The days of a 30% yield may be over, but I’d still buy this FTSE 250 share for dividend income!

This FTSE 250 stock has proven that high-yielding shares must be viewed with caution. But even after slashing its dividend by 67%, I still want to invest.

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Until 19 March, Diversified Energy Company (LSE:DEC), the US gas producer, was the highest yielding share on the FTSE 250.

And it’s easy to see why. Since March 2023, Diversified Energy’s stock price has fallen 52%. But during this period it maintained its dividend at a generous $3.50 (£2.75) per share. This helped lift its yield to over 30%.

But on 19 March, along with the release of its 2023 results, the company announced an immediate 67% reduction in its quarterly payment, to $0.29 per share.

The cash that it saves from reducing its payout will be used to reduce its borrowings and fund acquisitions.

However, the directors claim that even with a revised yield of 10%, the company remains within the top quartile of FTSE 350 stocks.

Different properties

My interpretation is that the company isn’t reducing its dividend because it’s running out of cash. Instead, it wants to use its surplus funds in a different way, in an attempt to arrest the fall in its share price.

The company’s business model involves acquiring existing gas wells rather than drilling new ones. It then seeks to extend their productive lives before capping them forever.

But the problem with this strategy is that it needs to buy more fields to grow its earnings, increasing its debt further. And investors tend to shy away from highly geared businesses.

At 31 December 2023, net debt was $1.284bn, equivalent to 2.3 times its adjusted EBITDA (earnings before interest, tax, depreciation, and amortisation). I think this is on the high side, although currently manageable. The company has a target of keeping this below 2.5.

To reassure investors, the company has prepared a detailed financial model. This ‘proves’ that it will generate enough cash to retire all its wells — at current values plus inflation — and repay all its debt.

And according to its latest report on its well closure programme, it will be debt-free within 10 years. This is a significantly shorter period that the average life of its wells, which is estimated to be 50 years. This all sounds very positive to me. And not typical of a company that’s decided to slash its dividend by two-thirds.

Opportunities

The company believes there’s currently an over-supply of gas in the US. This is likely to put downwards pressure on prices. But with a low cost base and a high proportion of its output hedged, it claims it can cope with a downturn.

It also predicts that the anticipated slump will create opportunities to buy more businesses with “extreme valuation disconnects”. I think that’s American for ‘bargains’!

The company had a solid 2023. Its preferred measure of profitability — adjusted EBITDA — increased by 8% to $543m, compared to $503m, in 2022.

But on 19 March, there was no mention of the letter it received in December 2023 from four members of a House of Representatives committee. The correspondence raised concerns about its accounting for the costs associated with the closure of its wells.

And even though the company claims its business model is better for the environment, it’s out of bounds for most ethical investors.

But despite the risks — and even though its dividend cut is disappointing — I’d still buy the stock if I had some spare cash.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

James Beard has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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