Could Dragon Oil Be An Ideal Stock For Dividend Growth Investors?

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It is difficult to pinpoint precisely when it all started but for a while now there has been growing chatter among market-watchers, commentators and bloggers in the United States about a neat ‘new’ concept called Dividend Growth Investing. The clue is in the name of course, but put simply it’s a technique that reinvents the dividend investing wheel, throws in a heavy dose of rear-view mirror analysis and sells itself as an ideal antidote to a low interest rate environment. 

As opposed to a conventional dividend formula that might, say, look for sustainable high yields, stalwart performers and strong cashflows, Dividend Growth Investing seems to find more favour among investors looking for attractively valued stocks combined with dividend progression. The idea is to find companies that look like they might be able to increase dividends over the long-term, thus giving the canny investor the benefits of regular (and inflation busting) payouts and likely capital growth in return for very little ongoing work. I’m frankly not sure whether this is really anything new or not… 

While Dividend Growth Investing may be a hot investing topic in the US, here in the UK the opportunities for investors that might want to adopt or adapt the strategy are less certain. Indeed, after a couple of distorting factors, dividend growth actually slowed in the first quarter of this year. But there were exceptions, and some of them came from sectors that aren’t necessarily associated with widespread dividend payouts. 

Can dividends and oil really mix? 

For anyone that bought shares in Tullow Oil (LON:TLW) at 100p eight years ago, the intervening period has been a quite beautiful experience. Its price has more than quadrupled, profits have broken $1bn, it has brought a world-class field (Jubilee, offshore Ghana) into production and, perhaps more importantly, has shown the wit and luck to keep making massive discoveries. The dividend doubled to 12p last year as cash from Jubilee quite literally poured in but Tullow, like the majority of oil companies, has always had to play it safe with its payments to shareholders. 

Of the 130+ oil and gas companies listed in London only around ten actually pay a dividend, ranging from pension fund favourites like Shell, BP and Glencore through to AIM quoted minnow Melrose Resources. Meanwhile, Tullow has quite rightly capped its payouts in recent years when heavy capex projects have put more demands on its cash. Indeed, while last year’s dividend was well covered at 6x, the yield is only 0.50% largely because Tullow’s shares are relatively expensive – the stock trades on a P/E ratio of 27.1 against an industry average of 7.37, which effectively smothers the yield of the £13bn market cap company. 

In fairness, that isn’t bad news for Tullow shareholders that have stayed the course and are now being rewarded for their loyalty. But it does mean the stock isn’t necessarily an immediate option for income investors. So, for dividend hunters that fancy the upside potential of an oil stock (and the current full price for a barrel of brent crude) plus a dividend to boot, is anyone else offering a better deal? 

Dragon Oil Public Co (LON:DGO) is the next largest London listed oil stock after Tullow in terms of market capitalisation, albeit £10bn smaller. It trades on a P/E of 6.68 and has a dividend yield of 2.3%. Unlike Tullow, where the broker consensus hovers between “hold” and “buy”, Dragon stock is rated a “strong buy” among analysts (although we’ve discussed in the past the pitfalls of listening to analyst recommendations). 

Stock comparisons are tricky 

Comparing oil and gas stocks is notoriously difficult verging on pointless when you start taking into consideration exploration and production strategies, geopolitics, expected long term outcomes and management ability etc, etc. However, comparing the fundamentals of these two stocks – whose production rates were not a million miles apart last year (78,200 boepd for Tullow and 61,500 barrels for Dragon) – raises some interesting points. 

Using the Stockopedia stock comparison tool, it is clear that all the historic valuation indicators and quality ratios favour Dragon, whereas the forecast valuations are more evenly spread. Meanwhile, the technical and momentum signals, such as strength of the share price against the market, all favour Tullow. One possible reason for this could be the excitement and expectation surrounding Tullow’s remarkable exploration success and its ability to monetise those assets by farming down and delivering production. In turn, Dragon’s comparatively modest exploration efforts are offset by its ability to squeeze increasing production from its assets in the Caspian Sea. 

Indeed, looking at Dragon’s Stock Report, it is immediately clear that this is a hugely profitable company that is throwing off an awful lot of cash. Operating margins last year were an impressive 74.4 percent and cash on the balance sheet stood at $1.8 billion. On its own, that cashflow appears to be more than enough to cover the $1 billion+ capex needed for plans to boost production to 100,000 barrels per year by 2015 and then sustain that level for five years. A broader question is perhaps what the company will do to diversify its operations (a bid for Bowleven was recently retracted but some sort of acquisition could well be on the cards). Unsurprisingly, Dragon’s fundamentals qualify it for six guru trading strategies on Stockopedia, among them the Warren Buffet – Hagstrom quality screen, which puts a major emphasis on long term fundamental strength. You can review how the fundamentals stack up for any oil and gas listed company by using Stockopedia’s screening tools

As for the dividend, Dragon initiated a 14 cents per share payout at the end of 2010 and increased it last year to 20 cents, maintaining that its oil production offered sufficient cashflows needed for capex, dividends and diversification. 

Of course, as much as we love the quant, the numbers may not tell the whole picture. For catalyst/Mamp;A focused investors in the energy space, one fly in the ointment is the fact that the company is majority owned by Emirates National Oil Company (ENOC), which holds a 51.9% stake. It’s also unlikely to be an attractive stock for those that are not at all comfortable with the risks, rewards and potential capital growth of oil and gas. Still, with strong oil prices and rising production swelling its coffers, these numbers do suggest that Dragoncould be worth closer inspection by income investors (and, dare I say it, Dividend Growth Investors) that might have otherwise dismissed it. 

As ever, comments below are welcome. 

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