Economy Will Test Russel's Dividend Mettle

05/18/2012 12:00 pm EST

Focus: DIVIDEND

John Heinzl

Reporter and Columnist, GlobeInvestor.com

Steel industry has its ups and downs according to the economy, but company learned its lesson during the last slump, writes John Heinzl, reporter and columnist for Globe Investor.

High-yielding Russel Metals (Toronto: RUS) has gone on a dividend-raising binge before, only to cut its payment when times got tough.

Will this time be any different?

Buoyed by the recovering economy and solid demand for steel, particularly from the oil patch, the Mississauga-based metals processor and distributor has raised its dividend three times in the past 15 months. That includes a 17% increase announced on May 3, the same day Russel posted first-quarter results that topped expectations.

The stock, which closed Tuesday at $26.05, now yields an enticing 5.4% based on the new dividend rate of 35 cents a quarter—or $1.40 annually.

A Rocky History
When a yield gets that high, investors need to start asking about the sustainability of the dividend. That's especially true with a cyclical company like Russel, which chopped its dividend before when the global economy went into the tank.

After a string of increases during the good times, the company slashed its payment by 44% in 2009, dropping it to 25 cents a quarter from 45 cents. The share price also took a massive hit.

"We felt strongly about our dividend, but unfortunately we did have to cut it...and that was partly because our banking had to be redone, because there were certain covenants we knew we weren't going to meet," said Marion Britton, Russel's chief financial officer.

"In the end, could I have got it done without cutting my dividend? Probably. But it was the right thing to do...we cut management salaries by 10%, we cut the dividend. Everybody took a haircut because it was a serious event."

The 2008-2009 downturn was serious indeed for Russel. The company suffered a 40% drop in shipments and took a huge inventory write-off, Britton said. Normally, demand doesn't rise or fall more than about 5%, unless something unusual happens such as the loss of a major customer, she said.

More Cautious This Time
The dividend is still well below its pre-recession levels, and for now, there are no plans to increase it again. The company aims for a payout ratio of about 80% of average after-tax earnings over a cycle lasting four to five years. Based on 2012 earnings estimates, the current payout is about 71%.

"They are the type of firm that now, more than ever, are very cautious about the way they manage the business," said Raymond James analyst Frederic Bastien, who has an "outperform" rating and $29 target price on the stock.

The economy would have to suffer another shock like the 2008-2009 downturn before Russel would contemplate another cut, he said. But the company should have no trouble maintaining the dividend through the normal ups and downs of the business cycle, he said.

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Silver Lining
The 2008 slump actually had a silver lining for Russel, Bastien added.

To limit their inventory risk, more customers started purchasing steel in smaller quantities from Russel's metal service centers, instead of buying in bulk directly from steel mills. Metal service centers carry products in a wide range of sizes and shapes tailored to the customer's specific needs.

During the last downturn, "a lot of end users were stuck with very high-priced inventory of steel," he said. As a result, they are now more cautious and have adopted just-in-time inventory strategies.

The Risks
That said, steel is still a cyclical business tied to the ups and downs of industries such as equipment manufacturing, construction, shipbuilding, and energy.

Given the risks, some analysts are more cautious about the stock. Scotia Capital analyst Anthony Zicha has a "sector perform" and "high risk" rating, citing economic uncertainty, lower energy prices, and expectations of higher steel supplies in 2012, both from North American mills and imports.

The Verdict
Barring a severe recession, Russel's dividend is probably safe. The company is a mature business with low capital requirements, so it's able to throw off lots of cash and pay out a hefty chunk to shareholders.

"We're relatively comfortable" with the dividend, Britton said. There are no guarantees, but "we're increasing it to a level we feel is sustainable over the cycle."

The share price, however, could provide more excitement than some investors want. In the past year, it has swung between $18.90 and $27.95, making it about 37% more volatile than the S&P/TSX composite index.

If the economy takes a dive, expect the shares to follow, but Russel's rich dividend will at least blunt some of the pain.

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