First Newsletter

Hello, Matt here. And with a fresh dividend newsletter issue for June.

It’s been a while since I’ve written on Dividend Monk. And as I’m sure people that have been reading the new articles over the last few weeks know, I’ve sold the blog to Mike, who I’m glad to see is running it well. It’s good see that this style of stock analysis will persist beyond me doing the writing.

I want to thank all the readers that emailed me asking where I was, and asking if I was okay, over the last year. That means a lot to me. And for my part, I wasn’t very good at getting back to most people about my status. I know it can be unnerving to see a popular multi-year blog suddenly stop posting.

The fact is, I’ve had a multitude of family issues and personal health issues to deal with, including two deaths in the family, so I stopped posting articles and newsletters for quite a while due to my time and attention being needed elsewhere. I did continue to check email from readers, mainly at least to make sure customers of the Dividend Toolkit were satisfied and had any technical questions answered, as that continued to have strong sales despite my absence. But for most everything else, I was rather absent.

I’m back to normalcy now, but decided to sell the site so that it can be operated with the attention it deserves, and that the readers deserve. And for now, I’ll continue to publish quarterly newsletters, and I’m excited to do so, starting with this one here.

Thanks everyone,

-Matt Alden S., founder of Dividend Monk

May 2015: The Market is Overvalued

The current Shiller P/E of the market is about 27. For those that are not familiar with this measurement, you can see an explanation here and the chart here. It’s one of the most useful measures of the valuation of the S&P 500, and tells us whether the market as is undervalued, overvalued, or fairly valued compared to historical norms.

To put a Shiller P/E of 27 into perspective, it was about 32 in 1929 when Black Tuesday occurred. The highest ever was about 45 at the peak of the Dot Com bubble. Those are the only two times in history when the market had a noticeably higher Shiller P/E than right now. The mid-2000’s, the time before the Great Recession, were about equal to the current value, around 27. All other times in history, it was lower than it is now. Usually significantly lower. We’ve had a six year bull market at this point.

But long term investors are not worried about market corrections. Most of us rather like them, since they are like sales for us, or like a pressure valve being released on lofty valuations. And we don’t try to predict them, as that would be a distraction. What we’re worried about is an overvalued market where it’s challenging to find undervalued stocks, for however long that period lasts. And that’s kind of where we are right now. A sea of mediocre and expensive stock valuations.

Diamonds in the Rough: 5 Attractive Stocks

Fortunately, even in an expensive market, there are usually reasonable values to be found. Just about any financially healthy company will be trading at a sizable valuation these days, so drastically undervalued stocks in the dividend space are all but nonexistent.

But modestly undervalued or fairly valued stocks? Those still do exist, and I’ll describe five companies below that I believe match that description. Some of them offer substantial long-term returns at these price points, in my view. As always, do your own homework and make sure you are comfortable with your investment decisions.

Brookfield Infrastructure Partners (BIP)

BIP is a publicly traded partnership that owns and operates a globally diversified portfolio of infrastructure assets shown in the operations map below and offers investors a 4.8% distribution yield with significant growth. The partnership organizes itself under three main segments: Utilities, Transport, and Energy.

bip_operations

The Utilities segment produces 44% of BIP’s total cash flow and consists of 10,800 kilometers of electricity transmission lines in North and South America, 2.1 million natural gas and electricity distribution connections, and 85 mpta of coal handling capacity in Australia.

The Transport segment produces 48% of BIP’s total cash flow and consists of 9,100 kilometers of rail track in Australia and South America, 3,200 kilometers of toll roads in South America, and 30 shipping ports in North America and Europe.

The Energy segment produces the remaining 8% of BIP’s total cash flow and consists of 14,800 kilometers of natural gas distribution pipelines in the US, 40,000 natural gas customers in the UK, and 370 billion cubic feet of natural gas storage in North America.

BIP management expects to raise the distribution over the long term by 5-9% per year. This figure comes from their expectation to raise prices at or above inflation by 3-4% per year, have natural volume expansion in line with GDP growth of 1-2% per year, and reinvest cash flows for another 2-3% per year in the form of expansion projects and acquisitions. An example of organic growth opportunity is their plan to spend $650 million over three years to increase capacity of ports, rails, and toll roads. Over the last several years BIP has been expanding its various segments when it has been profitable to do so, and has been making new acquisitions when appropriate.

A 2013 report by McKinsey & Company estimated that the global investment in infrastructure needed between 2013 and 2030 will be $57 trillion. BIP has had no problems finding appealing ways to spend capital over the last several years and there should be an immense amount of opportunities for the foreseeable future for them to carve a small piece of that huge pie for themselves, even if there may be some bumps along the way.

I first began recommending BIP units five years ago when they were trading for $18 and the distribution yield was over 6%. Over time, BIP has sailed up to around $45/share and although they have continued to grow distributions, the yield is down to under 5% due to a heftier valuation from an overall more highly valued market. Along this time I’ve been less enthused about their valuation than I was in the cheap days, but overall I still find it’s one of the more attractive investments on the market in terms of risk-adjusted return potential.

Although BIP has a wide moat due to the regulated and asset-heavy investments they own, they face risks from the state of the global economy. Most of their assets are not subject to competition, such as their electricity transmission business that serves 98% of the population of Chile, or their toll roads, or their rails and ports, etc. Instead their risk is mainly related to volume changes based on the economy.

Back in 2010 when BIP units were cheap, investors were worried about how much exposure they had to the troubled Chinese economy due to their large Australian coal export terminals that mainly went to China. And back then there were also worries about their European shipping ports. Like any business, BIP will face headwinds if the economy sinks in the form of reduced volume at some of their locations. But they’ll also likely have opportunities to snatch up cheap assets from financially troubled companies, should that occur.

To help mitigate risk in investor minds, BIP has stable debt levels and prudent management, and most of their cash flow is protected, meaning that 90% is regulated or contracted, 70% is indexed to inflation, and 60% has no volume risk. The partnership pays out just under two-thirds of its FFO as distributions, which gives a lot of room for flexibility in keeping the distribution payouts safe and growing.

Based on $1.97 in distributions paid over the last 12 months, this is the valuation table for Brookfield Infrastructure Partners using the Dividend Discount Model to figure out what prices we’d look to pay for different estimates of distribution growth and different target rates of return:

bip_valuation

Source: Dividend Toolkit Valuation Spreadsheet

If they grow the distribution at an average of 7%/year for the foreseeable future, in line with the middle of management’s growth estimate, then even with a fairly aggressive discount rate (aka target rate of return in our case) of 11%, the valuation is over $50 per unit. A similar valuation can come from using the lower end of their distribution growth estimate (6%) and “only” a 10% target rate of return discount rate. If the growth is as low as 5%, then a target rate of return of 9% still yields a valuation of over $50.

At the current unit price of around $44, BIP’s distribution growth would have to seriously underperform management estimates for the current price to result in poor long-term returns for investors. So, while BIP may not be quite as undervalued as it once was, I do believe it continues to be a decent value in today’s market even if BIP’s performance is in the low end of their estimated range. And if their performance is towards the higher end, then even better.

Chevron Corporation (CVX)

As everyone knows, gas prices have been relatively low lately across the world. This oil price crash has been large enough to wreck Russia’s energy-focused economy. When oil prices fall, it still takes about the same amount of money to get it out of the ground as it did when oil was expensive, and yet they can’t sell it for as much, so the profit margin is narrower. Companies like Chevron and Exxon Mobil take a hit to both revenue and profit.

And that’s when it’s nice to buy them. XOM has fallen from its 52 week high of over $104 to its current price of around $88. CVX has fallen from its 52 week high of around $135 to its current price of around $112. Earnings for both oil giants have dropped as well, but their dividends will keep growing because they keep their payout ratio low for cycles like this. Chevron currently offers an attractive 3.8% dividend yield and XOM’s is a bit lower at 3.1%. In comparison, the Vanguard “High Dividend Yield” ETF offers only about 2.8%. Both XOM and CVX are solid dividend payers; especially Chevron.

A March 2015 investor presentation by Chevron stated that they expect global energy demand to increase by 40% between 2015 and 2035, and that natural gas will have the biggest increase of 45% compared to liquids at 20%. The long-term case for the large energy companies remains strong, especially as they have expanded into gas.

For Chevron specifically, they plan to reduce spending for 2014-2017 as their large liquified natural gas projects are coming online and as they divest certain assets. Spending is still high currently, though. And in spite of this eventual reduced spending, their daily production in 2017 is expected to be 20% higher than it was in 2014 due to these online projects.

chevron_production

The major energy companies face a variety of risks, including the increasing difficulty of acquiring oil and gas reserves at appealing prices. But Chevron currently produces 2.6 million barrels of oil equivalent per day and has proved reserves of over 11 billion barrels of oil equivalent. The company also has a strong balance sheet.

Another long-term risk for companies that deal primarily with fossil fuels is the rise of renewable energy, particularly solar. Unlike most forms of grid energy that use mechanical energy to spin a turbine (and therefore inevitably lose some energy in each step), solar photovoltaic panels turn sunlight directly into electricity. Plus, because solar can be placed closer to the source of use, such as on top of a home that uses the energy it generates, there isn’t as much energy lost in the transmission process over long distances. Solar prices seem to be dipping down to competitive levels for electricity production, and since solar easily fits for both residential and commercial projects, it’s a prime candidate to provide the electricity if (and it’s still a big if) electric cars start to take off years and decades down the line with all the associated infrastructure like charging or battery replacement stations everywhere.

solar-price

EU-PV-LCOE-Projection

Installation costs now constitute a larger and larger portion of total solar costs, although those installation costs are dropping as well as the industry matures.

International usage of abundant energy-dense coal for electricity generation may remain very strong as well, unless regulatory action severely limits it. In many emerging economies, regulation for that might remain light. This only is competition against oil and gas for grid power rather than in vehicles.

The abundance of coal and the increasing competitiveness of solar and other renewables potentially threaten the business model of the major energy companies, but it’s a gradual threat. Even rather optimistic predictions rarely show solar and other renewables being a true threat to fossil fuels in the next couple decades. Major energy companies dealing in oil and gas seem to have a place for the foreseeable future, which can be extended if they adapt to whatever the market happens to be doing at any given time. An example was their switched focus from oil to gas, although other switches would be less clear-cut than this transition was.

Chevron is a dividend champion with 27 straight years of dividend increases. The current yield is over 3.8%.

Based on the valuation table below, Chevron looks fairly valued. Not overvalued but not undervalued either:

chevron_valuation

Source: Dividend Toolkit Valuation Spreadsheet

I currently consider Chevron a decent place to put some long-term money as part of a diversified portfolio. The current market price of about $111 is fair if we expect 6% dividend growth and have a target rate of return of 10%. There’s not much of a margin of safety though, so compared to many other investments its solid but I don’t consider it the top of my list.

Emerson Electric (EMR)

Emerson has increased its dividend for 58 consecutive years at an average long-term rate of 11% per year. This makes it one of the longest-running dividend champions around.

I don’t expect full-on 11% dividend growth going forward, and I’m not going to use that figure for my valuation estimate, but I do think EMR looks like a solid investment right now.

The company is broken into five segments: Process Management, Industrial Automation, Network Power, Climate Technologies, and Appliances/Tools. But Emerson is more than the sum of its parts. Most of Emerson’s customers are businesses, and the company often sells a total system solution where Emerson engineers will apply a range of technologies to solve a customer problem and get paid a premium for this mix of service and product. This is what separates them from more commodity-like competition with little product differentiation.

More than half of company sales come from outside of North America as Emerson has expanded its geographical footprint aggressively.

emerson_operations

About a third of Emerson’s sales come from the energy sector. That’s another reason why I mention this company. It’s being pulled down in the moderate-term by the same forces dragging on Chevron. The company has underperformed the market over the last five years, although this was only the latest hit to their growth.

Most of the free cash flow of the company goes back to investors in the form of dividends and share buybacks. The outstanding share count is falling, dividends per share keep going up, revenue has gone up modestly over the last five years, but earnings have remained flat which has kept the stock price flat. The segments for Network Power and Industrial Automation have not been as successful as they ideally could be, and Emerson’s Process Management segment is facing headwinds from the difficult energy sector, where a lot of the customers are.

Emerson is adjusting by managing their segments like a portfolio, divesting non-core businesses and making acquisitions to strengthen the areas they are already strong in. Companies go through periods of strength and weakness, and while Emerson’s performance hasn’t been great, that’s exactly the reason why current valuation isn’t as lofty as it might otherwise be, and gives long-term investors an opportunity to invest at reasonable prices if they think the company is well-positioned overall.

This is the valuation table:

emerson_valuation

Source: Dividend Toolkit Valuation Spreadsheet

The current price of about $59/share looks pretty good and offers a 3.2% dividend yield. Based on the current valuation we can expect a long term rate of return of around 9 or 10 percent based on a long term dividend growth rate of 6 or 7 percent.

A more conservative way to take a position in Emerson would be to sell a covered put option with the intention of buying if exercised. This would lower the cost basis of the purchase at the cost of limiting your short term upside potential. That’s a good tradeoff for a long-term investor in this high-valued market, in my opinion.

For example, selling a January 2016 put option for $5/share at a strike price of $60 would mean one of two things.

Scenario One is that the share price ends at under $60/share before mid-January 2016, and the option is excised, meaning you buy the shares for exactly $60 each regardless of what the share price is at that time, while also having been paid $5/share, resulting in entering a position in EMR at a cost basis of $55/share.

Scenario Two is that the share price ends over $60, so the option buyer does not exercise the option and it expires without value. This would mean you pocket $5/share and can then sell another option if you want. This would be a 8.3% return over 8.5 months.

Oneok Inc. (OKE)

In my article, What To Look for in a MLP, I listed three types of partnerships that are particularly appealing to buy. The second item on the list is publicly traded general partners, which is what Oneok Inc is. This company Oneok Inc. (OKE) owns the general partner interest (GP) of Oneok Partners LP (OKS) and about a third of the limited partner units (LP), and both OKE and OKS are publicly traded. When given the choice, I usually prefer owning shares or units of the general partner for my portfolio in this sort of arrangement, rather than owning limited partner units, for reasons described in that article I linked to.

To quantify it in this case, here it is:

oneok_distributions

In 2010, Oneok Inc. received $191 million in distributions from the limited partner units they own of OKS. In the same year, 2010, Oneok Inc. received only $120 million from its holding of the general partner of OKS. Fast forward to 2015 estimated numbers, and Oneok Inc. should receive $292 million in distributions from its limited partner units and $402 million from its general partner holding. GP income grew much faster than LP income. The income they get from holding the general partner of a successfully growing partnership compounds like wildfire.

OKS offers a high distribution yield at around 7.5% and a modest distribution growth rate. OKE offers a lower dividend yield of about 5% but higher dividend growth. Analysts at Morningstar predict a 10% dividend growth rate going forward for at least the next few years for OKE.

Oneok Partners, and by extension Oneok Inc., is involved in midstream energy. They gather, process, and transport natural gas. According to a recent investor presentation, they have a $4-$5 billion backlog of growth projects, with 60% of that in the form of natural gas liquids, 15% natural gas gathering and processing, and the remaining 25% in natural gas pipelines.

Because Oneok operates expensive infrastructure across multiple states in central USA between Texas and North Dakota, it is well-protected from competitors. They face risks from shifts in energy usage and can face headwinds from what the energy market is doing at any given time. Like any pipeline business, they need to use substantial leverage to fund their projects, which means they are sensitive to interest rate changes.

Here’s a valuation table:

oke_valuation

Source: Dividend Toolkit Valuation Spreadsheet

The current price of OKE is under $49/share. Compared to the estimated valuations derived from different dividend growth rates and target rates of return, the company appears to be attractively valued under just about any reasonably-performing scenario.

Kinder Morgan Inc. (KMI)

Does 10% annual dividend growth and a 4.5% dividend yield sound pretty good? And in an otherwise expensive market? It does to me, if the company can perform as expected.

Kinder Morgan Inc. used to be another publicly traded general partnership like Oneok Inc., except much larger and more complex, until they recently consolidated. Analyzing it was a nightmare regardless of experience level due to the multi-level hierarchy they had and the sheer quantity of information to go through. Now, Kinder Morgan operates in a much simpler and cleaner structure. The P/E ratio is still not a useful metric to analyze this company by, however, due to its asset-heavy nature. Even though it’s no longer in an MLP structure it’s still financially similar to one. The focus of investors should be on its ability to generate cash flow and pay growing dividends while maintaining a stable credit rating.

KMI’s infrastructure spans across the entire United States, and they’re the largest midstream energy company in the country and the third largest overall energy company in the country. But unlike oil majors, Kinder Morgan focuses on being an energy toll road. Their revenue is fee-based for transporting energy and providing other midstream services. 85% of their cash flow is fee-based and about half of the remaining 15% is hedged, leaving the company with less sensitivity to energy prices. Slightly over half of their cash flow comes from natural gas pipelines, and the remaining half comes from a variety of terminals and other pipelines.

kinder_morgan_operations

The company still faces risk, in part because their huge size dictates massive expansion profits or acquisitions each year to continue their growth. Environmental regulatory risk can reduce their ability to pursue certain projects. There’s a tradeoff between delivering consumers the energy they want and preserving the natural landscape and ecological purity of the land they transport it over.

Ten percent is the annual dividend growth rate that KMI management has stated that they expect to achieve between 2015 and 2020. That would mean a 60% increase in the annual dividend over a five year period. This is expected to come from ongoing acquisitions and their $18 billion backlog of growth projects.

Richard Kinder, founder and CEO of Kinder Morgan since 1997 has $10 billion personally invested in the company and receives annual compensation of $1 to run the company. His wealth is self-made from his long-term outperformance in this sector over nearly two decades now and his real income comes from his dividends from the portion of KMI he owns. This is something long-term investors should love to see- a CEO whose financial incentive is entirely derived from long-term company performance rather than derived from short-term performance. He has little incentive to pursue quarter-by-quarter profits and instead has the luxury and the incentive to sit back and take action for the long-term strategic profitable growth of his company. If there is a Warren Buffet of pipelines, Richard Kinder is him.

Here’s a valuation table for KMI:

kmi_valuation

Source: Dividend Toolkit Valuation Spreadsheet

Using long-term estimated dividend growth of 7%/year (compared to 10%/year for at least the next five years as expected by management), the current price of $43/share appears poised to offer great returns if operations go well.

For KMI here, I’ll provide a two-stage Dividend Discount model valuation table as well for another valuation check:

kmi_valuation_2

Source: Dividend Toolkit Valuation Spreadsheet

That table used a 9% dividend growth rate for the next 10 years followed by 5% forever after that, and is centered on a 10% discount rate / target rate of return.

Conclusion

The market is currently at a higher-than-usual average P/E ratio, but valuation estimates show that under reasonable scenarios, some stocks in the infrastructure sector appear modestly undervalued and some energy and engineering companies are in good shape for investors too.

There are always a variety of risks, including an unexpectedly bad recession at some point, or unfavorable interest rates (particularly for infrastructure companies that need a lot of leverage), but what most of these companies share in common is that they have competitive advantages. Particularly for the infrastructure examples (BIP, OKE, and KMI), their asset-heavy toll-road-like business models (and literally including toll roads in BIP’s case), act as a sturdy foundation for dividends and distributions, and if managed well and not over-leveraged, can weather most types of economic troubles. The world has a lot of infrastructure development coming in future decades, and so pipelines, ports, roads, terminals, transmission lines, and other sorts of capital-heavy assets are a reasonable place to put money for good dividend/distribution yields, in my view.

Regards,
-M. Alden

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JM Smucker: Fair at $100

-Seven Year Average Revenue Growth Rate: 15.4% Dividend Stock Report
-Seven Year Average EPS Growth Rate: 10.7%
-Seven Year Average Dividend Growth Rate: 9.5%
-Current Dividend Yield: 2.29%
-Balance Sheet Strength: Strong

For solid if not impressive risk-adjusted returns, J.M. Smucker seems well-positioned and fairly valued.

Overview

The J.M. Smucker Company (symbol: SJM) was founded in 1897, is headquartered in Ohio, and is still run by the Smuckers family.

The company produces jam, jelly, preserves, peanut butter, sandwich products, ice cream toppings, baking products, oil, juices, and coffee. The company draws its revenue mostly from North America, but has international ambitions as well. The company focuses primarily on having the #1 brand in any given category.

Coffee
For coffee brands, Smuckers has gone on a buying spree. They acquired the large Folgers brand of coffee from Procter and Gamble, and they also sell Dunkin Donuts coffee for retail markets. They now sell Millstone, Cafe Bustelo, and Pilon coffee, with the last two being popular among Hispanic demographics, statistically speaking.

K-Cups are becoming more popular, and Smuckers has offerings in this area, including from their Folgers Gourmet Selections brand. Smuckers does face strong coffee competition from several brands, with Starbucks and Green Mountain Coffee Roasters being the two most worth mentioning.

Coffee contributes 39% of SJM sales.

U.S. Retail Consumer Foods
The company’s original flagship product is their line of Smuckers fruit spreads: jams, jellies, and preserves. They were smart to acquire the Jif peanut butter brand as well, and they also control or license other brands like Crisco, Pillsbury, and Hungry Jack.

This segment contributes 38% of SJM sales.

International, Foodservice, and “Natural” Foods
Some of the company’s largest brands compete internationally, and they also have brands dedicated to certain markets, like Canada. For “natural foods” in this category, they have Santa Cruz Organic and R.W. Krudsen Family. In fiscal year 2012, the company invested in Seamild, a leading provider of oats products throughout China.

This segment contributes the remaining 23% of sales.

Valuation Metrics

Price to Earnings: 19
Price to Free Cash Flow: 22
Price to Book: 2.1

Revenue

Smuckers Revenue
(Chart Source: DividendMonk.com)

The revenue growth rate is high at 15.4% per year averaged over the past 7 years. This is because the company issued new shares for capital to make acquisitions up until 2010.

Earnings and Dividends

Smuckers Dividends
(Chart Source: DividendMonk.com)

Over the same 7 year period, EPS growth was 10.7% per year while dividend growth was close behind at 9.5% per year. The most recent dividend increase was 11.5%.

The current dividend payout ratio from earnings is about 40%, so the dividend is well-covered and has room to grow.

Approximate historical dividend yield at beginning of each year:

Year Yield
Current 2.3%
2013 2.3%
2012 2.5%
2011 2.6%
2010 2.3%
2009 2.9%
2008 2.4%
2007 2.3%
2006 2.3%

As can be seen by the chart, except for certain points of volatility, Smuckers stock has maintained a fairly consistent mediocre dividend yield. The price of the stock has risen at almost exactly the same rate as the dividend growth.

How Does SJM Spend Its Cash?

Over the past three years combined, Smuckers brought in about $1,300 million in reported free cash flow. About half of that, or $630 million, was spent on dividends. Over $1 billion was spent to buy back stock, and the outstanding share count has decreased by nearly 8% cumulatively over the past three years. Approximately $730 million was spent on acquisitions.

Balance Sheet

Smuckers has a total debt/equity ratio of under 45%, although goodwill makes up about 60% of existing shareholder equity due to acquisitions. The total debt/income ratio is about 4x. The interest coverage ratio is just over 10x, indicating that Smuckers can easily pay all debt interest.

Overall, the balance sheet is in a strong position. Management has used leverage appropriately and conservatively.

Investment Thesis

Smuckers has substantially outperformed the market over the last 15 years due to a series of large successful acquisitions and good management of their capital. A diverse set of top brands gives the company a steady, defensive position while outperforming, and therefore the risk-adjusted returns have been particularly good.

Looking to the future, management aims for sales growth of 6% per year (organic growth of 3-4% and acquisition growth of 2-3%), and EPS growth of 8% driven primarily from that sales growth plus share buybacks. With the dividend, this would lead to total returns of 10-10.5% or so, which is higher than the S&P 500 historical average.

The internal strategic efforts appear to be a page out of Pepsico’s current playbook with their “Healthy for You”, “Good for You” and “Fun for You” levels of products representing the spectrum of how bad for you a given product is. Smuckers has “Good for You”, “Easy for You” and “Makes You Smile”.

Overall focus of the company includes concentrating on North America and China rather than expanding everywhere, focusing on health products such as ones with natural ingredients or special-diet options such as gluten free products, and continuing to look for bolt-on acquisitions to complement their previous transformational acquisitions.

Risks

Like any company, SJM has risks. Being a food company, they are a defensive stock, but they always face risk in two main forms: commodity costs and cheaper private label competition. In addition, in contrast to many large American companies, Smuckers has most of its sales and operations in North America, meaning it is geographically concentrated.

Packaged food is a competitive business, and Smuckers expects flat volume growth and a 1% sales reduction in 2014, but decent EPS and dividend growth.

Conclusion and Valuation

With the DJIA and S&P 500 continuing to hit new records, stocks at a decent valuation are difficult to find, and this is especially so for relatively stable blue-chips that you can buy and set aside for a while. In addition to increasing risk and reducing overall returns, this pushes dividend yields lower across the market, which reduces the amount of dividend income you can buy with any given amount of cash.

That being said, SJM neither appears to be a clear value or a clear overvaluation. While the markets soared upward throughout 2013, SJM actually fell over ten bucks from its mid-year high.

The earnings multiple approach should work well for valuating the company. If management is successful and raises EPS by 8% per year over the next 10 years, then the EPS figure will be $10.57 at that time. Putting an earnings multiple of 16 on that EPS figure in ten years (compared to an earnings multiple of 19 now) puts the stock price at about $169. If dividends continue to be paid with a payout ratio of 40%, that’ll be about $30 in cumulative dividends over those ten years, or about $42 if they are reinvested into the stock. So, $169 + $42 = $211 in value in ten years.

That’s an annualized rate of return of about 7.5% from the current price of $101, which is neither particularly appealing, nor particularly bad for a defensive company in a highly valued market, and assumes a significant drop in valuation. If instead the valuation remains constant at a P/E of about 19, the rate of return under the same conditions would be about 9% per year, which is in line with historical S&P 500 growth.

Excluding any major company missteps, it seems unlikely that investors would be disappointed having invested in Smuckers stock at the current price over the long-term, and so I view the company as a reasonable, if not appealing, buy. There is of course a large risk of near or mid-term stock price declines during a market correction.

Full Disclosure: As of this writing, I am long SJM.
You can see my dividend portfolio here.

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Johnson and Johnson: Let it Dip to a 3% Yield

-Seven Year Average Revenue Growth Rate: 4.2% Dividend Stock Report
-Seven Year Average EPS Growth Rate: 1.6%
-Seven Year Average Dividend Growth Rate: 9.4%
-Current Dividend Yield: 2.83%
-Balance Sheet Strength: Perfect

The company has a good foundation for growth after a difficult few years, but the current price in the low $90’s leaves little or no margin of safety.

Overview

Johnson and Johnson (NYSE: JNJ) was founded in 1886 and today is the largest and among the most diverse of health care companies in the world. The company consists of three segments: Medical Devices, Pharmaceuticals, and Consumer.

Medical Devices and Diagnostics Segment
This segment was responsible for $27.4 billion in sales in 2012, which is up 6.4% from the previous year. Orthopaedics is the largest unit, accounting for over a quarter of the sales from this segment. Surgical care is the next largest unit, accounting for nearly a quarter of segment sales. The remaining units are vision care, diabetes care, specialty surgery, cardiovascular care, diagnostics, and infection.

Pharmaceuticals Segment
Johnson and Johnson brought in $25.4 billion in sales for 2012 with pharmaceuticals, and this figure was up 4% from the previous year. Immunology is the largest pharmaceutical unit (nearly a third of segment sales), followed by neuroscience (about a quarter of segment sales), infectious diseases, oncology, and other.

Consumer Segment
Consumer sales were $14.4 billion in 2012, and this figure was down 2.9% from the previous year. OTC is the largest unit accounting for nearly a third of segment sales. Skin care is another big unit, accounting for a quarter of segment sales. Other units are baby care, oral care, women’s health, and wound care.

Valuation Metrics

Price to Earnings: 20.7
Price to Free Cash Flow: 21.2
Price to Book: 3.8

Revenue

Johnson and Johnson Revenue
(Chart Source: DividendMonk.com)

The revenue growth rate over the latest seven year period was about 4.2% per year on average. Over the trailing twelve month period, the company has sustained strong revenue growth, going from $67.2 billion in 2012 to about $70 billion over the last four quarters.

Earnings and Dividends

Johnson and Johnson Dividends
(Chart Source: DividendMonk.com)

The EPS growth rate over this period was only 1.6%. But, EPS for the trailing twelve month period is much higher than it was in 2012, and using that adjusted time period, the EPS growth rate is 2.7%. Overall, JNJ has had weak earnings growth.

The dividend growth rate over this period has been a solid 9.4% per year, which when combined with a yield of 3% or so represents very solid long-term returns. The dividend payout ratio from earnings however, has increased over the last decade from comfortably under 40% to nearly 60%.

Approximate historical dividend yield at beginning of each year:

Year Yield
Current 2.9%
2013 3.5%
2012 3.5%
2011 3.5%
2010 3.0%
2009 3.0%
2008 2.5%
2007 2.2%
2006 2.1%
2005 1.8%

The yield for Johnson and Johnson is currently at a low point. Although JNJ boosted its dividend for 2013, the fact that the stock price roared from the low $70’s to the low $90’s during the year to date, has increased the valuation and decreased the current dividend yield.

How Does JNJ Spend Its Cash?

During the fiscal years of 2010, 2011, and 2012, the company brought in nearly $38 billion in free cash flow. Over the same period, the company paid about $18.5 billion in dividends, another $18.2 billion on share repurchases, and about $8.5 billion on net acquisitions.

Balance Sheet

Johnson and Johnson is one of only a very few non-financial companies that maintains a perfect AAA credit rating.

The total debt/equity ratio is about 21%, and less than a third of existing shareholder equity consists of goodwill. The existing amount of total debt is less than 1.2x the annual net income figure, and the interest coverage ratio is 35x, which is extremely well-covered.

The company generates positive free cash flow each year from a highly diverse sales base, and often it’s a higher figure than net income.

Investment Thesis

The company has started fresh with a relatively new CEO (of which there have only been 7 in over 120 years of operating history) with substantial industry experience, and with several difficult years behind the company, the next few years look brighter.

Johnson and Johnson is often viewed as the quintessential blue chip stock. The combination of a particularly strong balance sheet, five consecutive decades of annual dividend growth without a miss, strong free cash flow generation, and a highly diverse sales base, is hard to compare to any other company.

Most segments have various durable economic advantages which help to protect their cash flows. For example, the pharmaceutical segment, like other pharmaceutical companies, uses a series of patents to maintain a consistent pipeline and portfolio of patented drugs, and because of their size, they can fund the largest of R&D projects or they can acquire drugs for their pipeline. This makes their pipeline rather consistent from year to year. The medical devices segment is similar, with advanced patented devices created from one of the largest medical device segments in the world. The consumers segment is a bit different in that it relies on brand strength. Each of the three segments is supported by the others, so a weak pharmaceutical period can be balanced by strong medical device sales during that time, or as we saw in previous years, a weak consumer segment can be balanced by the pharmaceuticals and medical devices. Most of JNJ’s products are protected from recessions due to their rather necessary nature, with the exception of some of their over-the-counter products which are vulnerable to market share losses to private label products during those times.

Risks

Although the company is large and well-diversified, the complex nature of the company results in numerous risks. 2010 was a particularly difficult year for the company, as they recalled 43 over-the-counter medications due to systemic quality control issues in their subsidiary that is responsible for this lineup of products, recalled hip replacements due to a revision ratio that was far above acceptable levels, and faced a shareholder lawsuit regarding these quality issues and other aspects of company governance.

The pharmaceuticals segment, like any company in the industry, has pipeline risk. It can take billions of dollars to develop or acquire a blockbuster drug, and a weak pipeline of upcoming drugs can mean that sales will be lackluster in upcoming years. Unexpected events of drugs failing approval or showing to be ineffective can be a major blow to the segment. Currently the pipeline is strong, and unlike pure pharmaceutical companies, Johnson and Johnson buffers this risk with their other business segments.

Litigation is a constant risk for any large health care company, because so many lives are affected so dramatically. Products can mean the difference between life and death for patients, and something like a hip replacement that has a revision rate of over 10% compared to the typical and acceptable 1% can mean major financial losses, recalls, and/or litigation.

Conclusion and Valuation

There’s little doubt that overall, JNJ is a particularly strong company. Just about every metric is spectacular from the balance sheet to the cash flow generation to the diversification to the dividend safety. Still, the company does have downsides.

Growth has been poor in the recent several years due to the recalls which were acting as anchors on profitability, as well as the financial crisis and recession to a limited extent. On one hand, the fact that the company weathered a cluster of problems with flat sales base and earnings base shows the strength of the company. On the other hand, several years of poor growth does have a major negative impact on shareholder returns.

With a strong pipeline and with better quality oversight in place, the company is in a good state for growth going forward. The one problem, of course, is valuation. Johnson and Johnson outperformed the S&P 500 by nearly 10% year to date, and the S&P 500 itself outperformed its average growth rate during 2013 to reach record highs. Last year in the JNJ stock analysis report, I stated similar views about JNJ- that it was in a good position for growth (which based on revenue growth has been true), but at that time the stock was in the high $60’s and I was cautiously optimistic about it being a buying opportunity at that price.

Now at $93/share, we’re looking at a similar situation with a much higher valuation. Using the earnings multiple valuation approach, if the company grows EPS by 8% per year over the next 7 years on average, and we place an earnings multiple of 18x on the stock at the end of that seventh year, then the price will be around $138. The investor will have received about $26 in dividends per share, and if reinvested, can expect another $8 or so in value. The seventh year value therefore would be $184, which is roughly double the current value. This translates into a rate of return of about 9%, which is not bad on a conservative dividend payer.

But that doesn’t leave any margin of safety. If EPS growth averages only 7%, the rate of return under the same circumstances would be down to a bit over 8%, and if the earnings multiple at that time is 16 instead of 18, the annual rate of return is down to about 7%.

In conclusion, I believe that few investors would be disappointed several years from now with a purchase of JNJ stock today, but I don’t think it’s in a good position to outperform unless estimates use very optimistic growth estimates. So, the price is fair but not ideal, in my view. The yield is historically low for the company at 2.83%, and I believe a wiser play would be to wait for the growth to catch up with the valuation and see if the stock becomes available at a lower earnings multiple of under 20, and with a yield of over 3%.

Full Disclosure: As of this writing, I am long JNJ.
You can see my dividend portfolio here.

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