had ballooned to RM1.01 billion as of end-June 2015.

Other sources of worries are around too. Nam Cheong’s in the business of building offshore support vessels, as I had already mentioned. This means that the price of oil would have impacts on how well its business can perform.

Strains stemming from a lower oil price (the price of oil has cratered by more than half since mid-2014) may have started to rear their ugly head. In Nam Cheong’s last quarter (the second-quarter of 2015), its revenue had fallen by nearly half compared to a year ago while its profit had been slashed by 83%.

A Fool’s take

Given what we’ve seen with Nam Cheong – namely its lack of free cash flow, its debt-laden balance sheet, and the low price of oil – it’d appear that the company does not have much room for error when it comes to protecting its dividend. That’s a risk investors may want to be aware of.

That being said, investors should note that this look at Nam Cheong’s financial history is not a holistic overview of the entire picture. Investors would still need to dig deeper into the qualitative aspects of the firm’s business and consider if brighter days are ahead. Only then can an intelligent investing decision be reached.

For more analyses on dividend investing and important updates about the stock market, sign up to 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. Also, like us on Facebook to follow our latest hot articles.

The Motley Fool’s purpose is to help the world invest, better.

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.