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Is Alliance Data Systems Corporation (NYSE:ADS) A Smart Choice For Dividend Investors?

Simply Wall St

Could Alliance Data Systems Corporation (NYSE:ADS) be an attractive dividend share to own for the long haul? Investors are often drawn to strong companies with the idea of reinvesting the dividends. On the other hand, investors have been known to buy a stock because of its yield, and then lose money if the company's dividend doesn't live up to expectations.

Some readers mightn't know much about Alliance Data Systems's 2.3% dividend, as it has only been paying distributions for the last three years. A low dividend might not be a bad thing, if the company is reinvesting heavily and growing its sales and profits. The company also bought back stock during the year, equivalent to approximately 24% of the company's market capitalisation at the time. Before you buy any stock for its dividend however, you should always remember Warren Buffett's two rules: 1) Don't lose money, and 2) Remember rule #1. We'll run through some checks below to help with this.

Click the interactive chart for our full dividend analysis

NYSE:ADS Historical Dividend Yield, November 10th 2019

Payout ratios

Dividends are typically paid from company earnings. If a company pays more in dividends than it earned, then the dividend might become unsustainable - hardly an ideal situation. As a result, we should always investigate whether a company can afford its dividend, measured as a percentage of a company's net income after tax. Looking at the data, we can see that 18% of Alliance Data Systems's profits were paid out as dividends in the last 12 months. Given the low payout ratio, it is hard to envision the dividend coming under threat, barring a catastrophe.

We also measure dividends paid against a company's levered free cash flow, to see if enough cash was generated to cover the dividend. Alliance Data Systems paid out 6.1% of its free cash flow as dividends last year, which is conservative and suggests the dividend is sustainable. It's positive to see that Alliance Data Systems's dividend is covered by both profits and cash flow, since this is generally a sign that the dividend is sustainable, and a lower payout ratio usually suggests a greater margin of safety before the dividend gets cut.

Is Alliance Data Systems's Balance Sheet Risky?

As Alliance Data Systems has a meaningful amount of debt, we need to check its balance sheet to see if the company might have debt risks. A quick check of its financial situation can be done with two ratios: net debt divided by EBITDA (earnings before interest, tax, depreciation and amortisation), and net interest cover. Net debt to EBITDA measures total debt load relative to company earnings (lower = less debt), while net interest cover measures the ability to pay interest on the debt (higher = greater ability to pay interest costs). Alliance Data Systems has net debt of 10.36 times its EBITDA, which we think carries substantial risk if earnings aren't sustainable.

We calculated its interest cover by measuring its earnings before interest and tax (EBIT), and dividing this by the company's net interest expense. Alliance Data Systems has EBIT of 5.09 times its interest expense, which we think is adequate. Adequate interest cover may make the debt look safe, relative to companies with a lower interest cover ratio. However with such a large mountain of debt overall, we're cautious of what could happen if interest rates rise.

We update our data on Alliance Data Systems every 24 hours, so you can always get our latest analysis of its financial health, here.

Dividend Volatility

One of the major risks of relying on dividend income, is the potential for a company to struggle financially and cut its dividend. Not only is your income cut, but the value of your investment declines as well - nasty. The company has been paying a stable dividend for a few years now, but we'd like to see more evidence of consistency over a longer period. During the past three-year period, the first annual payment was US$2.08 in 2016, compared to US$2.52 last year. This works out to be a compound annual growth rate (CAGR) of approximately 6.6% a year over that time.

Alliance Data Systems has been growing its dividend at a decent rate, and the payments have been stable despite the short payment history. This is a positive start.

Dividend Growth Potential

Dividend payments have been consistent over the past few years, but we should always check if earnings per share (EPS) are growing, as this will help maintain the purchasing power of the dividend. Earnings have grown at around 6.1% a year for the past five years, which is better than seeing them shrink! With a decent amount of growth and a low payout ratio, we think this bodes well for Alliance Data Systems's prospects of growing its dividend payments in the future.

Conclusion

When we look at a dividend stock, we need to form a judgement on whether the dividend will grow, if the company is able to maintain it in a wide range of economic circumstances, and if the dividend payout is sustainable. Firstly, we like that Alliance Data Systems has low and conservative payout ratios. Second, earnings growth has been ordinary, and its history of dividend payments is shorter than we'd like. Overall we think Alliance Data Systems is an interesting dividend stock, although it could be better.

Companies that are growing earnings tend to be the best dividend stocks over the long term. See what the 17 analysts we track are forecasting for Alliance Data Systems for free with public analyst estimates for the company.

If you are a dividend investor, you might also want to look at our curated list of dividend stocks yielding above 3%.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.