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Not All Dividends Are Desirable: Seadrill Ltd (SDRL), Energy Transfer Partners LP (ETP)

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Dividend income plays an important part of retirement planning.  Large dividends attract attention from those smart enough not to rely on Social Security for their retirement income.  While I like big yields as much as anyone, I’ve learned the hard way investing in high-yield companies requires due diligence as much as investing in growth or value companies.  Below are three examples of high-yield companies that require some work before investing.

Seadrill Ltd (NYSE:SDRL)Dividend in decline

Consider Exelon Corporation (NYSE:EXC), a utility company currently paying a 6.7% dividend.  Not a bad yield until we discover that the dividend payout ratio is 112%.  Not surprisingly, Exelon announced it was cutting its dividend starting in June. Standard and Poor’s has forecast a decline in earnings for 2013.

While the announced dividend cut is good for the long-term health of the company, it also raises the specter of additional dividend cuts if things go badly for Exelon.  Low power costs in the unregulated wholesale power market, continued historically low natural gas prices and generally weak electricity demand all threaten Exelon’s future earnings.  Those investors relying on Exelon dividend checks risk the most pain from the company’s current woes.

When will it end?  Not soon enough. Exelon CEO Christopher Crane believes natural gas prices will rise and help boost his company’s revenues in 2013.  I think Mr. Crane hopes for higher natural gas prices despite continued production from hydraulic fracturing.  Exelon has already canceled plans for upgrading its nuclear power plants citing low natural gas prices and soft electricity demand.  New safety upgrades stemming from the Fukushima disaster will also pressure earnings.

On the plus side, earnings stemming from the merger with Constellation Energy should boost revenues. Morningstar gives Exelon a wide moat rating, but also forecasts declining earnings through 2014. So much for the benefits of a wide moat. Overall, I would avoid Exelon. The coming dividend cut will result in an effective yield of around 4%. You can do better elsewhere.

And that ‘elsewhere’ is in deep water

For all the news of US shale oil production, deepwater oil exploration and production performed quite well in 2012.  One big reason: more discoveries in more diverse regions of the world. Certainly, the Gulf of Mexico, Brazil and West Africa held their own.

However, in less well-known parts of the world, such as Cyprus and Nova Scotia, oil exploration grows with no end in sight.  This exploration creates an opportunity with deep water drilling contract companies. Rather than invest in say, Petroleo Brasileiro Petrobras SA (ADR) (NYSE:PBR), which is forecasting a tough year ahead, invest in Seadrill Ltd (NYSE:SDRL), which will likely benefit from Petrobas’ plans to drill 40 new deep water wells in the next two years.  In fact, global deep water drilling is forecast to grow over the next few years.  Given the tight market for drilling rigs, contract drillers may see long-term contracts pay as much as$714,000/d.

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