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Facts about the US Debt and Weekend Reading 7/28/2011

Most investors are probably paying rather close attention to these charades in Washington. As the debt ceiling inches closer, Congress still hasn’t come to a deal. I do expect, however, that they will come up with a typical last minute solution. I usually keep politics out of this blog, but inevitably, sometimes politics and investing mix.

It’s important as investors and US citizens to remain calm and look at the facts about this. I’ve seen a ton of incorrect information out there. An overreaction to the debt, especially from Congress (or the voters that elect Congress), would be more economically problematic than the debt itself. For value investors, a depressed Mr. Market may be coming to your door daily to offer you some good bargains.

History of the Contemporary US Debt

Although the US has almost always had debt, our contemporary debt situation began seriously accumulating in 1981, towards the beginning of Ronald Reagan’s term as president. Before that, both Republican and Democrat controlled legislative and executive branches had steadily decreased debt as a percentage of GDP from World War II. But after 1981, starting with Reagan’s significant decrease in the top marginal tax rate and sustained or increased spending, debt as a percentage of GDP began quickly increasing. Both Republican and Democrat controlled executive and legislative branches led to an accumulation of debt over these last 30 years, beginning with Reagan’s first term. An exception is that at the end of Democrat Bill Clinton’s term as president when Congress was controlled by Republicans, the US had a budget surplus and had managed to decrease debt as a percentage of GDP. More recently, the debt is due to tax cuts, two wars, and an unfunded portion of Medicare under President Bush, and recession-reduced tax revenues and stimulus spending under President Obama. US leaders and voters need to understand that if you cut taxes, you need to proportionally cut spending, or if you increase spending, you need to proportionately increase taxes, at least over the long term. Short term variances are ok, but we can’t have it all.
National Debt by Presidential Terms, and Congress Majority- Wikipedia

Facts about the Current US Debt

-The US currently has about $14.3 trillion in debt. A significant percentage of this is owned by the government itself (such as the Social Security fund), another significant percentage of this is owned by US citizens and companies, and increasingly, a percentage of this is owned internationally.
Federal Debt Basics- US Government Accountability Office

-The US has the most debt out of any country. But when it comes to debt as a percentage of GDP, which is a much more important metric, the US is far from the highest. Many other developed countries have higher debt as a percentage of GDP than the US, but still, ours is higher than it should be.
List of Countries by Debt- CIA World Factbook

-The US is nowhere close to financially defaulting. We would only default if lawmakers decided to default. It would be like being completely in a position to pay your bills, but deciding to pay them late and incur the penalties.

-Overall, America has more than $50 trillion in private household net worth, and $14.3 trillion in public debt, so the public debt to private equity ratio is below 30%. If we exclude debt owned by the government, US corporations, and US citizens, that number drops further. If this were a business, it would be a good figure. The problem is, the US government doesn’t really have that equity unless it taxes for it. The interest coverage ratio (federal income divided by interest expense) can be estimated to be between 10 and 20, depending on what time period I use. Currently, interest rates are low, but as they rise, the interest coverage ratio will shrink. Overall, an interest coverage ratio of above 10 would be very solid for a company. But we want interest as close to zero as possible for the federal government, because any positive interest means that a portion of our taxes, perhaps 5-10%, go to interest payments, which is deeply unsatisfying. Essentially, the US has a reasonable balance sheet as long as problems are fixed fairly quickly. If the trillion dollar deficits or even “only” multi-hundred-billion dollar deficits continue, a larger and larger chunk of our spending will be on interest until the situation becomes unsustainable.
US Household Net Worth-Reuters
US Revenue and Expenditure- Wikipedia

-The US Debt situation is fundamentally different than the European Debt situation. The US currently has a perfect AAA credit rating because a) the balance sheet is worsening but still fair, b) it can print its own money, c) it can raise taxes as lawmakers see fit. This is why US debt is basically a proxy for “risk free”. In a worst case scenario, the US can slowly inflate its way out of the current debt (but would still have to fix its deficit, which is largely indexed to inflation), which would of course have disadvantages. To avoid bad inflation or hyperinflation, there needs to be confidence in the integrity of the currency, so it’s better to balance the budget and let slow GDP growth shrink debt as a percentage of GDP, which would naturally include moderate inflation. Many European countries, on the other hand, have joined their currencies in to the common Euro. This means that if any country grows its debt too high, it doesn’t have full control of the situation, and needs other European countries for help. Both areas have their balance sheet issues, but they are fundamentally different.

What Will Happen if the Debt Ceiling is Reached with No Solution?

-Nobody can really be sure, because this is unprecedented and rather silly. The August 2nd date may not be the exact date the problem occurs. In reality, the US reached its debt ceiling a few months ago, but has been able to juggle its books to make a bit of room. This room is expected to run out sometime in early to mid August, and the conservative figure is August 2. The US is still bringing in revenue, but not enough to cover its obligations, so some things will go unpaid, whether it’s treasuries, social security, nonessential government options (government shutdown), armed forces, etc, until the debt ceiling is increased.

-If the US credit rating is downgraded, either because it defaults, or because it cuts services to pay the debt, or because it doesn’t extend the debt ceiling far enough, or because the budget remains grossly imbalanced, it will mean the US will have to pay a higher interest rate on its debt. This essentially means higher taxes or lower spending for citizens. Various private interest rates could increase as well. In addition, this would sadly mean that the bonds of four non-financial US corporations that currently are rated “AAA” (Johnson and Johnson, Microsoft, Exxon Mobil, and Automatic Data Processing), would be considered “less risky” than US treasuries. (Disclosure, I own JNJ and XOM stock.)

-Individuals, governments, or companies that rely on the integrity of US treasuries could be greatly affected. This is perhaps the most problematic, and least understood, area of this situation.

-There are already problems. The Federal Aviation Administration has already partially shut down without notice for nearly a week now. Congress wouldn’t agree on tiny details of the FAA reauthorization (they concern unions and a few subsidies to small airports; partisan issues), so all research, development, and construction of the FAA is currently shut down without notice. The House of Representatives slipped in some new things into the bill, which includes a union-weakening measure and an elimination of subsidies, and the Senate rejected it. 4000 federal engineers, scientists, programmers, and managers are out of work with no pay and with virtually no warning. In addition, thousands of private contractors that provide engineering services and work along with those federal employees, or that provide construction services on airports around the country, are immediately halted. There are over $2 billion of contracts affected, and there are literally empty construction sites on airports right now, and empty offices with expensive equipment sitting there. This wasn’t specifically due to the debt ceiling (instead it was due to irresponsible partisan politics), but it’s a smaller taste of what can happen. 4,000 federal workers and 70,000 contractors/construction workers are affected.
The Airport Jobs We Desperately Need: Congress’ Failure has Consequences
We Need an FAA Bill Exension
4,000 feds and 70,000 construction workers

How Do We Fix the US Debt Situation?

I’m certainly no wiz, and there are many potential paths to take, but there are some things worth considering.

-The debt problem cannot be fixed simply by refusing to increase the debt ceiling. Without raising the debt ceiling, the US would literally have to balance its budget over a matter of days or weeks, which would mean increasing taxes or decreasing spending by over a trillion dollars per year. The current debt represents our previous promises, not our future ones. Spending would have to align with the volatility of US revenue. This would mean either enormous and abrupt tax increases, or enormous and abrupt cuts to social security, medicare, defense, and various domestic spending.

-The debt problem, however, can be fixed over time. If the budget is balanced over the next few years, then debt as a percentage of GDP will decrease as the GDP increases. The largest spending areas right now are Social Security, Defense, Welfare, and Medicare and Medicaid.

-Social Security currently has a trust fund of over $2 trillion due to surpluses, at least on paper. Receipts have exceeded expenditure. The problem, however, is that when social security was started, the date of retirement was approximately the same as the average life expectancy. The number of people paying into the system was much larger than the number of people withdrawing. As people live longer (into their 80s rather than 60s), and as a large generation retires, the ratio of payers to withdraws will continue to decrease. To keep social security sustainable, there are numerous options. People can pay more into it, the income cap can be increased, cost of living increases can be reduced, and/or the retirement age can be increased. The other problem is that other areas of the government have “borrowed” from social security to pay for other unfunded things, so although social security is not entirely broken, it is rather broke.

-Welfare has spiked recently with the recession. It used to be in the ~$300 billion range but now it is in the ~$500 billion range. This can decrease if the economy improves. It can also be decreased by making it harder to receive benefits to try to keep out people who don’t really need them.

-The US spends around $700 billion per year on the armed forces. This is a huge chunk of our total spending, and a huge chunk of the total worldwide defense spending. The US has less than 5% of the world population, but spends somewhere around 40% of the total world’s annual military expenditure. In addition, defense spending as a percentage of GPD is larger than almost all large and developed countries.
Military Spending by Country- Global Security

-Corporate tax accounts for a fairly small percentage of US revenue, while individual taxes are a major component. We have a trade deficit, meaning we import more products than we export. This trade deficit mainly became a problem during President Clinton’s term (the timeline is rather correlated to the signing of the North American Free Trade Agreement), and continued under President Bush and President Obama. Corporations have benefited, because they can get cheaper labor and fewer restrictions on environmental damage elsewhere. But, if inflation-adjusted labor rates decrease domestically, that increases the divide between socio-economic classes and reduces the tax base. Government regulation and/or consumer decisions to spend more consciously, can potentially help address this issue.

-Medicare and Medicaid currently are causing part of the deficit. It’s the same fundamental problem as social security- an aging population. Worse yet, the life expectancy is lower than many other highly developed countries, and the infant morality rate is higher than many other highly developed countries, and yet we pay more per capita, and as a percentage of GDP on healthcare, than most all other countries. There is a ton of improvement potential here.
Health Care Spending by Country
Infant Morality Rate- CIA World Factbook
Life Expectancy- CIA World Factbook

-The US has maintained rather consistent taxation as a percentage of its GDP over contemporary history, but has significantly lower taxation than other developed countries. Taxation has become less progressive, as the top marginal rate has significantly decreased, and dividend and partnership taxation has decreased. This how someone like Warren Buffett can pay a lower tax percentage than his secretary. Nonetheless, the upper middle and upper classes have most of the tax burden, mainly because they have most of the wealth. When discussing taxation, it’s important to compare the situation to the past, and to compare it internationally, to see what’s working and what is not. The United States currently attempts to provide services to its citizens that roughly correspond to the low end of other developed countries (social security, medicare, disability, high standards for medicine and food, but no universal health care, and rather low subsidy for higher education), yet taxes at levels that correspond to the upper end of developing countries. There needs to be a decision- either tax and provide the services of a developed nation, or tax and provide services at the high end of a developing nation. We can’t provide the services of one, and pay for it with the taxes of another.
15 Charts about Wealth and Inequality in America- Business Insider
Worldwide Tax as Percentage of GDP- World Bank
Tax Revenues Fall in OECD Countries

-Discretionary domestic spending is actually a fairly small part of the US budget, and so is foreign aid. These areas can be looked at and streamlined.

Summary

There are a variety of ways to fix the deficit, and it will require compromise, moderation, and reason. As previously mentioned, if the budget can be balanced, then debt as a percentage of GDP will decrease over time. I do not think the government will default, and in the off chance that it does, it would be due to leadership failure rather than due to necessity.

As for dealing with the current situation, the same answer pretty much always applies. Make sure you are diversified in terms of number of companies, number of sectors, and asset class (stocks, bonds, etc). Look for opportunities to buy on weakness; companies that may lose value if the markets react poorly to US silliness, but that you believe are good long term investments. Remain focus and fact-driven, and allow any potential market irrationality to help you rather than hurt you over the long term. Portfolio values may temporarily fall, but remember, for net buyers of stock, markets with low value are better than overvalued markets. As always, buy quality companies at reasonable prices.

There are some mixed signals on the economy. One one hand, jobless claims were reduced. But, if the research, development, management, and construction of the FAA federal employees and contractors remains shut down, and if other government agencies have to shut down, this will undo itself. In addition, Emerson Electric warned about a slowing economy in the US and Europe. Being a cyclical business, Emerson tends to have a pretty strong understanding of economic conditions. Emerson reported that orders are still growing, but that they “moderated”, and the stock price fell 7%. (Disclosure, long EMR). Housing is still not showing strong signs of improvement.

I’m interested in reader opinions- what do you think of the deficit, the debt, the current debt ceiling debate, the partial FAA shut down, the investing opportunities, and the current state of the world economy?

Other Weekend Reading

Dividend Stocks 101: The Essential Guide
If you’re new to the site, check out this key resource.

Carnival of Personal Finance 319
I was included in a blog carnival this week.

Master Limited Partnerships: The Perfect Dividend Stocks
The Dividend Growth Investor presents some dividend ideas.

Ensure your Dividends with Insurance Stocks
Dividend Mantra presents some insurance companies.

Should you Fear US Treasury Bonds?
Andrew Hallam presents some facts about America’s situation, from a non-American perspective.

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6 Dividend Stocks with High Profit Margins

I recently published an article on Seeking Alpha that highlights six companies that have particularly high profit margins. Different industries have different typical levels of profit, so I took into account absolute profit margins, relative profit margins, and returns on equity. When a company has margins that are higher than their competitors for an extended period of time, it provides evidence that either management is highly skilled, or the company has a firm economic advantage.

6 Dividend Stocks With High Profit Margins

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Emerson Electric Company (EMR) Dividend Stock Analysis

Summary

Emerson Electric Company (EMR) is a broad industrial technology company that sells necessary products around the world.

-Revenue growth over the past five years: 2%
-Income growth over the past five years: 5%
-Cash flow growth over the past five years: 8%
-Dividend Yield: 2.50%
-Balance Sheet: Fairly Strong

Shares look reasonably valued at the current price in my opinion. The stock carries a high valuation, but this is due to expectations of continued and significant rebounding and growth in earnings through 2012. Overall, I find the price to be reasonable, but without any margin of safety.

Overview

Emerson Electric Company (NYSE: EMR) is a Fortune 500 industrial technology company based in Missouri. The company was founded over 120 years ago and provides a very large array of technology products and services. The company draws 43% of its revenue from the United States, 21% from Europe, 23% from Asia, and 13% from other places of the world. With over 125,000 employees, Emerson uses its technology to help the world run.

Business Segments

The company currently consists of five business segments:

Process Management
Emerson’s largest business segment, Process Management, accounts for 28% of revenue. The Process Management segment provides control systems, monitoring systems, asset optimization, components, and services. Only about one third of the revenue from this particular segment comes from the United States, with the rest being spread out rather equally from Europe, Asia, and the rest of the world.

Network Power
Emerson’s Network Power segment accounts for 27% of revenue. In this segment, Emerson provides power products and solutions for data centers and telecommunications networks. This includes AC power systems, DC power systems, cooling systems, embedded computing and power, and service (including 24-hour service). Only about 40% of the revenue from this particular segment comes from the United States, with Asia accounting for another 34% of this revenue.

Industrial Automation
Emerson’s Industrial Automation segment accounts for 20% of revenue. They provide a variety of automation products for companies, including industrial equipment, power systems, motors and drives, mechanical power transmission, and fluid automation. Revenue from this particular segment comes strongly from Europe and the United States, though Asia and other areas provide revenue as well.

Climate Technologies
Emerson’s Climate Technologies segment accounts for 17% of revenue. Emerson provides compressors, temperature controls and electronics, and sensors, as well as a variety of other products and services, to provide homeowners and businesses with the tools needed for heating, air conditioning, refrigeration, and overall climate control. Slightly over half of the revenue from this particular segment comes from the United States, while the rest is spread out fairly equally around several other parts of the world.

Appliances and Tools
Emerson’s Appliances and Tools segment accounts for 8% of revenue. They produce a variety of products in this segment, ranging from commercial motors to ceiling fans. Over 80% of the revenue from this particular segment comes from within the United States.

Revenue, Earnings, Cash Flow, and Margins

Emerson was hit hard by the recession, as they sell many of their products and services to businesses that encountered severe financial troubles. The company, however, has decades of consistent growth, through peaks and recessions. They maintained profitability throughout the low point in the economy, and increased investment during the most difficult periods.

Revenue Growth

Year Revenue
TTM $22.647 billion
2010 $21.039 billion
2009 $20.915 billion
2008 $24.807 billion
2007 $22.572 billion
2006 $20.133 billion

Using the trailing twelve month period as a proxy for 2011 results, Emerson has an average annual revenue growth of between 2% and 3% over the last five years.

Income Growth

Year Income
TTM $2.370 billion
2010 $2.164 billion
2009 $1.724 billion
2008 $2.412 billion
2007 $2.136 billion
2006 $1.845 billion

Emerson has had an average of 5% annual income growth over this five year period. EPS growth was over 6%, taking into account share repurchases.

Operating Cash Flow Growth

Year Cash Flow
TTM $3.048 billion
2010 $3.292 billion
2009 $3.086 billion
2008 $3.293 billion
2007 $3.016 billion
2006 $2.512 billion

Emerson has grown cash flow by about 4% on average per year over the past five years, but most of this was due to 2007′s growth.

Metrics

Price to Earnings: 19
Price to Cash Flow: 14
Price to Book Value: 3.9
Return on Equity: 22%

Dividends

Emerson has increased their dividend for 54 consecutive years, which is absolutely remarkable. For over half of a century, there has not been one year where Emerson did not raise their dividend for shareholders. There have, however, been periods of economic or company difficulty that resulted in reduced dividend growth, and the company is currently in one of those periods. Becoming a 50 year consecutive dividend increaser is difficult enough; becoming one in a fairly cyclical industry is more so.

Dividend Growth

Year Dividend Yield
2011 >$1.38 2.50%
2010 $1.35 2.70%
2009 $1.325 3.30%
2008 $1.23 2.50%
2007 $1.0875 2.30%
2006 $0.93 2.30%

The figured displayed for the 2011 total dividend multiples the current quarterly dividend by four, but in reality, the fourth dividend of the year will likely be a bit higher. Over these past five years, Emerson has raised its dividend by over 8% per year on average. Between 2009 and 2010, however, Emerson decided to only raise its dividend by a tiny 1.5%; a token increase to preserve its unbroken chain of dividend increases. Then, the quarterly raise in 2010 was only 3%, and it is yet to be seen what the next quarterly increase will be, announced later this year.

EMR’s dividend payout ratio is currently about 45%, and their dividend yield is about 2.50%. So the payout is moderate in size and quite safe. The payout ratio is reduced compared to the last two years, since EPS has rebounded while dividend growth has been kept to a minimum. This shows the opportunity for Emerson to make more meaningful dividend increases in the future.

Share Repurchases

Over the past five years, Emerson has repurchased approximately $3.6 billion worth of its own shares. The company significantly slowed down its repurchases in 2010 to use capital for acquisitions, which I think is a better choice.

Balance Sheet

Emerson Electric has a LT Debt to Equity ratio of 40% and a Total Debt to Equity ratio of 48%. Goodwill, however, consists of over 80% of shareholder equity, due to Emerson’s acquisitions. The interest coverage ratio is 13, which is quite solid. Overall, Emerson’s balance sheet is very robust.

Investment Thesis

Emerson produces technology and services that keep the world running. Process Management control systems allow manufacturers to do what they do, and Network Power allows data centers and telecommunications networks to do what they do. The segments of this large business provide the necessary tools to keep the developed world operating as it does, and help the developing world continue to improve the standard of living. Fundamental backbone infrastructure requires companies like Emerson to exist and grow. As the world continues to develop and modernize, Emerson has an ocean of opportunities to grow as long as it can continue to compete.

Emerson is an engineering company that doesn’t require a huge amount of technical expertise to invest in. The products are straightforward, easily understood in principle, not flashy, and they have long product life times. They sit in the back room and keep the business running. Emerson also has a role to play in clean energy, providing products and services to control and optimize various forms of energy production.

Even in the deepest part of the recession, although EMR was very much affected, the cyclical company continued to produce a profit. Their stable financial condition, necessary products, and geographical spread around the world allowed them to weather the storm. In fact, Emerson spent $2 billion for acquisitions during 2010, which is up significantly from previous years. Specifically, the largest acquisitions were Avocent, which provides a host of technologies for data centers, and Chloride, which provides uninterruptible power supplies.

It’s not too hard to argue that being a leading player in the data center industry is going to be a good long term growth area for Emerson. In addition to continued growth in emerging markets, data centers play a key role in the shift of computing hardware from the client side to the server side. Various online media sources and business tools all need to run in data centers, and data centers need to be supported by multiple redundant systems and continually improved cooling technology. Emerson provides a broad set of products and services that support data centers, and recent acquisitions should strengthen its already strong position.

Combine these necessary products and services with a company culture that has produced over a half-century of consecutive dividend increases, and I expect Emerson to continue to do well for years to come. Their balance sheet and cash flow are fairly strong, and the company exists within growing industries and operates around the world.

Risks

Like any company, Emerson has risks. Notably, Emerson took a rather large financial hit in this recession. EMR is reliant upon the health of businesses around the world to continue to operate, and has a variety of competitors from around the globe. It is well positioned within appealing industries, and to preserve its status and maintain its margins, it’s going to have to compete against other businesses that want a share in the growth. There is integration risk for acquisitions, risk of acquisitions not providing enough synergy to justify their costs, and currency risks.

Conclusion and Valuation

Emerson stock is not cheap right now with a P/E of about 19. Still, I think in the long term, EMR is going to prosper as a company. Using the analyst forecasts for the EPS growth between 2010 and 2011, and 2011 and 2012, the PEG ratio is around 1. I expect that after this rather long rebound from the market bottom to a couple years out, the valuation will come down a bit as the EPS grows to fill in the stock price. I personally think the current $55 represents a reasonable entry price for this stock at this time with the intention of long term holding, but admittedly does not offer a comfortable margin of safety. It may be worthwhile to wait for any potential dips.

Full Disclosure: I own shares of EMR at the time of this writing.
You can see my full list of individual holdings here.

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