Is Advanced Drainage Systems, Inc. (NYSE:WMS) a good dividend stock? How can we tell? Dividend paying companies with growing earnings can be highly rewarding in the long term. Unfortunately, it's common for investors to be enticed in by the seemingly attractive yield, and lose money when the company has to cut its dividend payments.
With a 0.9% yield and a five-year payment history, investors probably think Advanced Drainage Systems looks like a reliable dividend stock. While the yield may not look too great, the relatively long payment history is interesting. When buying stocks for their dividends, you should always run through the checks below, to see if the dividend looks sustainable.
Companies (usually) pay dividends out of their earnings. If a company is paying more than it earns, the dividend might have to be cut. Comparing dividend payments to a company's net profit after tax is a simple way of reality-checking whether a dividend is sustainable. Although Advanced Drainage Systems pays a dividend, it was loss-making during the past year. When a company recently reported a loss, we should investigate if its cash flows covered the dividend.
Advanced Drainage Systems paid out 15% of its free cash flow as dividends last year, which is conservative and suggests the dividend is sustainable.
Is Advanced Drainage Systems's Balance Sheet Risky?
Given Advanced Drainage Systems is paying a dividend but reported a loss over the past year, we need to check its balance sheet for signs of financial distress. 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). Advanced Drainage Systems is carrying net debt of 4.07 times its EBITDA, which is getting towards the upper limit of our comfort range on a dividend stock that the investor hopes will endure a wide range of economic circumstances.
Net interest cover can be calculated by dividing earnings before interest and tax (EBIT) by the company's net interest expense. With EBIT of 2.31 times its interest expense, Advanced Drainage Systems's interest cover is starting to look a bit thin.
Remember, you can always get a snapshot of Advanced Drainage Systems's latest financial position, by checking our visualisation of its financial health.
From the perspective of an income investor who wants to earn dividends for many years, there is not much point buying a stock if its dividend is regularly cut or is not reliable. Looking at the data, we can see that Advanced Drainage Systems has been paying a dividend for the past five years. During the past five-year period, the first annual payment was US$0.16 in 2015, compared to US$0.36 last year. This works out to be a compound annual growth rate (CAGR) of approximately 18% a year over that time.
Advanced Drainage Systems has been growing its dividend quite rapidly, which is exciting. However, the short payment history makes us question whether this performance will persist across a full market cycle.
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. Advanced Drainage Systems's earnings per share have shrunk at 12% a year over the past five years. A sharp decline in earnings per share is not great from from a dividend perspective, as even conservative payout ratios can come under pressure if earnings fall far enough.
We'd also point out that Advanced Drainage Systems issued a meaningful number of new shares in the past year. Trying to grow the dividend when issuing new shares reminds us of the ancient Greek tale of Sisyphus - perpetually pushing a boulder uphill. Companies that consistently issue new shares are often suboptimal from a dividend perspective.
To summarise, shareholders should always check that Advanced Drainage Systems's dividends are affordable, that its dividend payments are relatively stable, and that it has decent prospects for growing its earnings and dividend. We're a bit uncomfortable with the company paying a dividend while being loss-making, although at least the dividend was covered by free cash flow. Earnings per share have been falling, and the company has a relatively short dividend history - shorter than we like, anyway. In summary, Advanced Drainage Systems has a number of shortcomings that we'd find it hard to get past. Things could change, but we think there are a number of better ideas out there.
Without at least some growth in earnings per share over time, the dividend will eventually come under pressure either from costs or inflation. Very few businesses see earnings consistently shrink year after year in perpetuity though, and so it might be worth seeing what the 3 analysts we track are forecasting for the future.
Looking for more high-yielding dividend ideas? Try our curated list of dividend stocks with a yield above 3%.
If you spot an error that warrants correction, please contact the editor at email@example.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.
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