Monday, August 26, 2013

Stocks With a Sustainable Dividend

To succeed as a dividend growth investor you must identify and purchase stocks with sustainable dividend growth. Put another way, targeted companies must be both capable and willing to grow their dividends. Obviously, we can not look into the future and see who will and will not perform. However, there are critical bits of information that we can evaluate today that often foreshadow the company's future behavior. Here are some of the more relevant ones:

Years Of Consecutive Dividend Increases

Inertia is powerful force. Once a company has established a track record of growing its dividend over the decades and developed a shareholder base that expects higher dividends each year, it becomes increasing difficult for management to cut or fail to raise their dividend. No CEO of this type of company wants a dividend cut to occur on his or her watch. There are precious few Dividend Aristocrats remaining and those left enjoy their elite status.

Strong Financial Condition

Dividends are paid with cash, not earnings. The distinction is subtle, but very real. In its pursuit of theoretical perfection, the accounting profession has adulterated the financial statements to the point that it has become very difficult for non-accountants to interpret them.

For example, 2009 was a tough year for Nucor (NUE). Its consolidated statement of earnings showed a loss of $237 million, down from 2008's earnings of $1.8 billion. This decrease in earnings of $2 billion looks devastating until you look at the consolidated statements of cash flows and realize NUE's management ran the business to maximize cash generation. The $2 billion decrease in earnings only equated to $688 million dollar decrease in free cash flow and while earnings were negative, free cash flow remained positive at $792 million, more than enough to cover the $443 million dividend payments.

Consider another example. In 2009 Eli Lilly's (LLY) net earnings improved $6.4 billion, but its free cash flow decreased $2.8 billion. This oddity was primarily the result of how in-process research and development was accounted for. Here is an excerpt from their 2009 10-k describing the accounting:
Most of these acquisitions included IPR&D, which represented compounds, new indications, or line extensions under development that had not yet achieved regulatory approval for marketing. There are several methods that can be used to determine the estimated fair value of the IPR&D acquired in a business combination. We utilized the “income method”, which applies a probability weighting to the estimated future net cash flows that are derived from projected sales revenues and estimated costs. These projections are based on factors such as relevant market size, patent protection, historical pricing of similar products, and expected industry trends. The estimated future net cash flows are then discounted to the present value using an appropriate discount rate. This analysis is performed for each project independently. Pursuant to the existing rules, these acquired IPR&D intangible assets totaling $4.71 billion and $340.5 million in 2008 and 2007, respectively, were expensed immediately subsequent to the acquisition because the products had no alternative future use. The ongoing expenses with respect to each of these products in development are not material to our total research and development expense currently and are not expected to be material to our total research and development expense on an annual basis in the future.
In effect LLY realized a $4.7 billion dollar non-cash charge in 2008, which was an add-back to operating cash flow. There was no similar charge in 2009, thus the substantial increase in earnings.

When evaluating a company's financials you must also consider competing uses for the free cash flow generated. Many companies generate significant free cash flow, but often that cash is already spoken for in the form of debt obligations. One of the key metrics I look for when evaluating a company is a debt to total capital ratio of 45% or less.

Stocks With a Sustainable Dividend

Using my D4L-Data spreadsheet to screen the 230+ stocks that I follow, I limited my search to stocks with the following characteristics:

- Years of consecutive dividend increases > 20 years
- Yield > 2.5%
- Debt to total capital < 45%
- Free Cash Flow Payout < 60%

Below are several stocks that meet the above criteria:

Wal-Mart Stores, Inc. (WMT) is the largest retailer in the world, Wal-Mart operates a chain of over 10,000 discount department stores, wholesale clubs, supermarkets and supercenters. The company has paid a cash dividend to shareholders every year since 1973 and has increased its dividend payments for 39 consecutive years.
Yield: 2.5% | FCF Payout: 44.83% | Debt/Tot. Capital: 53.96%

General Dynamics (GD) is the world's fourth largest military contractor and also one of the world's biggest makers of corporate jets. The company has paid a cash dividend to shareholders every year since 1979 and has increased its dividend payments for 22 consecutive years.GD is in better position than some of the other defense contractors to manage a reduction in defense spending.
Yield: 2.7% | FCF Payout: 25.23% | Debt/Tot. Capital: 33.16%

Emerson Electric Co. (EMR) designs and supplies product technology, and delivers engineering services and solutions to a wide range of industrial, commercial and consumer markets around the world. The company has paid a cash dividend to shareholders every year since 1947 and has increased its dividend payments for 57 consecutive years.
Yield: 2.7% | FCF Payout: 34.49% | Debt/Tot. Capital: 58.69%

Genuine Parts Co. (GPC) is a leading wholesale distributor of automotive replacement parts, industrial parts and supplies, and office products. The company has paid a cash dividend to shareholders every year since 1948 and has increased its dividend payments for 57 consecutive years. The company has paid a cash dividend to shareholders every year since 1948 and has increased its dividend payments for 57 consecutive years.
Yield: 2.8% | FCF Payout: 22.92% | Debt/Tot. Capital: 39.41%

Sonoco Products Co. (SON) makes of paper and plastic packaging products serves various industries and markets in more than 85 countries. The company has paid a cash dividend to shareholders every year since 1925 and has increased its dividend payments for 30 consecutive years.
Yield: 3.3% | FCF Payout: 42.09% | Debt/Tot. Capital: 43.09%

Meredith Corp. (MDP) publishes a suite of magazines and websites focused on food, parents and women (Better Homes and Gardens) and operates 12 local TV stations. The company has paid a cash dividend to shareholders every year since 1930 and has increased its dividend payments for 20 consecutive years.
Yield: 3.6% | FCF Payout: 30.33% | Debt/Tot. Capital: 43.64%

Bonus: Look For A Favorable Industry

Some industries are more stable than others. When the economy turns down and we are concerned about our job, we may discontinue our pest control or lawn service, but we will likely not stop taking our blood pressure medicine. Non-cyclical industries typically include pharmaceuticals, utilities, defense and certain consumer goods. A company's ability to grow its dividend is directly related to its ability to grow free cash flow.

Full Disclosure: WMT, GD, EMR, GPC, MDP. See a list of all my dividend growth holdings here.

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