With interest rates still near record lows income investors are naturally drawn to super high-yield stocks, such as Nordic American Tankers (NAT), which until recently was offering a seemingly mouth-watering payout of 10.8%.
But one of the most important factors to successful long-term dividend investing is risk management, and the realization that Wall Street generally doesn’t offer such high-yields without a very good reason.
Let’s take a look at the cautionary tale of Nordic American Tankers to see just why this recent dividend cut wasn’t at all a surprise and actually could have been avoided by income investors.
In fact, the company is a classic high-yield “value trap,” meaning that the business model is fundamentally flawed.
Not only was this latest dividend cut predictable (and avoidable), but it may not be the last payout cut the company is forced to make in the coming quarters.
Let’s take a closer look at the factors impacting Nordic American Tankers’ dividend profile and why the stock remains an inappropriate investment for our Conservative Retirees dividend portfolio.
The Business Model Is Terrible For Paying Stable Dividends
Shipping stocks with sky-high yields are nothing new. After all, nearly a decade of massive overbuilding has resulted in a giant supply glut of ships that has caused charter day rates to crater.
This has led to many shipping companies declaring bankruptcy in the past 10 years, devastating many investors with permanent capital losses.
However, even among shippers, specifically oil tanker operators, Nordic American Tankers has always been an especially high risk dividend stock.
That’s because of its unique business model, which focuses on owning exclusively one class of tanker (30 Suezmax tankers) and operating with only short-term (i.e. spot market) contracts.
As you can see below, the spot market for Suezmax tankers is highly erratic. The reason for this extreme volatility in tanker rates is due to the inherent nature of the spot market, where prices are set at the margins.
In other words, even small changes in supply/demand relationships can have drastic swings in the price of the next tanker getting a short-term contract, making for very unpredictable business results.
For example, thanks to the recent OPEC production cuts, demand for tankers has fallen. This resulted in the spot market day rate for Suezmax tankers falling by $23,000, or 50%, in the last year.
Not surprisingly, Nordic American Tankers has very volatile revenue, earnings, cash flow, and margins. When combined with a very capital-intensive industry such as shipping, the company has never been (and will never be) a good candidate for stable or growing dividends.
Let’s take a closer look to learn how investors could have known to avoid Nordic American Tankers before its dividend cut.
Nordic American Tankers’ Dividend Safety Score
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a company’s dividend.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at a company’s most important metrics such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, profitability trends, and more.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
The chart below plots each company’s Dividend Safety Score on the x-axis and the size of its dividend cut on the y-axis. You can see that almost all companies cutting their dividends scored below 40 for Dividend Safety at the time of their announcements, and companies with lower Dividend Safety Scores generally experienced larger dividend cuts.
We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been (including analysis of every dividend cut in the chart above), and how to use them for your portfolio. You can review this analysis and learn more about Dividend Safety Scores by clicking here.
Nordic American Tankers’ Dividend Safety Score at the time of its dividend cut announcement was 0, meaning that a dividend cut was all but inevitable as the payout security was among the lowest of any American stock.
After all, Nordic American’s dividend track record is hardly stable, meaning management is more than willing to vary the payout to match up with its latest results.
And as you can see, those very volatile results create highly dangerous payout ratios. In fact, not once in the last decade has Nordic American had a safe and sustainable payout ratio on an annual basis.
The company has either lost money or paid out more than 100% of its earnings and free cash flow each year:
Given that Nordic American’s revenue and operating cash flow in the last quarter declined by 31% and 47%, respectively, the latest dividend cut is both logical and necessary.
After all, on an EPS and FCF basis, the most recent quarter’s payout ratios were -325% and -54%, respectively.
Meanwhile, the company’s surprisingly strong balance sheet has been no help to lovers of stable and growing dividends, due to the shareholder-unfriendly way Nordic American has obtained it.
At first glance, Nordic American Tankers appears to have a pristine balance sheet, with a sky-high current ratio, very low debt, and a very high interest coverage ratio.
Furthermore, when you compare the balance sheet to its industry peers you can see that Nordic American has taken a very conservative approach to debt; with a much lower leverage ratio, debt/capital ratio, and a current ratio that is among the best in the industry.
|Company||Debt / EBITDA||Debt / Capital||Current ratio|
|Nordic American Tankers||2.66||32%||10.24|
But remember that the tanker industry is very capital intensive. Nordic American Tankers invested over $187 million into new vessels in 2015, an amount equal to nearly half of the company’s total 2015 revenue ($446 million).
Given Nordic American’s penchant for quickly growing its fleet, that money has to come from somewhere.
In this case, Nordic American has one of the most aggressive track records of raising growth capital through secondary share offerings of any shipping company.
As you can see below, Nordic American Tankers’ diluted shares outstanding have increased by nearly 500% from 2005 (15 million shares) to 2015 (89 million shares).
In November, the company completed yet another dilutionary share sale of 11 million shares (representing 11% dilution) to raise $120 million in order to acquire three new tankers (grow the fleet 10%) by 2018.
That brings the company’s share count to more than 100 million and means that over the past decade, Nordic American has funded its growth (as well as several of its dividends) by diluting existing investors to the tune of 18% annually, according to data from Morningstar.
Just in order for EPS and cash flow per share to remain constant, the company would need to grow sales, profits, and free cash flow by 18% per year; something that is all but impossible for a company with such an extremely volatile business model.
Or to put it another way, the massive amount of shareholder dilution that management uses to fund its fleet growth and dividend over time hasn’t resulted in long-term shareholder value creation.
In fact, the tangible book value per share (the net value of the company’s assets) for Nordic American is actually 32% below that of its IPO value back in 1995.
All of which means that Nordic American’s business model is 100% dependent on tapping equity markets, and in a big way, in order to fund non-accretive (non-shareholder friendly) growth that enriches management (through salaries that grow along with the fleet size) at the expense of individual investors.
With NAT’s stock price tumbling around 50% from its high in mid-2016, the cost of issuing new shares became unbearably high.
When combined with the company’s needs for massive future cash outlays (purchasing tankers isn’t cheap), unsustainable payout ratios, and depressed cash flow from the plunge in spot rates, a dividend cut was all but inevitable.
Why Nordic American Tankers May Have To Cut The Dividend Further
Nordic American’s choice to focus exclusively on short-term contracts means that its dividend is completely at the mercy of the hyper-volatile Suezmax spot market.
Unfortunately, there are two reasons that investors can’t count on this being the company’s last dividend cut.
For one thing, after a long and painful pricing war with U.S. shale oil producers, OPEC has thrown in the towel and is in the process of cutting production.
This means that the short to medium-term demand for Nordic American’s tankers could fall in 2017 and possibly 2018 as well. That could result in the day rates for Suezmax tankers remaining very low for the next few years, putting additional downward pressure on the company’s sales, earnings, and cash flow.
That’s especially true given the old average age of Nordic American’s tanker fleet, which is 13 years old compared to the industry average of 10 years.
Customers generally demand discounts for older tankers, which means that as its fleet continues to age, Nordic American will need to accept lower-than-market average day rates to charter its vessels.
Or the other option is to redirect the cash it uses to fund its dividend to upgrade its fleet, by selling older tankers and then using the proceeds, plus operating cash flow and new equity capital, to build brand new state-of-the-art tankers.
However, that will likely mean that the company will further need to cut its dividend, especially since right now, at the bottom of the industry cycle, selling old tankers won’t fetch very good prices.
For these reasons, Nordic American is at high risk of a downward spiral, in which the company must continue cutting its dividend, resulting in a falling share price, and also sell more and more shares to fund its fleet growth and renewal efforts.
Put another way, unless the Suezmax spot market makes a very large, sustained, and seemingly unlikely turnaround, Nordic American’s already high dilution rate will probably increase in the coming years; which will only further make sustaining or growing the dividend harder.
Closing Thoughts On Nordic American Tankers’ Dividend Cut
Nordic American Tankers’ second dividend cut in the last year should come as no surprise. It’s highly volatile business model creates extremely erratic earnings and cash flow that means the dividend is among the least safe of any income stock in America.
With the tanker industry currently in a downturn that isn’t likely to turnaround anytime soon, and the newly cut dividend still looking unsustainable over the next couple of years, income investors – especially those living off dividends in retirement – should take heed and avoid this high-risk value trap.