Introduction

When it comes to dividend growth investing, not all companies are created equal. Some businesses, such as Real Estate Investment Trusts (REITs), infrastructure companies, and midstream companies, require a unique set of metrics to analyze their dividend sustainability and growth potential. In this lesson, we will discuss why standard GAAP (Generally Accepted Accounting Principles) metrics may not be suitable for these special situations and explore the specific metrics required to evaluate their dividends effectively.

Part 1: Understanding Special Situations

1.1 Real Estate Investment Trusts (REITs)

REITs are companies that own, operate, and manage income-producing real estate properties. They are required to distribute at least 90% of their taxable income to shareholders as dividends.

1.2 Infrastructure Companies

Infrastructure companies own and manage essential assets such as roads, bridges, airports, and utility networks. These assets generate stable cash flows, allowing infrastructure companies to pay consistent dividends. However, the capital-intensive nature of their business model makes it necessary to assess their ability to maintain and grow dividends over time.

1.3 Midstream Companies

Midstream companies are involved in the transportation, storage, and processing of oil and gas. They generate income through long-term contracts, providing a predictable cash flow. Similar to infrastructure companies, midstream businesses require substantial capital investments, making dividend sustainability and growth evaluation essential.

Part 2: Limitations of GAAP Metrics for Special Situations

Standard GAAP metrics, such as net income and earnings per share, may not accurately reflect the financial performance of REITs, infrastructure companies, and midstream companies. This is because:

1. GAAP metrics focus on accounting earnings, which may not represent the actual cash flows generated by these businesses.
2. Depreciation and amortization, which are non-cash expenses, can significantly impact GAAP earnings, making them less useful for dividend analysis.
3. Capital-intensive businesses may have high levels of debt, which can distort GAAP earnings and not provide a clear picture of the company’s ability to pay dividends.

Part 3: Key Metrics for Evaluating Dividend Sustainability and Growth

3.1 Adjusted Funds From Operations (aFFO) for REITs

aFFO provides a clearer picture of a REIT’s ability to pay dividends and is a better metric than GAAP earnings for evaluating dividend sustainability and growth.

Calculating adjusted funds from operations (AFFO) for equity REITs involves several essential steps, but it’s crucial to understand that there isn’t a universally accepted formula for computing AFFO, so investors must carefully assess each company’s approach. Different companies may employ varying methods for calculating AFFO, which can make direct comparisons challenging. Therefore, it is vital for investors to familiarize themselves with the unique adjustments and methodologies used by each equity REIT to ensure a thorough understanding of their financial performance and sustainability.

Example:

Let’s break down the calculation of Adjusted Funds from Operations (AFFO) for a hypothetical equity REIT called PropCo.

1. Net Income

First, we need to determine PropCo’s net income. This is the profit generated by the company, which can be found on the income statement.

Let’s assume PropCo’s net income for the year is $1,000,000.

2. Add Back Depreciation & Amortization

As a non-cash expense, depreciation and amortization should be added back to the net income. This information can also be found in the income statement or the cash flow statement.

Let’s assume PropCo has $200,000 in depreciation and amortization expenses.

3. Subtract Gains/Losses on Property Sales

Any gains or losses on property sales should be excluded from the AFFO calculation, as they are non-recurring events.

Let’s assume PropCo has gained $100,000 from property sales this year.

4. Subtract Recurring Capital Expenditures

To account for the ongoing capital expenditures required to maintain the properties, we need to subtract recurring capital expenditures from the calculation.

Let’s assume PropCo’s recurring capital expenditures are $140,000.

5. Adjustments for Non-cash Items and Other Adjustments

Finally, we need to account for any other non-cash items and adjustments that are relevant to the AFFO calculation. This may include items such as stock-based compensation, straight-line rent adjustments, and other non-cash revenue or expense items.

Let’s assume PropCo has $100,000 in additional non-cash adjustments.

Now we can calculate PropCo’s AFFO using the following formula:

AFFO = Net Income + Depreciation & Amortization – Gains/Losses on Property Sales – Recurring Capital Expenditures + Adjustments for Non-cash Items and Other Adjustments

Plugging in the numbers:

AFFO = $1,000,000 + $200,000 – $100,000 – $140,000 + $100,000

AFFO = $1,060,000

So, PropCo’s Adjusted Funds from Operations (AFFO) for the year is $1,060,000.

3.2 Distributable Cash Flow (DCF) for Midstream Companies

DCF measures the cash available to be distributed to shareholders after accounting for capital expenditures and other necessary expenses. It is a useful metric for evaluating the dividend sustainability and growth potential of midstream companies.

Calculating distributable cash flow (DCF) for midstream companies involves a few key steps, but it is important to note that there is no standardized formula for calculating DCF, so investors should carefully evaluate each company’s method.

Let’s use a hypothetical midstream company, MidCo, to demonstrate how to calculate the Distributable Cash Flow (DCF) for a midstream business. Keep in mind that this is a simplified example, and the actual process might be more complex depending on the company’s specific situation.

1. Operating Cash Flow (OCF): Determine the operating cash flow generated by the company. This can be found in the company’s cash flow statement.Example: MidCo has an operating cash flow of $1,000,000.
2. Capital Expenditures (CapEx): Identify the amount of capital expenditures required to maintain the company’s assets. This is typically considered as “maintenance CapEx” and can be found in the company’s financial statements or estimated using industry benchmarks.Example: MidCo has maintenance CapEx of $200,000.
3. Distributions to Noncontrolling Interests and Preferred Equity: Consider any cash distributions paid to noncontrolling interests and preferred equity holders, as these reduce the amount available to common equity holders.Example: MidCo distributes $50,000 to noncontrolling interests and preferred equity holders.
4. Calculate Distributable Cash Flow (DCF): Subtract maintenance CapEx and distributions to noncontrolling interests and preferred equity holders from the operating cash flow.Example: DCF = OCF – Maintenance CapEx – Distributions to Noncontrolling Interests and Preferred Equity DCF = $1,000,000 – $200,000 – $50,000 DCF = $750,000

In this example, MidCo’s Distributable Cash Flow (DCF) is calculated as $750,000. This represents the cash available to common equity holders for distribution as dividends.

Keep in mind that each midstream company may have its own unique method of calculating DCF, so it is essential to review the company’s financial statements and disclosures to understand their specific approach

Summary

When it comes to dividend growth investing in special situations like REITs, infrastructure companies, and midstream companies, using the appropriate metrics is crucial for evaluating dividend sustainability and growth potential. By understanding the limitations of GAAP metrics and applying the specific metrics discussed in this lesson, investors can make more informed decisions and better assess the dividend prospects of these unique businesses.