In a recent column you mentioned Brookfield Renewable Energy Partners LP (BEP.UN). When I look at the earnings per share (EPS) and the dividend on Globeinvestor.com, the dividend is much higher than the EPS. Several other companies exhibit this same anomalous condition, such as Crescent Point Energy Corp. (CPG). Presumably there is an explanation for why these folks are still breathing. Can you explain how this can be?
Although it may seem impossible – or at the very least reckless – for a company to distribute more than it earns, it's actually not uncommon. Nor does it necessarily mean the company is courting disaster.
To understand why, we need a very brief lesson in accounting – specifically on the difference between net earnings and cash flow.
Net earnings (or net income) – also known as a firm's "bottom line" – is the strictest measure of a company's profitability. It's what is left over after deducting all of the company's various expenses – the cost of raw materials, labour, rent, advertising, utilities and catered lunches for the executives, for example. These are all cash expenses, meaning actual dollars had to be spent to pay for them.
But a company's income statement might also include non-cash expenses, such as depreciation and amortization, that reduce net earnings but don't require any money to go out the door in that particular year. Consider a simple example: If a company previously purchased and paid for a $10-million piece of machinery that it writes down in value by $1-million each year, that $1-million will come off its earnings annually. But it won't put a dent in the company's cash flow because it's just an accounting entry.
As a result, a company's cash flow might well be higher than its net earnings, allowing it to conceivably pay out more to shareholders than it earns.
Companies measure cash flow in different ways and call it different things. For example, Brookfield Renewable Energy refers to "funds from operations," or FFO. It also uses a more stringent measure, adjusted funds from operations, or AFFO, which subtracts maintenance capital expenditures from FFO. You've probably heard the term "free cash flow," which is similar to AFFO. (Real estate investment trusts also typically use FFO and AFFO).
In 2013, Brookfield Renewable reported FFO of $594-million (U.S.) and AFFO of $538-million, both of which were greater than its net income of $215-million. This helps explain why the company can distribute more than its net income while still having a comfortable cash cushion.
According to Scotia Capital analyst Matthew Akman, last year Brookfield Renewable's payout ratio, based on free cash flow, was 72 per cent. The company itself says it aims for a payout ratio, based on FFO, of approximately 60 to 70 per cent. Evidently, management is confident that it can maintain a prudent payout ratio while continuing to increase its distribution to unitholders; in September, the company hiked its annual distribution growth target to a range of 5 to 9 per cent annually, from 3 to 5 per cent previously.
Crescent Point is a similar case. For the nine months ended Sept. 30, the oil and gas producer paid dividends of $2.07 (Canadian) a share – more than double its net income of 94 cents a share. However, what it calls "funds flow from operations" – an adjusted version of cash flow from operating activities – was $4.45. On that basis, the payout ratio was a manageable 47 per cent.
It's also possible (though not necessarily advisable) for a company to distribute 100 per cent or more of its cash flow to investors. How? Well, it could borrow money or use the liquid assets on its balance sheet to fund the dividend. What's more, if a company offers a dividend reinvestment plan (DRIP), it may be able to distribute more than 100 per cent of its cash flow because some of its shareholders are paid with shares instead of money.
None of this is to say that a company can never run into trouble by distributing more than it makes. If it's burning through cash to pay shareholders, the music has to stop at some point. Look at TransAlta Corp., which cut its dividend earlier this year, or Yellow Media Ltd., which eliminated its dividend in 2011.
But if a company has the cash flow to cover its distribution, as both Brookfield Renewable and Crescent Point do, there's no reason to worry. I own both of these stocks and – unless something changes for the worse – I expect that the dividends will continue to roll in.
John Heinzl