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Is Melcor Developments Ltd. (TSE:MRD) A Smart Choice For Dividend Investors?

Simply Wall St

Today we'll take a closer look at Melcor Developments Ltd. (TSE:MRD) from a dividend investor's perspective. Owning a strong business and reinvesting the dividends is widely seen as an attractive way of growing your wealth. Yet sometimes, investors buy a popular dividend stock because of its yield, and then lose money if the company's dividend doesn't live up to expectations.

In this case, Melcor Developments likely looks attractive to investors, given its 3.7% dividend yield and a payment history of over ten years. We'd guess that plenty of investors have purchased it for the income. The company also bought back stock during the year, equivalent to approximately 0.5% of the company's market capitalisation at the time. Some simple analysis can reduce the risk of holding Melcor Developments for its dividend, and we'll focus on the most important aspects below.

Click the interactive chart for our full dividend analysis

TSX:MRD Historical Dividend Yield, February 6th 2020

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. Melcor Developments paid out 30% of its profit as dividends, over the trailing twelve month period. This is a medium payout level that leaves enough capital in the business to fund opportunities that might arise, while also rewarding shareholders. Plus, there is room to increase the payout ratio over time.

Another important check we do is to see if the free cash flow generated is sufficient to pay the dividend. Of the free cash flow it generated last year, Melcor Developments paid out 35% as dividends, suggesting the dividend is affordable. It's encouraging to see that the dividend is covered by both profit and cash flow. This generally suggests the dividend is sustainable, as long as earnings don't drop precipitously.

Is Melcor Developments's Balance Sheet Risky?

As Melcor Developments 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). Melcor Developments has net debt of 6.93 times its EBITDA, which implies meaningful risk if interest rates rise of earnings decline.

We calculated its interest cover by measuring its earnings before interest and tax (EBIT), and dividing this by the company's net interest expense. Interest cover of 4.02 times its interest expense is starting to become a concern for Melcor Developments, and be aware that lenders may place additional restrictions on the company as well. Low interest cover and high debt can create problems right when the investor least needs them, and we're reluctant to rely on the dividend of companies with these traits.

Consider getting our latest analysis on Melcor Developments's financial position here.

Dividend Volatility

Before buying a stock for its income, we want to see if the dividends have been stable in the past, and if the company has a track record of maintaining its dividend. Melcor Developments has been paying dividends for a long time, but for the purpose of this analysis, we only examine the past 10 years of payments. Its dividend payments have declined on at least one occasion over the past ten years. During the past ten-year period, the first annual payment was CA$0.34 in 2010, compared to CA$0.48 last year. This works out to be a compound annual growth rate (CAGR) of approximately 3.5% a year over that time. Melcor Developments's dividend payments have fluctuated, so it hasn't grown 3.5% every year, but the CAGR is a useful rule of thumb for approximating the historical growth.

It's good to see some dividend growth, but the dividend has been cut at least once, and the size of the cut would eliminate most of the growth, anyway. We're not that enthused by this.

Dividend Growth Potential

With a relatively unstable dividend, it's even more important to see if earnings per share (EPS) are growing. Why take the risk of a dividend getting cut, unless there's a good chance of bigger dividends in future? Melcor Developments's EPS have fallen by approximately 12% per year during the past five years. With this kind of significant decline, we always wonder what has changed in the business. Dividends are about stability, and Melcor Developments's earnings per share, which support the dividend, have been anything but stable.

Conclusion

To summarise, shareholders should always check that Melcor Developments's dividends are affordable, that its dividend payments are relatively stable, and that it has decent prospects for growing its earnings and dividend. First, we like that the company's dividend payments appear well covered, although the retained capital also needs to be effectively reinvested. Earnings per share have been falling, and the company has cut its dividend at least once in the past. From a dividend perspective, this is a cause for concern. Ultimately, Melcor Developments comes up short on our dividend analysis. It's not that we think it is a bad company - just that there are likely more appealing dividend prospects out there on this analysis.

You can also discover whether shareholders are aligned with insider interests by checking our visualisation of insider shareholdings and trades in Melcor Developments stock.

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

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.

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. Thank you for reading.