As Oil Prices Drop, Keep a Sharp Eye on Energy Stocks
Tuesday, December 9th, 2014
I've received many calls on my radio show about how excited people are by a company paying a high dividend, giving them a yield that is far above the norm.
I look over the fundamentals of the company to determine whether it can continue paying out such a high yield by considering such things as the amount of cash it has on the balance sheet, its amount of debt and its cash flow.
These are very important factors for an investor to look at before jumping into a company that has an attractive dividend yield. If the company cannot afford to keep paying that dividend, it will have to reduce the dividend or perhaps suspend payments completely.
Be aware that the dividends are set quarterly by the company's board of directors, and each quarter it is at the board's discretion whether to pay that dividend, reduce it or pay no dividend all. This may not happen tomorrow but could happen three, six or even 12 months down the road, when you least expect it.
And most of the time, investors will also experience a large drop in the stock price as those who bought the company just for the dividend will sell the stock at any price they can get.
This is what happened to oil driller Seadrill Ltd. (NYSE: SDRL) recently when it reported earnings and also announced that it would suspend payment of the dividend. The stock then fell from about $20 per share to just more than $16 per share, a decline of about 20 percent in one day.
The entire energy industry is experiencing difficulties. And with declining oil prices, investors must look very hard at the energy-related companies they hold in their portfolio.
I am confident that oil prices will rebound; however, no one knows exactly when or how far prices may fall before then. This is why it is imperative to understand the energy company you hold and make sure that when it goes down, it has the fundamentals to weather the storm.
Looking at the fundamentals for the recent earnings reported for
Seadrill, I did see some warning signs that should have kept investors away. The first one was the price to tangible book value of 1.12, which was above the industry average of 0.93.
What really concerns me is the current ratio of 0.78, far below the industry average of 1.96. The company also shows a debt-to-equity of 130 percent when the industry average is 67 percent.
What worries me here is that the company has to make payments on interest and principal on that debt. It would not be worth the time for an investor to understand more about that debt; it's simply enough to know that the debt is way too high and any disruption in the business, such as falling oil prices, will cause financial stress for the company.
The mean estimate by 31 analysts looking for earnings is $3.06 with the year ending December 2015. The high estimate of one analyst was $5.83 and the low estimate of another was $2.33. Even the lowest estimate, using the average S&P 500 forward PE over the last 40 years of 16.5, would give investors a target sell price of $38 per share - roughly 150 percent gain from current levels.
If it were not for the weak balance sheet, showing the high debt and low current ratio, this company would be a buy.
This company may turn things around. It just will be harder, since last week the OPEC nations decided to keep oil production at the current level. This was not welcome news and caused West Texas intermediate crude to fall to $67 a barrel.
If this decline continues, it will become more and more difficult for Seadrill to meet current obligations.
If it can't meet current obligations, it could be forced into bankruptcy.
While I enjoy buying companies that are trading at very good values and are temporarily down in price, they must have a strong balance sheet and good fundamentals. Seadrill does not meet this criteria and I recommend investors look for other energy companies.
Do you have a question or a company you'd like me to take a look at? Email me at Brent@WilseyAssetManagement.com!
Wilsey is president of Wilsey Asset Management and can be heard at 8 a.m. every Saturday on KFMB AM760. Information is provided by Reuters.
Sign up for our free weekly e-newsletter for economic updates, investment advice, and various company analyses. Articles are written by well renowned investment expert Brent Wilsey. Please visit our Archived Newsletters tab to view past articles.
Would you like the Smart Investing E-Newsletter sent to your inbox every Tuesday?