Despite being home to small- and medium-cap companies, the FTSE 250‘ s filled with high-yield opportunities. And among the highest lies NextEnergy Solar Fund (LSE:NESF). After all, the renewable energy enterprise is currently offering a staggering 10.2% dividend yield to shareholders!
In a lot of cases, seeing a double-digit yield is a clear signal to stay away. After all, these are rarely sustainable and often created by a tumbling stock price rather than dividend hikes. So is NextEnergy an income trap to avoid? Or is it one of the few exceptions where investors can reap enormous long-term income? Let’s explore.
Testing for sustainability
One of the most critical metrics for judging the quality of dividends is free cash flow. Businesses need to be capable of generating sufficient excess cash from operations. This provides the capacity needed to not only pay dividends but maintain them with ample coverage.
So where does NextEnergy Solar stand when it comes to dividend cover? Looking at the latest results, this metric stands at 1.3 times for the 12 months leading to March. As a quick reminder, any number greater than 1.0 is what we want to see, and the bigger, the better.
What’s more, management expects dividend cover to remain healthy for the foreseeable future. So much so, it hiked dividends by 11% to 8.35p per share on the back of its full-year results published last month. But if dividends are so healthy, why are investors not capitalising on this income opportunity?
Every investment carries risk
Building and maintaining renewable energy infrastructure isn’t exactly cheap. Subsequently, the company’s racked up a considerable pile of debt over the years. Today, 29.3% of the group’s capital structure is debt. That’s hardly an exorbitant amount, but NextEnergy’s gearing has been rising over the years.
In the past, this wasn’t too much of a concern. However, now that interest rates sit above 5%, the group’s loans are becoming increasingly expensive to service, with the average cost of debt reaching 4.5%, from 3.9% a year prior. As a side effect, the group’s solar asset valuations have also been tumbling.
So if the firm’s forced to start selling off assets to pay off liabilities, shareholder value may end up getting destroyed rather than created.
A buying opportunity?
The risk surrounding this business cannot be ignored. After all, NextEnergy has no control when it comes to monetary policy, yet its income stream’s highly sensitive to it.
However, with the Bank of England expected to cut interest rates later this year, these adverse pressures may start to weaken. And since demand for electricity isn’t going anywhere, that grants far more flexibility to expand its solar portfolio driving up cash flow and, in turn, dividends.
At least, that’s what I think. And it seems management agrees, given it’s been busy buying back shares to capitalise on its weak valuation. Therefore, I think it’s possible a buying opportunity may have emerged, and it’s a company I’m digging deeper into this month.
This post was originally published on Motley Fool
