Quick Ideas

Without a significant promotion, relatively view people could say they got a 7.3% raise this year.

However, that’s the combined average 2012 dividend income increase from these five of some of the strongest dividend payers around. And considering they offer an average dividend yield of over 3%, that’s not so bad.

These five businesses have fairly strong balance sheets, are some of the largest players in their industries, and have 25 or more years of consecutive annual dividend growth. Many of the bluest of blue chips can potentially have their dividend growth taken for granted since it occurs like clockwork, so it’s good to observe and recognize raises from some of the strongest dividend payers.

The Coca Cola Company (KO)

Topping this particular list with 8.5% annual dividend growth this year is Coca Cola. Sporting only a 2.67% dividend yield, it’s a little light for current income (it is, after all, supporting a P/E of around 20), but the company has strong finances, among the widest of moats thanks to its distribution system and brand strength, and very consistent dividend growth for about five decades.

The dividend income is well-covered by earnings, with a dividend payout ratio from earnings of around 55%. The balance sheet has been a bit strained from the bottler acquisition from not too long ago, but it holds well enough, with a strong interest coverage ratio of over 25.

A key thing to take into account, in my view, about Coke, is that while their reach extends quite so far, it’s still doesn’t have near the market penetration in some of the world’s most populous nations as it does in North America.

From the last Coca Cola Analysis:

Although the Coca Cola Company already has worldwide distribution, their potential in emerging markets is substantial. The average per-capita annual consumption of Coca Cola products is 89 servings according to their own information. The nation with the highest annual consumption is Mexico, with 675 annual 8 ounce servings per capita. The United States is fourth on the list, with 394. The consumption in China and India is only 34 and 11 respectfully, and these are the two most populous countries in the world. Other high population areas such as Nigeria, Pakistan, and Indonesia only consume 28, 15, and 13 servings per year.

So from a health perspective, this probably isn’t good news. But from a financial standpoint, it looks like Coca Cola’s year-after-year growth shows little sign of stopping. That being said, with their valuation where it is now, I’d look for dips before putting more capital towards their shares.

3M Company (MMM)

One might not expect it, but some of the companies with the longest streaks of dividend increases are semi-cyclical engineering businesses- companies like Emerson Electric, Dover Corporation, Illinois Tool Works, Leggett and Platt, and 3M Company. 3M offers a 2.77% dividend yield, with 7.3% annual dividend growth for 2012.

The company’s six business segments are:
Industrial and Transportation
Health Care
Consumer and Office
Displays and Graphics
Safety, Security, and Protection
Electro and Communications

To get more specific, from the 2012 3M Analysis, here are some of their targeted growth areas:

-Water purification
-Environmental protection, sustainability, renewable energy
-Health care in both developed and developing countries
-Automotive OEM growth
-International/Emerging consumer products
-Increased and sustained unemployment in the developed world
-A long term increase in petty crime resulting from economic problems, and 3M’s corresponding safety, security, and protection businesses
-A trend towards worker protection in emerging markets
-The continued trend toward electronic and software interaction, robotics, communication, and globalization

Overall, 3M also offers one of the strongest balance sheets on this list, with total debt/equity under 30%, and an interest coverage ratio of over 30. I’d look for a price dip of 10% or more before committing to a position, however. With Eurozone uncertainty, we may get a bigger broader dip than that.

Johnson and Johnson (JNJ)

Johnson and Johnson offers the highest dividend yield on this list, at 3.83%. I’ve been looking towards health care as a fairly decent area for long-term investment, and yet since the recession, their stock prices have been relatively flat. But flat stock prices and sustainable continued dividend growth means bigger yields, and if JNJ boosts the dividend next year by the same rate as this year, and the stock price is still the same, it’ll breach a 4% yield.

Although many investors have not been impressed by company management over the last few years, at least their drug pipeline is strong, and their areas of operation remain as diverse as ever in pharmaceuticals, medical devices, and consumer products.

From the 2011 JNJ Analysis:

Johnson and Johnson has a strong presence in emerging markets, including the BRIC countries of Brazil, Russia, India, and China. Double digit emerging market growth helps to offset lackluster performance in developed countries, and over the long-term, many developed countries have an aging population that will continue to require large amounts of medical treatment.

As far as comparing balance sheets, Johnson and Johnson is the one on this list that has an AAA rating, and based on balance sheet metrics such as interest coverage, debt/equity, and overall diversification, it looks deserved.

Procter and Gamble (PG)

Much like Johnson and Johnson, PG’s performance over the last few years has been lackluster. The 50+ years of consecutive dividend growth are appreciated, but it’s the future that matters. Can this $180 billion company showcase another half-century of dividend increases going forward, or is it running out of steam?

The company currently offers a 3.50% dividend yield and 7% recent dividend growth for 2012. The dividend certainly looks safe for now, since less than 2/3rds of earnings are being paid out as dividends and the balance sheet is respectable enough, with interest being covered more than 15 times over by operating income, and with a very manageable total debt/equity situation.

From the 2011 PG Analysis:

At it’s core, Procter and Gamble is a brand management company. Their products are often the best around, but their brands just as important. The company owns 23 billion-dollar brands and 20 half-billion-dollar brands.

Developing markets are playing a larger and larger role in the growth of the company, accounting for 29% of sales in 2007 and 32% of sales in 2009. The company has over 4.2 billion customers, and targets 5 billion by 2015.

I view PG as being reasonably valued at the current time, but am not particularly excited about its long-term prospects compared to some smaller businesses, or some higher-yielding businesses. Procter and Gamble is currently undergoing multi-billion-dollar restructuring, including several divestitures, in order to reignite EPS growth. Both JNJ and PG face the need to continue EPS growth if they hope to continue dividend growth.

Colgate Palmolive (CL)

Colgate Palmolive is a leaner competitor to Procter and Gamble. They have the lowest dividend yield and 2012 dividend growth on this list, at 2.45% and 6.9% respectively. The company has been paying consecutively growing dividends since the 1960′s, and currently has a market capitalization of approximately one third of what Procter and Gamble has.

In addition, although Procter and Gamble’s global diversification is impressive, in terms of international sales as a percentage of total sales, Colgate Palmolive actually leads Procter and Gamble. From the 2012 Colgate Report:

Colgate-Palmolive is a very high-quality and diverse international company. Approximately 75% of sales come from outside of North America, and the company defines approximately half of their sales as coming from emerging markets.

The fact that most of the sales of this company come from abroad allows North American investors to participate in the faster growth of some foreign markets. Even among blue-chip American companies that as a group have rather large global exposure, Colgate-Palmolive is ahead of the curve. The company markets their products in over 200 countries and territories, and the Colgate brand has been in Asia for over 50 years and Latin America for over 75 years.

Unfortunately for value investors, Colgate has completely defied the latest market decrease, and went ahead and breached $100 to get a new all-time high. I’d look elsewhere until the stock is a bit less heated.

For a more actionable current investment, this week’s analysis of Philip Morris presents an argument as to why the company is a solid buy at the current price.

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

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For investors looking for fairly safe high yields, Master Limited Partnerships can potentially be a good choice. They offer fairly high distribution yields that are typically well-supported by cash flows from stable toll-booth type businesses. Since most of the cash flow is paid out as distributions, growth usually comes from issuing new units. This dilutes unitholder ownership but if the numbers work out, it adds value to all parties involved.

One of the primary aspects of an MLP is the Incentive Distribution Rights (IDRs) payout that the partnership pays to the General Partner (GP). The thing that makes MLPs particularly appealing for dividend investors, is that the whole structure is centered around the distribution payout, rather than allowing the payout to be an optional use of cash like in a typical corporation. Put simply, IDRs are structured as follows: the general partner is entitled to a percentage of the total cash flow of the partnership, and this percentage is based on the current size of their quarterly distribution payout to limited partners. So if management does a good job of growing the per-unit value of the partnership (and correspondingly the per-unit distribution to limited partners) over time, then the holders of the general partner benefit even more, but everyone should be pleased with substantial returns.

A potential problem arises, however, if those incentive distribution payouts get too large. Many MLPs IDR agreements allow the payout to the general partner to approach 50% of total cash flow. If the payout gets quite high, it typically means that both the limited partners and the holders of the general partner have done quite nicely in terms of returns up to this point (since these payouts were explicitly determined based on quarterly distribution growth), but going forward, the general partner has a lot more value to look forward to than the limited partners.

This is because the effective cost of capital becomes so high. Since the partnership has to issue new units and debt in order to make acquisitions or grow organically, and upwards of 30+% or more of the free operating cash can go to the general partner due to IDRs at later stages, it ends up leaving little money for distribution growth for limited partners. The general partner still benefits, however, because their payouts grow both when they raise the quarterly distribution to limited partners and when they increase the total number of partnership units (and more specifically, the total size of the partnership cash flows). In the early stage of a partnership, it doesn’t directly benefit the GP to increase the number of units, because they get only at small percentage of total cash flow anyway. But once they are entitled to such a large percentage of the total cash flow of the partnership, then their cash flow can grow primarily from increasing the number of units and correspondingly, the total cash flows of the partnership. Limited partner unit distribution growth can slow or stall.

There are, however, several ways to invest in MLPs and avoid this problem. Presented below is a solid but non-exhaustive list of seven partnership investments that put investors on the right side of the IDRs.

Energy Transfer Equity (ETE)

The most straightforward way of avoiding problematic IDRs is to be on the receiving side of them rather than the paying side of them, which means owning a stake in a General Partner. This list, therefore, begins with 4 different publicly traded general partners, starting with Energy Transfer Equity. Energy Transfer Equity (ETE) owns the general partners and IDRs of both Energy Transfer Partners (ETP) and Regency Energy Partners (RGP). As a whole, ETE and its partnerships constitute one of the largest partnerships in the U.S., and they own natural gas pipeline systems across much of the United States.

Energy Transfer Equity also represents a good example of a partnership that has run into issues due to IDRs. ETP has been unable to grow its quarterly distribution for a few years now, while the general partner, ETE, has been able to grow its own quarterly distribution. The downside to general partners is that their distribution yields are not typically as high as those of limited partners, but the total yield + growth tends to be higher. ETE currently has a 6.23% yield.

My analysis of ETE is a bit dated and could use an update, but if you’re interested in learning more about general partners or IDRs, this ETE analysis provides a far more quantitative overview of how general partners benefit disproportionally after a certain point: Energy Transfer Equity Analysis

Brookfield Asset Management (BAM)

Brookfield Asset Management owns IDRs to a few partnerships, with exposure to real estate, renewable energy, and global infrastructure assets. Further, their payments from IDRs are set to max out at 25% rather than 50%, so they should never run into the issue of being weighed down in heavy cost of capital due to IDR payouts, and they’re on the appealing side of the IDRs anyway (the receiving side). They also receive lucrative management fees that scale in a similar fashion to their IDRs. BAM unfortunately offers the lowest yield on this list, at under 2%, but I believe that perhaps due in part to the highly complex structure of the partnership, they’re currently attractively priced.

Kinder Morgan Inc. (KMI)

Kinder Morgan Inc is the general partner of Kinder Morgan Energy Partners (KMP). It’s structured as a corporation, so investors can get MLP exposure without the associated tax complexity that typically comes with owning an MLP. The yield is modest, at only around 3.5%, but the dividend growth rate should exceed the growth rate of KMP. KMP, however, is a solid counter-example of a partnership that despite reaching high levels of IDR payouts, continues to be able to modestly increase the distribution to the limited partners.

Oneok, Inc. (OKE)

Oneok holds numerous investments, and one of them is a stake in the Oneok Partners LP (OKS). The business gathers, processes, stores, transports, and distributes natural gas and natural gas liquids around the country. Interestingly, Oneok provides some diversification alongside other partnerships, because while partnerships tend to be centralized around the Gulf of Mexico, Oneok’s primary infrastructure hub is farther north in Oklahoma and Kansas, and stretches around the country from the Gulf, to the Great Lakes, to Canada. While OKS provides a 4.56% yield, OKE currently provides only a 2.89% yield, albeit with greater growth.

Brookfield Infrastructure Partners (BIP)

Owning general partners isn’t the only way around the IDR problem. Brookfield Asset Management, which was previously described, is structured slightly differently than many other partnerships. Most relevant for this discussion is that their total allowance of the cash flows from IDRs maxes out at 25% rather than 50%. This means in practice, their payout will not exceed the upper-teens or the low-20s in terms of total percentage of partnership cash flows, rather than the 30+% that MLPs can get to. BAM receives IDRs from multiple partnerships, and one of those is Brookfield Infrastructure Partners (BIP). The partnership owns a diversified set of assets on multiple continents, including coal terminals and railroads in Australia, timberlands in North America, shipping ports in Europe, electric transmission lines in Chile, and a number of other assets around the world including natural gas pipelines. Personally, I’d look for dips below $30 to snag units with a 5+% yield.

My full analysis of the partnership is available here: Brookfield Infrastructure Partners Analysis

Buckeye Partners (BPL)

The third way here to avoid being on the wrong side of high IDR payouts is to own partnerships that no longer have to pay IDRs. Buckeye bought out its general partner a couple of years ago, and no longer has any IDR payouts to pay. This lowers the effective cost of capital for the limited partners, and allows distributions to grow more quickly. Buckeye currently offers the highest yield on this list, with a 7.35% yield, and was able to raise distributions every quarter straight through the financial crisis and recession, but currently doesn’t cover the distributions as strongly with cash flow as many others on this list.

Enterprise Products Partners (EPD)

Enterprise Products Partners is another large partnership that bought out its general partner and cancelled its IDRs. No longer burdened by these payments, EPD can give more cash to unitholders. The partnership currently offers a 4.86% distribution yield, and has raised the distribution for more than 30 consecutive quarters. EPD has 21,000+ miles of natural gas pipelines, 17,000+ miles of NGL and petrochemical pipelines, 6,000+ miles of crude oil pipelines, 190 million barrels worth of liquids storage capacity, 14 billion cubic feet of natural gas storage capacity, 24 natural gas processing plants, 20 NGL and propylene fractionation facilities, and 6 offshore hub platforms.

I published a report on EPD earlier this week, and it can be found here: Enterprise Products Partners Analysis

Full Disclosure: I am long ETE and BIP at the time of this writing.
You can see my portfolio here.

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Last week, I published an overview of the only four companies that currently have a perfect AAA credit rating.

It’s not surprising that all of those financially secure companies are also companies that have had long consistent stretches of dividend growth, ranging from the better part of a decade to almost half a century.

They are not, however, the only four businesses that have great balance sheets. Several other businesses have extremely secure financial positions, and in this article, I’ll provide an overview of five excellent balance sheets. Some of them have balance sheets that rival or exceed their AAA counterparts.

Apple Inc. (AAPL)

Apple doesn’t have an AAA rating because it has no debt to rate. If it did, however, the Apple balance sheet would arguably be considered the strongest balance sheet of any business. It’s so strong actually, that one of the biggest financial complaints towards Apple was that it was hoarding too much cash instead of returning it to shareholders, and so CEO Tim Cook finally announced a dividend. The yield will be under 2%, but in terms of total payout, it’s one of the biggest quarterly dividend payments of any company in the world.

The company has approximately $100 billion in liquid money on its books. The company’s dividend may slow down cash accumulation, but shouldn’t draw into the cash reserves, because the current free cash flow covers the proposed dividend payout several times over. And because Apple sticks to only small, strategic acquisitions, the free cash isn’t reduced by any major acquisition expenditure.

The question for investment purposes is whether Apple can maintain their current innovation, or whether they’ll eventually fall behind. Unlike businesses that produce reliable cash flows with an economic moat, Apple is dependent on being able to release trendy market-beating products each year.

Chevron Corporation (CVX)

A few months ago, I posted an analysis of Chevron where I discussed how the company could absorb even a multi-billion-dollar litigation penalty if it had to, with regards to current media reports at the time.

Chevron’s total debt/equity ratio is around 8%, and their interest coverage ratio is very high. The company has approximately 10% worth of its market capitalization worth of cash equivalents on hand.

Due to heavy capital expenditure, free cash flow is fairly weak compared to net income ($14.5 billion in FCF vs. $27 billion in net income for 2011), but free cash flow still covers the dividend payout twice over in most years.

Intel Corporation (INTC)

Microsoft made it onto the AAA list, but Intel did not. Intel, however, has a current ratio of over 2, a total debt/equity ratio of around 16%, and an interest coverage ratio that is considerably above 100. The company has more cash on hand than their current liabilities are worth.

Intel, like Apple, is dependent on its ability to produce the best products every year. But unlike Apple, Intel gets design wins based almost strictly on performance rather than a combination of consumer preference and specs, and supports this performance with an R&D budget and a capital expenditure budget that vastly outmatches its rivals.

Here’s the recent analysis: Intel: Where are their Growth Opportunities?

Canadian National Railway (CNI)

Canadian National Railway may not have quite as low of a total debt/equity ratio as some of the others on this list, but what constitutes a good balance sheet varies by industry. When a company has a large base of assets and reliable cash flows, and still rather conservative balance sheet metrics, then it be considered as financially sturdy as a fast paced business with a leaner balance sheet.

This railroad system has tracks extending from the Atlantic Ocean to Pacific Ocean through Canada, and also has tracks extending down to the Gulf of Mexico. Railways, based on their position once developed, and based on their energy efficiency compared to other forms of transportation, have solid economic moats.

With a debt/equity ratio of around 60% and an interest coverage ratio of almost 10, CNI’s balance sheet is robust. Their dividend, which has increaed every year since the mid-1990′s, is comfortably covered by free cash flows.

National Presto (NPK)

National Presto has some troubles with its cooking appliances segment, and while their defense segment is strong, there is uncertainty regarding how much of it can be maintained with a reduction in military activity. But one problem that National Presto doesn’t have, is a poor balance sheet.

This company, like Apple, has tons of cash and no debt. The company has $133 million in cash on their books, which is equal to approximately 25% of their total market capitalization. So, this small cap has a higher cash/market cap percentage than Apple or any other company on this list.

Their dividend policy differs from many others; rather than pay a set dividend that grows each year, they pay a large annual special dividend that is equal to approximately 90% of earnings. So their dividend scales with their performance, which has advantages and disadvantages.

The recent analysis: National Presto: Value Play or Value Trap?

Importance of Balance Sheet Strength

The importance of a strong balance sheet goes far beyond credit risk and liquidity risk. A company that has tons of cash and little debt is a company that’s flexible. Given the right opportunity, their balance sheet can absorb a big change by taking on debt, if need be.

If, for example, you have a company with $1 billion in assets, $500 million in debt, and $200 million in net income, then you have a fairly leveraged company. On the other hand, if a company with $1 billion in assets, no debt, and $200 million in net income existed at the same valuation, it would be a much better bargain, all else being equal. This second company could, for instance, make a targeted acquisition to come up to the same debt/assets ratio as the first company, but could then have tens of millions more in income. Emerson Electric, for instance, acquired companies to enhance its data center business during the recent recession. They had the balance strength to absorb a slightly higher degree of debt for a good opportunity.

Overall, it’s good to look for companies with above average balance sheets, as they can weather storms, and are more flexible for opportunities such as extremely low interest rate environments or opportunistic acquisitions or large capital expenditures.

Full Disclosure: I am long MSFT, JNJ, XOM, CVX, and NPK at the time of this writing. You can see my dividend portfolio here.

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