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Just Energy Group's fat yield is no free lunch

John Heinzl is the dividend investor for Globe Investor's Strategy Lab. Follow his contributions here. You can see his model portfolio here.

A few weeks ago, I heard from a reader who had purchased shares of Just Energy Group Inc.

He figured the company – which markets natural gas and electricity under fixed- and variable-rate contracts – would be a great long-term investment. Undaunted by the company's dividend cut in April, 2013, he purchased the stock in December "for the high yield," which at the time was about 11 per cent.

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The lofty yield apparently didn't faze him, but it should have. What happened next underscores one of the most important lessons of dividend investing: Stocks with supersized yields often come with supersized risk.

On May 15, citing the impact of severe winter weather, Just Energy announced results well below expectations for the fiscal fourth-quarter ended March 31. The company's guidance for the current year also disappointed analysts, who slashed their price targets on the stock. As investors rushed to the exits, over the next five days the shares skidded about 27 per cent.

It's not the first time investors have been seduced by the supposedly free lunch of a fat dividend – with unpleasant results. Yellow Media Ltd. (formerly Yellow Pages Income Fund) and TransAlta Corp., to take two examples, both at one time sported eye-popping yields. Yellow Media eventually eliminated its dividend in 2011 and later restructured, and earlier this year TransAlta slashed its dividend by 38 per cent.

With Just Energy's shares now yielding more than 13 per cent, the market is clearly signalling that it expects a second dividend reduction following last year's 32-per-cent cut. During the fourth-quarter conference call, executive chair Rebecca MacDonald didn't rule out such action, but said the company is "committed to the dividend for now and the board looks at the dividend policy every quarter."

In the current year, Just Energy will focus on reducing its long-term debt of $982-million by selling non-core assets, she said. These include its U.S.-based Hudson Energy Solar business and possibly its National Home Services water heater rental subsidiary in Ontario. Just Energy is aiming to reduce debt to four times earnings before interest, taxes, depreciation and amortization (EBITDA), down from 4.9 times EBITDA at March 31.

"We are very focused on delivering a more conservatively structured Just Energy in the future," she said.

However, analysts say asset sales alone will likely not repair the company's balance sheet, which is creaking under the weight of debt-financed acquisitions. That will require cutting the dividend, they say.

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In a recent note, TD Securities analyst Damir Gunja noted that Just Energy has been adding net customers at a much slower pace than in previous years, reflecting higher rates of attrition, among other factors. Net growth in "residential customer equivalents" – a number that also captures commercial clients – was just 1 per cent in the fourth quarter compared with the third quarter, down from sequential growth that often exceeded 2 or 3 per cent in 2011, 2012 and 2013.

What's more, new residential and commercial customers tend to be less profitable for the company than those who leave, reflecting the impact of heightened competition in energy markets.

"In our view, this has dampened the company's growth materially," said Mr. Gunja, who slashed his rating on the stock to "reduce" from "buy" and cut his price target to $5 from $10 after the fourth-quarter results. The shares closed Tuesday at $6.37 on the Toronto Stock Exchange.

Another concern is the company's elevated dividend payout ratio.

Nelson Ng, an analyst with RBC Dominion Securities, estimates that Just Energy's payout ratio will be about 140 per cent in the current fiscal year, based on distributable cash flow. If the solar and water heater businesses are both sold and the proceeds used to reduce debt, the ratio will drop to about 110 per cent, he said in a note. A dividend cut of 20 per cent (or 40 per cent if only the solar business is divested) would bring the payout ratio down to a more manageable 80 to 90 per cent, he said. (The company uses a different definition of payout ratio and says it expects the number to drop below 100 per cent this year, even without a dividend cut).

Mr. Gunja said Just Energy needs to go even further.

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"We believe that the dividend should be cut at least in half [to 42 cents annually from 84 cents] to allow for the repayment of debt," he said. "An elimination of the dividend altogether would be … preferable and would accelerate the balance sheet repair. However, it would likely alienate too many yield-based shareholders."

That's if they haven't been alienated already.

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About the Author
Investment Reporter and Columnist

John Heinzl has been writing about business and investing since 1990. A native of Hamilton, he earned a master's degree from the University of Western Ontario's Graduate School of Journalism and completed the Canadian Securities Course with honours. More

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