Summary

Chubb Corporation (CB) is an international property and casualty insurer.

-Seven year revenue growth: 0%
-Seven year EPS growth: 6.4%
-Seven year dividend growth: 10.4%
-Current dividend yield: 2.30%

In my opinion, with a long dividend history, a modest stock valuation, solid business standards, and a sizable net payout, Chubb would make a decent investment at under $70/share.

Overview

Chubb Corporation (NYSE: CB) was founded in 1882 as a marine underwriting business in New York, and now exists as an international property and casualty insurance company with over 10,000 employees.

The premise behind an insurance company is that they spread risk out over a wide number of people and businesses. They collect premiums (payments) from clients and in return those clients are covered in case of a serious loss. From an insurance business standpoint, it’s ideal to collect more in premiums than you pay out for losses. This is not the primary form of earnings, though. An insurance business, after collecting all of the premiums, holds a great deal of assets that, over time, are paid out for client losses. Since they constantly receive premiums and pay out for losses, as long as they are prudent with their business, they get to constantly keep this large sum of stored-up assets as a float. As any investor reading this knows, a great sum of money can be used to generate income from investments, and that’s how an insurance company really makes money. They invest the insurance float in conservative and liquid securities in order to produce business income. Chubb, however, is unusually adept at ensuring that their premiums exceed their payouts, so compared to many other insurers, Chubb receives significant income from their underwriting businesses as well.

Chubb brings in 74% of its premiums from the United States and the other 26% from outside the United States.

Business Segments

Chubb has three business segments, and the executives expect an underwriting profit from each of them.

Commercial Insurance
This segment accounted for $4.7 billion in premiums in 2010, representing 42% of the total. Insurance products are offered for casualty, peril, workers compensation, property, and marine.

Personal Insurance
This segment accounted for $3.8 billion in premiums in 2010, representing 34% of the total. Insurance products are offered for fine homes, automobiles, and possessions.

Specialty Insurance
This segment accounted for $2.7 billion in premiums in 2010, representing 24% of the total. Insurance products are offered for specialty professional liability for companies, institutions, firms, and healthcare organizations.

Revenue, Profit, and Equity

Chubb receives revenue from premiums written, in addition to income earned from investments and a few other areas.

Revenue

Premiums and overall revenue growth over this period was basically flat.

Between 2004 and 2010, average invested assets (the assets that generate investment income for Chubb), increased from $26.8 billion to $38.3 billion. Investment income increased at a somewhat slower pace than the asset growth due to a mild but sustained reduction in the interest rates on their investment assets over this period. The interest rate on Chubb’s investments dropped from around four and a half percent to only around 4 percent, and since the Fed stated that interest rates will likely remain low throughout 2014, I expect Chubb’s interest rates on its assets to continue to mildly decrease.

Earnings Growth

Chubb grew EPS by an annualized rate of 6.4% over this period.

Growth of Book Value Per Share

Book value per share grew at an annualized rate of 10.4% per year.

Dividend Growth

Chubb has increased its dividend consecutively every year for well over four decades, currently offers a 2.30% dividend yield, and has a payout ratio of around 25%. (They are, however, scheduled for a dividend increase in the first quarter of 2012 which will lift these figures somewhat).

Dividend Growth

Chubb has grown its dividend by a rate of 10.4% per year over this period. The most recent increase from 2010 to 2011, however, was only 5.4%. I’m hoping for a larger increase in 2012.

Share Repurchases

Chubb repurchases a tremendous amount of shares each year. Between 2003 and now, Chubb has reduced the total number of shares outstanding from 387 million to 298 million. This means that investors that hold their shares over this period own a larger and larger portion of the company. It’s as though Chubb paid dividends but reinvested it in their stock on your behalf. Over the past 12 months, Chubb has paid out $455 million in dividends, but has repurchased $1,738 million worth of net shares. By net shares, I mean that this figure already takes into account the shares they issue in executive compensation, which is a comparatively small figure.

In other words, Chubb is indeed returning considerable value to shareholders with these repurchases and dividends combined. Management sends approximately 100% of net income to shareholders in the form of dividends and net share repurchases. The repurchases fuel EPS growth, dividend growth, and book value growth.

I evaluate the effectiveness of share repurchases on a case by case basis, based mostly on a) consistency of the share repurchases, b) whether the shares were repurchased at a fair price, and c) how effectively it is reducing the share count. I believe Chubb performs well with regard to all of these criteria, which is in contrast to Costco (COST) which I demonstrated had a flawed share repurchase history, as most companies do.

I’d prefer, however, for Chubb to double its dividend so that it yields comfortably over 4%, and then, and only then, worry about share repurchases. This would slow EPS growth and book value growth down moderately, but the dividend yield would be bigger. I think that would serve investors slightly better than the current policy of low dividends and big share repurchases. Let the shareholders decide if, when, and how to invest their share of the earnings; in my view.

Metrics

Price to Earnings: 11
Price to Book: 1.3

Balance Sheet

Chubb’s Property and Casualty Finance strength has been given an AA rating by Standard and Poor’s, and comparable ratings by other agencies. The company holds a comparatively small amount of debt compared to their assets.

Combined Loss to Expense ratio was reported to be 89.3% in 2010, which is excellent. In fact, Chubb has has kept this ratio below 100% every year since 2003, when the current CEO took over. As I mentioned previously, an insurer doesn’t even necessarily have to keep this ratio below 100%; they could carry a slight loss of claims compared to premiums, and recoup that with investment income. But by having such strict and profitable underwriting standards, Chubb generates not only investment income, but substantial income from the difference between premiums earned and claims paid. The combined ratio looks like it’ll be somewhat higher in 2011 due to an increase in catastrophic losses; perhaps in the upper-90′s. But this comparatively poor combined ratio for Chubb will be a solid combined ratio for the industry, as Chubb’s ratios are atypically low in most years, which is a great thing.

Investment Thesis

Chubb has a business model that is slightly different than some other insurers. The premiums they charge tend to be a bit high, but they typically offer superior claim service. They strive to be the gold standard of the industry, and are one of the largest businesses in the industry. Management insists on a culture where the company does not chase premium growth at the expense of having to under-charge on insurance products. The company conservatively allocates its resources, and has weathered mass asbestos claims, hurricane Katrina, and the economic crisis of 2008. The company has significant market share among high net worth individuals, which includes insurance of expensive homes and cars, as well as personal liability insurance of large amounts.

The company has stated that they focus primarily on bottom line growth; profitability. They look to boost premiums where possible, but not at the expense of profitability. Their business model has been summed up as follows by the son of the founder of the business:

The way to success is to select good risks and cover them. Obviously this does not lead to great size, but it should produce profitable business.
-Percy Chubb, 1857-1930

By offering great claim service for slightly higher premiums, the company hopes to be looked upon as the select company in their various niches. This is working quite well for their Masterpiece policy, which is an insurance product for the affluent.

I find that many insurers are having stagnant premium growth over the last several years. Many businesses have gone out of business or have decreased in size, which means less insurance demand. Less demand for insurance means lower premiums. In addition, interest rates have been held unusually low for an unusually long period of time due to the recession, and this affects the interest income on insurance portfolios, which is generally the primary source of income for an insurance company. Chubb is a bit buffered from that by their strong underwriting standards (they earn meaningful profits aside from interest), but the low interest environment still does negatively affect them.

Chubb’s policy of strong underwriting principles and an inflexibility with regards to lower premiums to capture market share leads to weakness in soft insurance markets, and leads to strength in stronger insurance markets. Basically the whole second half of the last decade was difficult for Chubb, but I believe that over the long term, their fortunes will improve. Their international expansion is good news, and I believe that Chubb will rebound as businesses become stronger. Over the long term (2+ years away), higher interest rates should act as a minor tailwind as well.

The good news to contrast the bad news of no premium growth, is that Chubb stock is basically priced for no growth. This company, which has grown its dividend every year for four-and-a-half consecutive decades and is among the most respected companies in the industry, has a P/E of under 12. This means that through dividends and share repurchases (and I’d prefer that ratio to lean more towards dividends), Chubb can still provide solid shareholder returns through dividend growth and stock price appreciation.

Overall, during a time when I am not finding very many great value opportunities on the market, I believe Chubb is a fair investment.

Risks

All companies face risk. Insurance companies are businesses about reducing risk and spreading it out, and they even insure their own operations against risk. Chubb faces the risk of a continued difficult global economy, as well as catastrophic losses, continued low interest rates, lack of premium growth, and currency risk. If their underwriting quality were to decrease, it would have a negative impact on profitability.

Insurance companies have little to no competitive advantages, or moats. Their insurance products are basically a commodity. What’s worse, is that customers often don’t get to appreciate the difference in quality of products until a claim is filed. Chubb specializes and has a great reputation in certain niches and is among the largest in its industry, which reduces risk, but it doesn’t provide a convincingly robust long-term competitive advantage in my view. Chubb is as good as its management is at any given time. Fortunately, the company has had a history of good management in my opinion, present management included.

Conclusion and Valuation

In conclusion, Chubb looks like a decent dividend growth investment at current prices. Management seems quite adept at investing and building value, but time will tell whether they can grow their market share, boost profits, and improve premiums earned. Chubb can grow its dividend and EPS despite static company-wide results due to its continual repurchasing of its own cheap shares. With a strong balance sheet, good earnings, prudent management, and growing dividends, this represents a good way to add some conservative financial exposure to a portfolio. The low P/E of under 12 combined with the strong financial condition of this business and their long history of consecutive dividend increases provides a little margin of safety.

Chubb was around $56/share last year when I wrote a positive analysis of it and called it a solid buy. Now that the market as a whole is offering fewer appealing investments in my view, Chubb’s increased stock valuation at $68/share makes it still decent, yet not quite as appealing as last year. I’m willing to buy at the current price of under $70/share.

Full Disclosure: At the time of this writing, I am long CB.
You can see my portfolio here.

If this article was valuable to you, consider subscribing to get my articles delivered to your email or reader.

Further reading:
Costco Wholesale (COST): Great Business, Mediocre Price
Hasbro (HAS) Might Be Undervalued
Chevron Corporation (CVX): Good Value or High Risk?
Automatic Data Processing (ADP) Dividend Stock Analysis
Illinois Tool Works (ITW) Dividend Stock Analysis

Summary

Costco Wholesale (COST) is a large membership warehouse retailer that sells a variety of bulk goods in several countries.

-Seven year average revenue growth: 9%
-Seven year average EPS growth: 8.6%
-Dividend Yield: 1.18%
-Dividend Growth Rate: 13%

Overall, I think Costco is a fantastic company, but at the current time, it’s fully valued with little or no margin of safety, and doesn’t offer a very appealing dividend yield.

Overview

Founded in 1983, Costco Wholesale (NASDAQ: COST) is a large warehouse-based retailer, primarily located throughout North America but with a presence in Europe and Asia as well.

With over 160,000 employees, Costco operates 598 warehouses. Of these, 433 are in the US and Puerto Rico, 82 are in Canada, 32 are in Mexico, 22 are in the UK, 11 are in Japan, 8 are in Taiwan, 7 are in Korea, and 3 are in Australia. In addition, Costco operates its large online retail site.

Category Sales

Costco warehouses offer various items, clothes, food, electronics, glasses, pharmacy drugs, gasoline, car-washes, and more. There are bulk items for cheap shopping, but there are select higher-end items.

Sundries (cleaning supplies, tobacco, alcohol, candy, snacks, etc.) accounted for 22% of 2011 sales.

Hardlines (electronics, hardware, office supplies, beauty supplies, furniture, garden, etc.) accounted for 17% of sales.

Food accounted for 21% of sales.

Softlines (clothing, housewares, small appliances, jewelry, etc.) accounted for 10% of sales.

Fresh food accounted for 12% of sales.

Ancillary and other (gas, pharmacy, food court, optical, etc.) accounted for 18% of sales. (This is their fastest growing segment, as they put more of these areas in newer Costcos.)

Revenue, Earnings, Cash Flow, and Margin

Costco has been growing revenue at an impressive rate, while earnings and cash flow have grown more slowly.

Revenue Growth

Over this period, revenue growth has averaged over 9% per year on average, which is excellent. The trailing twelve month period boasts over $91 billion in revenue.

Earnings Growth

Earnings growth has averaged 8.6% over this period, which is reasonable. It’s fairly unusual for a company to have faster revenue growth than EPS growth over this long of a period.

Cash Flow Growth

Over this period, operating cash flow grew by 6.2% annually, and free cash flow grew by 4.6% annually. These numbers where somewhat erratic; especially FCF which had a high year in 2004 which lowers the annualized growth calculation over the period. If FCF growth was calculated between 2005 and 2011 instead, the growth rate would have been nearly 16%. The “real” FCF growth rate lies between these numbers.

Metrics

Price to Earnings: 24
Price to Free Cash Flow: 20
Price to Book: 3
Return on Equity: 12.5%

Dividends

Costco currently has a 1.18% dividend yield with a payout ratio of slightly under 30%. The yield is fairly low despite the reasonable payout ratio because the company has a high P/E.

Dividend Growth

Costco began paying a dividend part of the way through 2004. Between 2005 and 2011, Costco grew the dividend by an average rate of nearly 13%.

Share Repurchases
In addition to returning value to shareholders in the form of dividends, Costco repurchases some of its shares. For example, in 2011, Costco spent $398 million on dividends to shareholders, but spent $624 million on net share repurchases. The same can be said for most recent years: Costco spent more on share repurchases than dividends every year from 2005 onwards, with the single exception of 2009. Of course, 2009 was the absolute best time to buy Costco stock, but that’s the year that Costco was pinching pennies instead of buying its stock as it was every other year. They bought stock high, but wouldn’t buy stock low, and this example perfectly highlights a primary critique of share repurchases among dividend investors.

Share repurchases make good supplementary purchases, but in my opinion, dividends should usually be the primary form of shareholder returns, especially for a stable business like Costco. Energy companies and tech companies at least have the viable excuse of being in cyclical industries, and so they have to keep payout ratios low. But with so much free cash flow generation, Costco could easily shift more towards dividends and less towards repurchases.

Balance Sheet

Costco has a total debt/equity ratio of under 0.20, and the interest ratio is over 20. The total debt load is only 1.5x annual net income. Since Costco doesn’t rely on acquisitions, goodwill is negligible. Overall, by every metric, Costco has an excellent balance sheet.

Investment Thesis

Costco’s business model is meant to maximize efficiency. The warehouse format keeps costs low, as they buy and sell items in bulk. Shoppers (both consumers and small business owners) pay membership fees, and in return receive exceptionally low prices. The warehouse model also generally operates moderately reduced hours compared to typical retailers. Although Costco offers a large range of products, they limit their selections in each category to only the best-selling ones, so the number of individual products is actually lower than many other retailers. This further streamlines their business.

Costco’s memberships keep customers loyal, and they have a high renewal rate. Costco can keep its prices reasonably competitive with Wal-Mart by maintaining such a low profit margin. The company gets most of its profit from membership fees (which they recently successfully increased by 10%), while its goods are sold at very low markups.

Growth

Each year in this snapshot, as well as in many previous years, Costco increased their number of warehouses, and saw an increase in both gold star members and business members. As of the most recent report, Coscto now has 598 warehouses. Costco management has the goal of operating 1000 warehouses by the next 10-12 years, and I think that target is a fairly conservative estimate.

In addition, Costco has been reporting consistent same-store sales growth. In general, as a given Costco exists longer, it gets more sales per year. A year or two after opening, an average Costco will bring in approximately $100 million in annual sales. After ten years, that average number is around $150 million. In fact, between 2010 and 2011, the number of Costco locations with over $200 million in sales jumped from 56 to 93. And, 4 of their Costco locations now bring in over $300 million in sales, including their #1 Costco which brings in an enormous $400+ million.

Despite Costco’s mild setback in 2009 due to the recession, Costco became the 3rd largest retailer in the US compared to its spot at 5th in 2008. It is the 9th largest retailer in the world.

Costco reports that its most recent warehouse openings in Japan, Taiwan, and Korea had record-breaking opening-day sales, and that the warehouse they opened in Australia was particularly well-received. The company expects these countries to be great places for continued expansion.

The Three Point Case for Bullishness

There are a few key things I want to highlight that, in my view, makes Costco not (quite) as overvalued as it seems.

1. FCF is solid. Costco is currently a business that generates more free cash flow than net income. It’s not as highly valued in terms of FCF as it is net income. DCF analysis with an estimated FCF growth rate of 5% going forward, and a 10% discount rate, gives me an intrinsic value of approximately $32 billion, compared to the current market cap of over $35 billion. Therefore, if the valuation were to decrease by 10%, I’d consider Costco fairly valued. If a lower discount rate is used, Costco is reasonably valued as-is, although without a margin of safety.

2. Revenue growth is outstanding. Most large businesses aren’t growing revenue at nearly the pace of Costco. Costco’s number of stores is growing, their number of members is growing, and they recently boosted membership fees by 10%, and it was well-accepted.

3. Low profit margins can mean eventual upside. Costco is currently sacrificing profitability for solid ethics and outstanding growth. Costco is a viable competitor to even Walmart, and yet has only existed since the 1980′s. The larger the revenue becomes, the more pricing power they have, and the denser their store locations get, the more efficient they become. I believe Costco will eventually reach a tipping point where net profit margins will improve.

Costco Vs. Walmart

From an investor standpoint, I liked Walmart (WMT) stock better than Costco stock (despite liking Costco better than Walmart as a business) until the recent 20% increase in Walmart stock from around $50/share to over $60/share. This pushed Walmart’s valuation from undervalued to fairly valued, in my view. Therefore, if I absolutely had to buy one or the other, I’d be buying Costco, and here’s why:

1. Costco completely outperforms Walmart’s comparable warehouse business, Sam’s Club. As of 2011, there were 609 Sam’s Clubs compared to 592 Costcos, Costco had 84 million square feet of retail space compared to 81 million for Sam’s Club, and yet Costco’s sales excluding membership fees were approximately $87 billion compared to Sam’s Clubs $49 billion. Costco is growing more quickly than Sam’s Club (the latter only grew the number of locations from 588 to 609 between 2007 and 2011), and at approximately the same size, Costco completely outshines Sam’s Club in terms of sales.

2. Costco’s balance sheet is far less leveraged than Walmart’s. Costco has a total debt/equity ratio of 0.2, interest coverage of 21, and practically no goodwill, compared to Walmart’s total debt/equity ratio of over 0.8, interest coverage ratio of 11, and goodwill of over $20 billion. They’re both fine balance sheets, but Costco could safely take on more leverage than Walmart currently can, since Walmart is already using more leverage. So far, Costco hasn’t needed much leverage to grow very quickly.

3. Costco has had consistent expansion internationally, and it’s likely only the tip of the iceberg. Their Canadian segment is strong, and their Australian presence recently began in 2009 and has had very good success so far. I expect that to be a very good long term opportunity for them. Both companies have solid international prospects, but Walmart is rather saturated in the US, and has had mixed success internationally, and relies partially on acquisitions for international growth, while Costco has grown organically and is far less saturated.

4. Walmart’s net profit margin is comfortably over 3% and I doubt it’ll go much higher (and may go lower), while Costco’s net profit margin is considerably below 2%. With even modest improvements in profit margin over time, I expect Costco’s EPS and FCF to eventually outpace sales growth.

5. Walmart trades at a lower P/E ratio, but a comparable P/FCF ratio, to Costco. Walmart has a larger dividend yield, and a longer dividend history.

I’m not rocking Walmart here; I even picked them for the Dividend Growth Index (before they jumped to $60/share). But the comparison, in my opinion, really helps to highlight Costco’s strengths.

Wrapping Up the Thesis

Overall, my opinion is that Costco has a great business model and is positioned to grow its business for the foreseeable future. Costco is one of my favorite examples of a moat-breaker. Walmart has the quintessential moat of scale; they have such massive purchasing power that translates into pricing power, that they can underprice their competition and attract more customers, in a viciously successful circle. To combat that, Costco has done three main things.

One, they have focused on having a rather small number of products, meaning they can divide their total purchasing power among fewer products, and therefore increase their purchasing power with those businesses. That’s a wise way to compete when you’re the smaller competitor. Offer fewer products, but offer them at unbeatable prices.

Two, they have maximized efficiency, and they have paid highly for employees to reduce turnover and build morale, and have therefore achieved superior sales per square foot.

Three, they have sacrificed net profit margins in order to compete on pricing power, and therefore have grown revenue at a very strong rate, which will pay literal and figurative dividends over time as they become a larger and larger rival.

Risks

Costco, like any other company, has risk. As a retailer, Costco is a middle-man, with limited pricing power, and the retail industry is incredibly competitive. Costco faces competition from warehouses like BJ’s and Sam’s Club (owned by Wal-Mart), general retailers like Wal-Mart, Target, and Kohls, as well as from other threats like Amazon. In addition, since the stock has a fairly high valuation, there is considerable risk of poor stock performance if Costco doesn’t continue to outperform as a company. One of Costco’s strengths is its free cash flow, which can be highly variable, and may decrease if the management team spends more. In addition, Costco’s CEO Jim Sinegal has retired from his position. The board and management team of Costco is very experienced, and Sinegal will remain on the board of directors for now, but it is still a transition to be aware of.

Conclusion and Valuation

Costco is a fantastic company in my view. Their growth is decent (and their revenue growth is excellent), their business model is very strong, and it’s a very well-respected business that is known for its integrity. I’d wager that an investor 20 years from now probably wouldn’t regret purchasing this stock at these prices, even though shares are rather pricey at the moment. That being said, I do think it’s fully valued with little or no margin of safety. I would not be inclined to pay more than around $72 for the stock. Writing long term puts near the current share price may be a reasonable way to enter a position at a lower cost basis.

Costco’s P/E of 24 and P/FCF of 20 represents a lot of justified optimism. When everyone knows an investment is going to work out; it’s generally too late to get great returns. There is a lot of expectation built into the price, so any long-term disappointment, or any major error in an investment thesis such as this one, can mean sub-par returns.

Excellent companies are worth paying up for, but there’s a limit, and currently Costco’s price is a bit more than I’d be willing to pay. If Costco stock were to drop back to the low $70s, I’d be interested in the stock even though it would still be a bit pricier than most of my portfolio holdings.

Full Disclosure: At the time of this writing, I have no position in COST.
You can see my portfolio here.

If this article was valuable to you, consider subscribing to get my articles delivered to your email or reader.

Further reading:
Hasbro (HAS) Might Be Undervalued
Chevron Corporation (CVX): Good Value or High Risk?
Automatic Data Processing (ADP) Dividend Stock Analysis
Illinois Tool Works (ITW) Dividend Stock Analysis
General Mills (GIS) Dividend Stock Analysis

Summary

Hasbro (HAS) is a major toy and game company with several powerful brands including Transformers, Nerf, G.I. Joe, My Little Pony, and Monopoly.

-Seven year revenue growth: 6%
-Seven year EPS growth: 16%
-Dividend Yield: 3.66%
-Dividend Growth Rate: 27%
-Balance Sheet Strength: Medium

With a P/E of 11.2, a P/FCF of 16.5, a dividend yield of 3.66%, an acceptable balance sheet, and good long term potential, I calculate Hasbro to currently be mildly or moderately undervalued.

Overview

Hasbro (NASDAQ: HAS) is among the largest toy and game companies in the world. Hasbro produces toys, games, and characters that lead to not only physical products, but movies, video games, and electronic media as well.

Major Brands:

Transformers
Avalon Hill
Wizards of the Coast (Magic the Gathering and other trading card games, Dungeons and Dragons and other role-playing games)
G.I. Joe
Playskool
Littlest Pet Shop
My Little Pony
Milton Bradley, Parker Brothers, and other games (Monopoly, Scrabble, Trivial Pursuit, Twister, Battleship, Candy Land, Operation, Cranium, Life, Jenga, Yahtzee, Clue, Risk, etc.)
Nerf
Tonka
Supersoaker

Hasbro is also involved in licensing their brands and characters to other companies, such as Electronic Arts and Universal Pictures, to produce further entertainment products.

The company operates in three main segments:

U.S. and Canada
This segment sells products to the United States and Canada, and accounted for 57% of revenue and 58% of operating profit, in 2010.

International
This segment sells products to many other countries. Hasbro is attempting to achieve strong growth in emerging markets. For 2010, this segment accounted for 39% of revenue and 35% of operating profit.

Licensing and Entertainment
This segment licenses Hasbro brands to television, movies, games, and various other media. The segment accounted for less than 4% of total revenue, and 7% of operating profit, for 2010.

Breaking down revenue in another way, 34% of revenue came from products marketed to boys, 32% came from games and puzzles, 21% came from products marketed to girls, and 13% came from products marketed towards preschool age children.

Revenue, Earnings, Cash Flow, and Metrics

Hasbro has experienced a fair amount of revenue growth over the last several years.

Revenue Growth

Over this seven year period, Hasbro has grown revenue by approximately 5% annually.

Earnings Growth

EPS growth for this period was over 16% annually. This is great, but don’t count on this level of growth for the future.

Cash Flow Growth

Cash flow growth has been flat over this period. In the last three years specifically, inventory, accounts receivable, and other changes in working capital have kept cash flows pretty low.

Metrics

Price to Earnings: 11.3
Price to FCF: 16.5
Price to Book: 2.6
Return on Equity: 24%

Dividends

Hasbro currently has a dividend yield of 3.66%, a solid dividend growth rate, and a payout ratio of around 40%.

Dividend Growth

Hasbro has grown the dividend by over 27% per year, on average, over this period. The most recent quarterly increase, in 2011, was from $0.25 per quarter to $0.30 per quarter, which is a 20% raise. Eventually, in order to keep the payout ratio static, the dividend growth rate will have to slow down to match earnings or FCF growth rates.

Over the last several years, the company has spent more money on net share repurchases than on dividends. In the first three reported quarters of 2011, for instance, the company spent three times as much money on share repurchases as they did on dividends. Shares outstanding have decreased from 204 million in 2004 to 139 million currently. I find share repurchases acceptable compliments to dividends, and based on my view of the intrinsic value for the shares, I do view this as value creation instead of value destruction, but I don’t like to see this much being spent on repurchases compared to dividends.

Balance Sheet

Hasbro has a fairly mediocre balance sheet. The total debt to equity ratio is 1.02, which is a bit high. About a third of shareholder equity consists of goodwill, which is fine. The interest coverage ratio is between 6 and 7, which is a bit low for my tastes. Total debt/income is approximately 4.

Hasbro was improving its balance sheet until 2007, when the company began taking on more debt. From 2008 to 2010, the total debt basically doubled, and it’s been rather flat from 2010 to 2011. I’d rather see an improving balance sheet than a worsening one. Overall, Hasbro’s balance sheet is safe, but it’s not as clean as I would like. They’re using some substantial leverage.

It’s interesting that the debt increase and the amount of share repurchases over these two years, is approximately equivalent. Hasbro isn’t borrowing because they need to; if they weren’t buying back shares, they could have kept debt levels static. Based on my calculated intrinsic value of the shares, the share repurchases likely do result in a higher rate of return than the interest on debt used to buy them, but I view it as an unnecessary degree of leverage.

Investment Thesis

Hasbro is more than just a toy company; it’s a brand company. Hasbro has many memorable brands which have lasted through generations and which can be converted to various media. This is why, according to management, they put brands at the center of their business model. By strengthening the core brands, Hasbro is setting up substantial, long-lasting sources of cash flow that can withstand all sorts of technology and generational shifts through time. Their games can be played on physical boards or digital boards. Their characters can be sold as action figures or in movies. Hasbro can deliver their brands across various platforms, and all of it complements itself. It builds a cycle of toys selling movies, movies selling video games, and video games and movies selling more toys. Hasbro spends approximately $200 million on research and development, and over $400 million on advertising, per year.

Transformers in particular is a very powerful brand. In 2009, that segment alone brought in nearly $600 million in revenue. This is cyclical depending on whether it’s a year for a blockbuster movie release or not. Nerf has recently been a very strong brand as well, with over $400 million in revenue in 2010.

Hasbro has not only their own ideas to benefit from, but ideas from others as well. The company makes strategic partnerships with companies like LucasFilms, Marvel, and Sesame Workshop to ensure that it is delivering the characters and entertainment that people of various ages want.

A key concern among investors, I believe, is whether Hasbro will continue to perform well in an increasingly digital age, or whether its toys will become less popular over time. This year is reported to have disappointing, but decent, holiday sales. When I analyzed Hasbro a year ago, the stock price was in the mid-$40′s, and I said it seems reasonably valued but without a margin of safety. It has since fallen to the low $30′s, and I believe it may be undervalued. I drop of this magnitude surprises me. I believe there may be too much pessimism regarding Hasbro’s future ability to adapt.

An increasingly digital age is a genuine concern, but I don’t believe kids will stop playing with Nerf guns, will stop playing with girl dolls, will stop playing trading card games, will stop with board games, and so forth. Hasbro will indeed have to make sure it keeps up with the times by licensing their content on as many digital mediums as possible (and they have been; the strategy of viewing themselves as a brand company is key), but if there becomes a time when people spend 100% of their time in front of screens instead of running around outdoors or playing with toys, then I’d have more to worry about than Hasbro, and Hasbro would have a share of that screen time anyway. This is, however, a trend to be aware of when investing.

To combat this, Hasbro’s brand strategy has meant going on several mediums. For instance, Hasbro has a joint venture with Discovery Communications for a television channel called “The Hub”, where they license their own characters as well as third-party entertainment. The Hub accounts for nearly 10% of Hasbro assets, but this venture currently operates at a loss of several million dollars per year. It’s not a huge impact on the income statement, but it ties up capital that could be spent elsewhere. It’s possible that toy sales that occurred due to channel content offset the small losses. The company also licenses its popular board games for mobile content.

It’s worthwhile to note that there’s a movie based on Hasbro’s game Battleship coming out in 2012 with a $200 million budget. It could prove successful, or it could be a disappointment. Hasbro has a deal with Universal Pictures to license at least three movies, and the success of these movies like Battleship might be a key indicator of Hasbro’s ability to monetize its brands with licenses and royalties. I’m somewhat skeptical of its chances of great performance, but then again, I’m not particularly the target audience for the film so I’m perhaps not the best judge. Hasbro also benefits when Marvel and other businesses release outperforming movies, since they can result in strong toy sales.

A last bit regarding the thesis: it’s not out of the question that Hasbro could eventually be bought out, with its market cap of a bit over $4 billion and its attractive collection of intellectual property. I wouldn’t count on this for investment purposes, however. It’s better to invest on numbers than on speculation, in my view.

Risks

Hasbro faces currency risk and commodity cost risk. The company is also reliant upon strategic partnership with both companies that they pay royalties to (such as Marvel), and companies that they license their brands to (such as Universal Pictures). These relationships are extremely important to Hasbro both financially and for the strength of their brands.

In addition, certain brands such as Transformers or Nerf make up large shares of total revenue, so the continued profitability of these brands will have an influence over total Hasbro profitability. It’s hard to say how long transformers will remain this popular; their trilogy of movies has been immensely successful, and there is discussion for more, but I’m not sure how long that can continue successfully. I’d prefer to estimate cautiously in that regard.

Also, retail has become increasingly corporate and consolidated for a while now, and Hasbro’s three largest customers, Walmart, Target, and Toys R Us, account for 23%, 12%, and 11% of Hasbro revenue these days. They collectively account for over 50% of total Hasbro revenue, and more than two-thirds of revenue in the US/Canada segment.

The longer term risk is the estimation regarding how well Hasbro products will sell in an increasingly digital age, and the extent of the digital media pie that they can capture and hold.

Conclusion and Valuation

The increase in debt and the low cash flows over the last few years worry me a bit. I do think the business model is strong, that their products (both physical and digital) will be around for a while, and that they have good global expansion prospects.

A discounted cash flow analysis for Hasbro proves tricky, because both operating and free cash flows have been weak over the last three years. If I use the current low figure of free cash flow, assume a 4% annual growth rate and utilize an 11% discount rate, and then add in the present value of the lesser of either tangible book value or cash (which is cash), I calculate an intrinsic value for the company of only $4 billion. The sum of free cash flows between 2006 and 2010 is roughly equal to net income over those same years, so if I go by that longer trend and assume free cash flow rebounds to higher levels, then the discounted cash flow analysis with the same growth and discount rates results in an intrinsic value calculation of between $5 billion and $6 billion. Overall, since the current market cap is around $4.3 billion, and I believe Hasbro is currently reasonably well positioned, I consider Hasbro to be mildly undervalued, and find the stock price reasonably attractive under about $35/share.

Full Disclosure: At the time of this writing, I have no position in HAS.
You can see my portfolio here.

If this article was valuable to you, consider subscribing to get my articles delivered to your email or reader.

Further reading:
Chevron Corporation (CVX) Dividend Stock Analysis
Automatic Data Processing (ADP) Dividend Stock Analysis
Illinois Tool Works (ITW) Dividend Stock Analysis
General Mills (GIS) Dividend Stock Analysis
McCormick (MKC) Dividend Stock Analysis

Summary

Chevron (CVX) is a leading energy company involved in crude oil, natural gas, and other energy production.

-Seven Year Revenue Growth: 7%
-Seven Year EPS Growth: 11.4%
-Dividend Yield: 3.03%
-Seven Year Dividend Growth: 10.5%
-Balance Sheet: Excellent

Overall, with a strong balance sheet, solid operations, a low valuation, but taking into account vulnerability to the volatile nature of oil prices and litigation risk, I find Chevron to be an acceptable buy at current prices in the low $100′s.

Overview

Founded in 1879, Chevron (NYSE: CVX) is currently one of the largest oil and gas companies in the world.

In 2010, Chevron reported a net production of 1.923 million barrels of crude oil and natural gas liquids and 5.040 billion cubic feet of natural gas per day. Overall, 2010 production was up to 2.763 million oil-equivalent barrels from 2.704 in 2009, a 2.2% increase. Over the same period, net proved reserves of oil and gas liquids, and natural gas decreased 7.4% and 6.3% respectively.

Businesses

Chevron is divided into a number of different businesses. Some of them are directly profitable while others are supplementary to meeting Chevron’s needs.

For 2010, $17.677 billion in income as attributed to upstream operations, $2.478 billion in income was attributed to downstream operations, and ($1.131 billion) was attributed to All Other. So upstream income was more than seven times downstream income. Even among supermajor oil companies, Chevron is particularly focused on upstream projects and therefore is most directly linked to the price of these resources.

Oil Exploration

Chevron extracts oil from locations around the world, including from deepwater wells in the Gulf of Mexico and off of other coasts such as Brazil, from offshore wells in Europe and other locations, and on land from California, Africa, Kazakhstan, and other places, and oil sands operations in Canada.

Natural Gas Exploration

Chevron’s natural gas portfolio stretches across six continents. Chevron has the ability to transport natural gas from production locations to user locations by means of pipelines, liquefied natural gas (LNG), and gas-to-liquid (GTL) technology.

Refining

Chevron has the capability to turn its basic produced resources into finished materials ready for use. Seven refineries make up three-quarters of Chevron’s total fuel refining capability.

Supply and Trading

Chevron’s requirements to get materials from upstream projects to downstream projects is huge. Chevron has to develop and maintain logistics and partners to get products to where they need to be safely and for a low cost. For instance, Chevron markets aviation fuel at more than 875 airports and is the leading marketer of jet fuels in the US.

Marketing

Chevron operates the three brands of Chevron, Texaco, and Caltex to drivers across the world.

Pipelines

Chevron operates and invests in pipelines around the world. Significant projects are located in North America, Asia, and Africa.

Lubricants

Chevron markets lubricants on six continents.

Shipping

Headquarted in California, Chevron Shipping commissioned their first ship in 1895 and now ships crude oil, liquefied gas, and refined products to customers globally.

Chemicals

Chevron’s chemical products are incredibly diverse, with uses in food packaging, electronics, to medicine.

Mining

Chevron operates three coal mines and a Molybdenum mine in the US.

Power

Chevron’s produces gigawatts of power. Much of the power is derived from natural gas, while some is from wind. Chevron is the largest producer of geothermal energy in the world.

Technology

Chevron invests in emerging energy opportunities including solar projects, hydrogen projects, and bio-fuels products.

Revenue and Earnings

Chevron’s growth was strong until 2009 when the effects from the global recession took a significant chunk out of the revenues and profits of all big oil companies. Growth has since rebounded, but weakness is currently estimated for 2012.

Revenue Growth

Please note that the revenue figure for 2011, and most other 2011 figures in this report, are estimated. The first three quarters for 2011 are reported, and the fourth quarter is based on analyst estimates, so there could be slight overall variance. Revenue over this seven year period grew by 7% per year annualized.

Earnings Growth

Earnings growth over this seven-year time period has averaged 11.4%, but has been highly erratic. EPS is estimated by analysts to be slightly lower next year.

Metrics

Price to Earnings: 7.9
Price to Free Cash Flow: 13.6
Price to Book: 1.8
Return on Equity: 22%

Dividends

Chevron has increased its dividend every year for two and half decades straight, currently yields 3.03%, and has a dividend payout ratio from earnings of only about 25%.

Dividend Growth

Chevron has grown its dividend by a 10.5% annualized rate over this period. It’s pretty nice to have dividend income double in a seven year period (and double more quickly if the dividends are reinvested).

It’s worth noting that Chevron increased its dividend not once, but twice this past year. The company increased the quarterly payout from $0.72 to $0.78, but after two quarters of paying $0.78, they increased the quarterly amount to $0.81.

Balance Sheet

Chevron is approximately tied with Exxon Mobil (XOM) as having the strongest integrated oil balance sheet. Total debt/equity is only 0.8, and the interest expense is negligible. Goodwill is nearly nonexistent on the balance sheet. Annual net income exceeds total debt by 2-3 times. Practically flawless.

Investment Thesis

Energy companies like Chevron face a changing world. Their proven energy reserves are huge, but finite, and increasing environmental concerns and backlash, along with increasingly cost-efficient alternative energy solutions are significant trends to be aware of. Chevron’s quantity of proved reserves has been flat to down over the last several years. Hydrocarbons are still among the most efficient energy sources, since the energy source consists basically of solar energy captured over long periods of time into energy-dense forms, but oil companies find themselves going to more costly methods to get oil, such as through capital intensive deep-sea drilling, or extracting it from oil sands over vast amounts of land in Canada. Chevron in particular specializes in deep-sea drilling.

Liquid Natural Gas (LNG) also plays a role in Chevron’s business. Natural gas uses up a lot of volume per unit of energy, and this is acceptable for pipelines, but to transport it to places without pipeline access is not cost effective. Chevron and other companies can now compress it into liquid form, ship it anywhere they want via specialized insulated ships, and then return it to its gas form on arrival. The Australian Gorgon LNG project is a significant development project.

Chevron acquired Atlas Energy, Inc. in 2011. The company now has access to the Marcellus shale; a very large U.S. reserve of natural gas.

Chevron Energy Solutions is a unit of Chevron that focuses on providing renewable power sources and maximizing energy efficiency for its clients. The size of their projects range from $1 million to over $100 million, and they are the largest installer of solar panels for educational facilities in the US as well as one of the largest developers of solar photovoltaic projects in California. Chevron is also the largest producer of geothermal energy in the world.

Although these alternative energy businesses are respectable, and their projects are valuable, they’re drops in the ocean of oil that is Chevron. Fossil fuels are where their money comes from. But, energy companies are aware of changing trends and the usefulness of a variety of energy sources. Big Oil companies are not just oil companies, but also some of the largest and most profitable corporations on the planet that employ an incredible number of scientists and engineers. The combination of enormous amounts of capital and technical prowess provides Chevron and similar companies the chance to grasp opportunities when presented with them. They’ve been undergoing shifts towards profitable natural gas growth, and can make other shifts as needed.

Over the last decade, Chevron has rapidly grown its asset base. The following table shows Chevron’s increasing company book value over the last seven years.

Expansion

Shareholder Equity has grown by an average of 15% annually over this seven-year period. The company has reduced debt totals and substantially increased asset totals.

Risks

Every company has risks, and big oil companies certainly have their fair share of them. Chevron faces uncertainty in terms of currencies, geopolitics, litigation, and regulation. Litigation is an ever-present risk due to the large scale that a company like Chevron operates at and the drastic effects they have, some for better and some for worse, on communities around the world. I’ve personally known people from several countries that have described first hand the kind of damage the world’s need for energy has caused their communities.

The primary risk for the business is that of changing oil prices, which are outside of Chevron’s control and have the largest impact on their profitability. Chevron is even more susceptible to changing oil prices than its peers. Refining margins are volatile and can affect downstream profitability substantially in a given year. In addition, not too long ago, BP reminded investors of yet another risk that is always present in this type of company: catastrophic failures.

A long-term risk to be aware of is reserve management. Oil majors have to maintain or increase proved energy reserves over the long term if they expect to continue to grow in production and profitability. It’s worth watching for multi-year trends, since oil and other fossil fuels are rather finite.

Ecuadorean Litigation
The largest and most public litigation against Chevron is from Ecuador. Texaco is charged with spilling a share of millions of gallons of oil, and dumping a share of billions of gallons of toxic waste into the Ecuadorean Amazon rainforest in the 1960′s, 1970′s, 1980′s, and 1990′s. Texaco became part of Chevron ten years ago, so Chevron has inherited this old and sustained litigation. There have been back and forth legal battles; plaintiffs claim tremendous damage has been done and is still present, Chevron claims it paid millions of dollars that supposedly cleaned it up. More specifically, Chevron also points out that Texaco was only one of the operators involved (the other being Petroecuador), and that Texaco remediated its part of production. Ecuador originally imposed a nearly $9 billion fine, but has recently doubled it to over $18 billion. A US court has upheld the fine, but the litigation continues. There have been reports of bribes, conflicts of interest, and the enormity of the mess is nearly unprecedented.

Brazilian Litigation
In late 2011, Chevron, along with everyone’s favorite offshore drilling contractor Transocean, were involved in an oil spill of thousands of barrels off of the Brazilian coast. Brazilian plaintiffs are currently seeking over $10 billion in damages. This is a potential risk, but I think that compared to the scale of the Ecuadorian damage, risk from major financial loss is larger from Ecuador than Brazil by a substantial margin. Billions of dollars for thousands of barrels isn’t typical.

In a more recent even, just days old, there has been a large fire on a Nigerian offshore drilling rig. The extent of effects are not currently known.

Comments on Litigation
There are a couple points to make regarding these.

The first is that these are the types of problems associated with oil. These types of energy sources often damage land, air, and water, so efforts to shift any political or environmental discussion purely towards the effects of carbon emissions detracts from these issues. Problems with hydrocarbons aren’t just on paper; they affect real lives all the time. Behind all the “We Agree” campaigns and solar installations is this reality. Events such as these cause not only tangible financial risk, but less tangible potential regulation changes down the road from all countries in which Chevron and other businesses operate.

The second is that Chevron is a legal giant. In terms of damages sought, we could compare these to some large examples: the 1989 Exxon Valdez spill in Alaska, and the 2010 BP spill in the Gulf of Mexico. Exxon Mobil dragged litigation on for decades and although it has paid out billions, the awards were reduced and spread out through cleaning costs and fines. BP ended up getting hit very hard financially for their spill, but this had a few key points. One was that it was one of the largest oil spills ever. Only a few have ever been larger, and most of those were attributed to Iraqi forces purposely burning unfathomable amounts of oil in Kuwait during the Gulf War. The second was that BP’s spill affected primarily people from a highly publicized developed country, and shown center-stage on television for months. With Chevron’s litigation concerning Ecuadorian environmental damage from decades ago, I’m more inclined to expect it’ll play out more similarly to the Exxon Valdez oil spill litigation. But we’ll see; the world has a different view towards environmental concerns than it did in the 1980′s.

Let’s suppose it’s a worst case scenario for Chevron, which might be where justice is. Let’s say they get hit with $20 billion worth of fines and legal fees for Ecuador and another $10 billion from Brazil (however unlikely); how large of a quantitative impact would this have on the company? Chevron has over $200 billion in assets, including over $20 billion in cash and other liquid funds. As previously described, the balance sheet is excellent. As for profitability, Chevron brought in $40 billion worth of cash flow over the past 12 months alone, and over $15 billion was free cash flow. Suppose after getting hit with $30 billion in litigation liabilities, they pay out $10 billion with cash and put the other $20 billion on as debt. Their total debt/equity ratio would increase to around 0.35. This would still be a strong balance sheet; comparable to the balance sheet of ConocoPhillips (COP).

So while the Ecuadorian and Brazilian litigation may be playing a part in Chevron’s lower valuation than COP or XOM, it’s something that the company could absorb (although it would be a major financial loss), and more likely may just continue to legally battle and delay. It’s no surprise that credit rating agencies aren’t particularly concerned with Chevron and have a high credit rating assigned to the company. There are certainly risks associated with Chevron, including litigation risks, regulation risks, and oil price risk, but as part of a diversified portfolio, Chevron’s risks are acceptable in my view.

Conclusion and Valuation

In my last Chevron analysis from 15 months ago when the stock price was in the low $80′s, I wrote that Chevron may be poised to offer investors a significant opportunity, and considered it a buy. After volatile upward movement, the stock is currently well over $100, although the valuation is lower than it was at that time. I’d caution, however, that there is likely less upside at this point, since oil prices have rebounded to substantial levels. Cyclical businesses sometimes have high P/E ratios during market bottoms and tend to have lower valuations during market tops, which can be counter-intuitive, as investors try to take into account the future.

I do think, however, that Chevron is currently a decent buy. I don’t consider it an extremely strong buy based on what its P/E of 8 might imply at first glance, but I do still think it would make a good long term investment at the current price. Litigation risks and relatively high current oil prices probably mean that Chevron’s valuation will stay low for a while. The low valuation, in my view, reasonably takes into account a potential reduction in oil prices or potential financial loss from litigation, as well as the industry-typical issue of having large capital expenditures (and therefore limited free cash flow). If Chevron had an earnings multiple equal to COP, it would be trading at $120/share right now. For investors looking for years of business growth, dividend growth, dividend reinvestment at a low earnings multiple, and solid total returns, I think Chevron can be a way to go. It’s important to factor in conservative oil prices, and make room for litigation problems, in order to have a margin of safety.

Full Disclosure: At the time of this writing, I own shares of CVX and XOM.
You can see my portfolio here.

If this article was valuable to you, consider subscribing to get my articles delivered to your email or reader.

Further reading:
Automatic Data Processing (ADP) Dividend Stock Analysis
Illinois Tool Works (ITW) Dividend Stock Analysis
General Mills (GIS) Dividend Stock Analysis
McCormick (MKC) Dividend Stock Analysis
International Business Machines (IBM) Dividend Stock Analysis

Summary

Automatic Data Processing (ADP) is a conservatively managed, diversified company that has increased its dividend every year for over 3 decades.

-Five year revenue growth: 2%
-Five year EPS growth: negative
-Five year cash flow growth: negative
-Dividend yield: 2.88%
-Dividend growth: 13%
-Balance Sheet: Perfect

Overall, I consider ADP to be somewhat expensive at the current price. There are, however, some positives that ADP likely has in its favor that are probably accounted for in its current stock valuation. For those interested in buying ADP as a defensive dividend grower, it would be prudent, in my view, to look for dips rather than to buy at the current price.

Overview

Automatic Data Processing (ADP) is one of the world’s largest outsourcing companies. ADP handles human resource needs, benefits, payroll, and computing processes for many companies around the world. They prepare employee payroll checks, direct deposits, and tax reports. They capture, calculate, and record employee time and attendance. They perform hiring services. They provide record-keeping and administrative services for retirement plans.

ADP also assists companies in certain industries with computing needs. For client businesses that sell cars, boats, are involved with heavy trucking, or similar fields, ADP can supply important software to help the business operate, from inventory, to networking, to data integration.

Revenue, Earnings, Cash Flow, and Margins

ADP has had slow business growth over the past several years, but nonetheless remains strong.

Revenue Growth

Revenue growth over this period has averaged only a bit over 2% annually, which is a rather slow pace. A positive note is that although growth was largely flat or down for the first half of this time period, revenue did grow by over 10% between 2010 and 2011. Revenue over the latest trailing twelve month period has breached $10 billion.

Earnings Growth

EPS growth has been erratic, and overall, negative during this period. Even over a full 10 year period, EPS growth has only averaged around 4% annually. Analysts have estimated high single-digit EPS growth for 2012 and 2013.

Operating Cash Flow Growth

ADP has had negative cash flow growth over this period as well.

Metrics

Price to Earnings: 21
Price to FCF: 19
Price to Book: 4.5
Return on Equity: 21%

Dividend Growth

ADP has paid growing dividends for over 3 decades. The current yield has slipped under 3% to only 2.88%, and the payout ratio is a bit over 60%.

Dividend Growth

Over the past 5 years, ADP has grown its dividend by an average of 13.4% annually, which is solid. The most recent quarterly increase at the end of 2011 was a bit under 10%. The dividend payout ratio, with respect to earnings, has been increasing. Over the long term, dividend growth must eventually slow down to the level of EPS growth (or EPS growth must accelerate), since the payout ratio cannot comfortably exceed past a certain point.

Share Repurchases

ADP has been spending more money on share repurchases than on dividends. For the three years of 2009, 2010, and 2011, ADP has paid out approximately $2 billion in dividends, and has spent slightly over $2 billion on net share repurchases. This has resulted in decreasing the number of shares outstanding by a bit over 5% over those three years. Before the recession, ADP was regularly spending at least twice the amount of money on share repurchases as on dividends. Over ten years, the number of shares outstanding has decreased from approximately 630 million to 490 million. The amount of money spent on dividends and share repurchases each year exceeds earnings, and approximately matches free cash flow over the long term. However, with a P/E of 21, I find that share repurchases are not the best use of returns for shareholders; the rate of return just isn’t particularly high.

Balance Sheet

ADP’s balance sheet is very, very strong. Total debt/equity is practically zero, and the interest coverage ratio is therefore practically infinite. However, approximately 50% of the shareholder equity consists of goodwill, but this isn’t a problem. ADP is one of only four non-financial US companies that currently hold a perfect AAA credit rating from the top rating agencies. (The other three are Exxon Mobil (XOM), Johnson and Johnson (JNJ), and Microsoft (MSFT), and as a disclosure, I own all three.) Rating agencies have received criticism for having been rather useless with regards to the financial collapse, but looking at ADP’s balance sheet, it’s rather clear why they receive the rating they do. The business has diverse revenue and income streams, practically zero debt, a large and defensive business that can withstand a major recession, etc.

Investment Thesis

When I analyzed ADP a year and a half ago, it was trading at slightly above $40/share, and I wrote that it was attractively priced. It has since gone up to $55, which may be great for short term investors who could have made basically a 40% rate of return over that period, but for longer term investors, I believe that means ADP is somewhat overvalued now. EPS has not grown at that rate, and therefore the P/E is higher, the dividend yield is lower.

However, it’s a great business, and I haven’t published an analysis on it for a year and a half, so it’s worth watching the company for dips. As explained below in the catalyst section, there is a case for optimism in terms of future growth that justifies at least a part of the current premium stock valuation, although I still propose that it’s overly expensive at the current price if one desires good returns.

There are a number of things that could be said for ADP’s strong market position. Although the company does have competitors, they’re not on the same scale as ADP. Their largest competitor is Paychex (PAYX), which has revenue of approximately one-fifth of ADP. Since ADP offers services that are so essential, so widespread, and go so deeply into a business, the company’s services have very high switching costs. For a business to switch a big segment of its human resources, payroll, and administrative components, it would be a significant expense and hassle. This is why the average client stays with ADP for over 10 years. Lastly, their strong balance sheet allows them to weather nearly any financial difficulty.

The company has over a half-million clients, and none of the larger ones account for even 2% of revenue each. In addition, the business has been expanding successful internationally. For instance, ADP’s “GlobalView” service had 105 multinational/global client contracts that account for nearly 1 million employees total.

Catalyst for Growth: Interest Rates
The recession has had more than the obvious effect on ADP. Apart from facing the same economic downturns as everyone else (and handling them defensively with their essential and widespread services), the company has faced the problem of low interest rates. Unlike other companies that use debt and therefore benefit from low interest rates, ADP would prefer higher interest rates for growth.

This is because ADP holds an enormous amount of client funds that they use for payroll and other functions. The result is similar to an insurance company, where an insurance company collects premiums, pays out claims, and uses that float, that collection of billions of dollars, to invest in income-producing assets from which get to keep the income. As of 2011, ADP holds nearly $17 billion in client funds, uses those funds for client purposes, but gets to keep the investment income that comes from those funds. Of course, ADP is conservatively managed and must keep these funds safe, so they invest in AAA/AA investments that produce a reliable, but low-return investment income. Due to the recession, interest rates have been held artificially low for an abnormal amount of time, which has affected ADP’s interest income.

Interest rates play a large role in ADP profitability. In 2011, the company reported $540 million in interest income. This fell slightly from 2010 levels of $543 million, because although their base of client funds grew by 11%, interest rates on their investments fell from 3.6% to 3.2%. The interest rate was 4.0% in 2009, 4.4% in 2008, 4.5% in 2007, and 4.1% in 2006. The following chart presents the information more clearly.

This is an important chart, because it helps to show a part of ADP’s “real” growth as compared to their reported income growth, which has been negatively affected by reduced interest rates. In addition to other metrics of growth such as number of clients, number of employees served, total revenue growth, and more, funds held for clients is a rather important metric of continued business growth and expansion for ADP. The amount of funds held grew by almost 4.5% annually over this period, on average, but reduced interest rates have kept interest income flat. ADP defends against interest rate changes by laddering the expiration of their investments, but as the interest rates have been held low for so long, ADP has had to continually reinvest the funds into lower-return investments.

Interest income only accounts for a small portion of revenue. Out of $9,880 million in 2011 revenue, interest from client funds was only $540 million, or less than 5.5%. However, total net income for 2011 was $1,254 million, so a major change of a couple hundred million dollars in total interest income has a considerable effect on net income and EPS results. This is part of the reason that ADP growth looks so slow; interest rates have been affecting their income and margins even as the business continues to grow. If a 4.0% interest rate were fixed onto the 2011 figure for client funds instead of the actual 3.2% figure, it would have boosted 2011 reported net income by $135 million, or more than 10%. If a 4.5% interest rate were fixed onto the 2011 figure for client funds, it would have boosted 2011 reported net income by $220 million, or over 17%.

Over time, interest rates will increase eventually, and this should act as a tailwind, rather than the headwind that it has been, for ADP’s reported net income and EPS. I believe that optimism of the current valuation is taking this into account, although interest rates will likely stay low for quite some time and even with generous interest rates factored in, the valuation is still a bit expensive in my opinion.

Risks

ADP is a very defensive, diverse, business. They do have a bit of concentration with auto dealers, and ADP in general is susceptible to global economic downturns. If there are high numbers of closing businesses in tough economic environments (which is more likely among their smaller clients), then ADP’s growth and profitability get impacted. Plus as with all large businesses, ADP has regulatory risk and some currency risk. Low interest rates, as previously described, can be a problem as far as net income is concerned. I believe most of the risk associated with the stock, at the current time, has more to do with the valuation than the underlying fundamental business. Slow business growth is a concern (even when taking into account the previous and current interest rate changes), as slow business growth can fundamentally impact stock valuation.

Conclusion and Valuation

In conclusion, I think ADP is a bit expensive, although I think there are more positives for the company than one might expect by looking at previous growth history alone. Based on the rather slow growth (with the potential for improved moderate growth ahead over the long term), and based on the excellent balance sheet and defensive nature of the business, I think ADP would be a decent buy at around $45 or so per share. Writing puts at a strike price of $48 for January 2013 with an intention of buying the stock should the option be assigned might be an acceptable use of capital for those looking to enter a position. Or, one could invest elsewhere for the time being and look to buy ADP on market weakness, if one were so inclined. The current $55 stock price seems to me to be too expensive; I’d hold at the current price if I owned ADP but wouldn’t buy.

Full Disclosure: I have no position in ADP at the time of this writing.
You can see my portfolio here.

If this article was valuable to you, consider subscribing to get my articles delivered to your email or reader.

Further reading:
Illinois Tool Works (ITW) Dividend Stock Analysis
General Mills (GIS) Dividend Stock Analysis
McCormick (MKC) Dividend Stock Analysis
International Business Machines (IBM) Dividend Stock Analysis
Diageo (DEO) Dividend Stock Analysis

Summary

Illinois Tool Works, Inc. is a decentralized and diverse collection of manufacturing businesses that has been in business for nearly 100 years and has paid consecutively growing dividends for more than four straight decades.

-Revenue Growth: 4.8%
-Earnings Growth: 5.8%
-Dividend Growth: 13% (slowing)
-Current Dividend Yield: 3.01%
-Balance Sheet Strength: Strong

Overall, with a P/E of 12, a strong balance sheet, and good growth and dividend history, I consider ITW to be a reasonable buy at the current price of a bit under $48. However, I do not consider it to have a substantial economic moat, it is rather cyclical, and the dividend growth has slowed considerably over the last few years. I believe it would do well as a cyclical choice in a dividend growth portfolio to get sector diversification. The charts below use the trailing twelve month period as a proxy for “2011″.

Overview

Illinois Tool Works, Inc. (NYSE: ITW), was founded nearly 100 years ago, has over 60,000 employees, thousands of patents, and operates as a decentralized and diverse collection of manufacturing and industrial businesses. The company’s focus is on intelligent acquisitions, where it can add to its collection of businesses that each operate as fairly small, streamlined businesses but share the corporate structure of ITW and therefore have risk protection.

In 2010, revenue came from the following business segments:
Transportation: $2.53 billion
Industrial Packaging: $2.28 billion
Power Systems and Electronics: $1.94 billion
Food Equipment: $1.87 billion
Construction Products: $1.76 billion
Polymers and Fluids: $1.36 billion
Decorative Surfaces: $1.01 billion
All Other: $3.22 billion

Geographically, 48% of revenue comes from North America, 32% comes for Europe, the Middle East, and Africa, and 20% comes from Asia Pacific and Other.

Revenue, Earnings, Cash Flow, and Metrics

ITW is rather cyclical, but has grown solidly over the decades. It was deeply impacted by, but remained profitable during, and has rebounded from, this large recession and financial crisis.

Revenue Growth

Revenue growth over this period was cyclical, but averaged over 4.8% annually, on average. The 2011 figure is not issued yet, so a proxy of the trailing twelve month period was used in its place.

Earnings Growth

Earnings were highly cyclical, dipping substantial during the recession. Over this period, EPS grew by an annualized rate of 5.8%.

Operating Cash Flow Growth

Cash flow growth was negative during this period.

Metrics

Price to Earnings: 12.1
Price to FCF: 13.8
Price to Book: 2.3
Return on Equity: 19%

Dividends

ITW has increased its dividend every year for more than four decades. The current dividend yield is approximately 3%, and the payout ratio is rather low, at around 35%. A rather cyclical company needs to keep its payout ratio on the lower end if it expects to increase the dividend through recessions. Additional capital in good years can be sent to shareholders through either a special dividend or share repurchases, and ITW chooses the latter.

Dividend Growth

The dividend grew by 13% annually over this period. Most of the dividend growth was before the recession. Throughout the recession, ITW held its dividend constant at $0.31 per quarter for eight consecutive quarters. However, the calendar spacing of these dividends means that ITW didn’t actually miss a year of dividend growth, even though practically, they basically did. The company increased its quarterly dividend by a bit under 10% in mid-2010, and only increased it by a bit under 6% in mid-2011.

ITW performs significant share repurchases. For example, over the last 12 months, ITW spent slightly more capital on net share repurchases than it did on dividends. A total of 72% of net income, or 85% of operating cash flow, was spent on a combination of dividends and net share repurchases over this period. During peak years, capital spent on net share repurchases can exceed three times the capital spent on dividends. They’re buying the most shares, therefore, when prices are highest. Share repurchases are fine in moderation, but I think it would be better for ITW to pay out an annual special dividend to give back some excess capital to shareholders in the form of more dividends. Let the investors decide whether or not to reinvest their capital at those peak prices.

Balance Sheet

Total debt/equity is under 0.5, which is rather strong. The total debt is equal to 2.2x current net income. The interest coverage ratio is nearly 15, which again, is quite strong. Despite being a company that makes significant acquisitions, goodwill only accounts for approximately 50% of shareholder equity. I’d rate ITW’s balance sheet as surprisingly strong.

Investing Thesis

ITW has a business model that is unusual for most companies of a similar size ($23 billion market cap), but not uncommon among large manufacturers. The company is highly decentralized and most growth is due to acquisitions. The company operates as basically a common pool of smaller companies.

The advantage of this decentralized acquisition-oriented business model is that risk is spread out and decentralized among numerous industries, brands, and business cultures. In addition, acquisitions, if performed smartly, can provide a regular amount of new revenue and operating income. It can be a consistent growth driver.

The disadvantage of this model is that the company does not harness substantial economies of scale, because it still mainly operates as a collection of small companies. In addition, an acquisition approach limits the rate of return that can be achieved, because acquisitions are generally more expensive than organic growth. Plus, consistent acquisitions cause goodwill to accumulate on the balance sheet.

ITW has been managed well, and over the last 25 years and longer, the company has substantially grown revenue, operating income, EPS, and the dividend, and maintains a robust balance sheet. Over the last ten years, the company has developed substantial international revenue streams. In 2000, 66% of revenue came from North America, 26% came from Europe, the Middle East, and Africa, and 8% came from Asia Pacific and Other. Ten years later, in 2010, those figures respectively were 48%, 32%, and 20%.

The company attributes much of its success to the 80/20 rule. That is, 80% of a company’s total sales are derived from sales to 20% of the total customers. In other words, the products being sold to key customers are what needs to be focused on. ITW’s decentralized business model allows each small business unit to apply this rule rather effectively.

How ITW Spends its Cash
I discussed the dividends, share repurchases, and acquisitions. For further quantitative discussion, here’s a sum of how ITW has spent its operating cash flow over the last five years (2006 through 2010, as a sum). This doesn’t list every area of expense or receipt; just the major ones in order to understand their priorities from a high level:
Operating Cash Flow: $10.481 billion
Spent on Investments in Property, Plant, Equipment: $1.542 billion
Spent on Net Acquisitions: $4.065 billion
Spent on Dividends: $2.756 billion
Spent on Net Share Repurchases: $3.477 billion
(Other sources of cash flow and expenditures of cash flow are smaller, and excluded)

So as can be seen, rather little is spent on capital expenditures, and the bulk of growth comes from making acquisitions. In addition, a significant amount of cash is given back to shareholders in the form of dividends and share repurchases. The dividends per share grow each year. The net share repurchases (meaning share’s repurchased minus shares issued) are more erratic and larger overall, and unfortunately the largest share repurchases occur during business peaks (which is the opposite of ideal). For example, more than $1.6 billion was spent on net share repurchases in 2007, and during 2007 the shares were at an all-time stock price high. Share repurchases over the last 10 years have reduced total shares outstanding from 603 million to 498 million, so it is indeed valuable for shareholders, but not in an optimized way.

Overall, I believe the company manages capital fairly well for shareholders, although there are areas for improvement. The bulk of growth comes from acquisitions, a little bit is spent on capital investment, and the rest is given back to shareholders by paying dividends and reducing the number of shares outstanding.

Risks

As the EPS table shows over the last six years, ITW is rather cyclical. It’s not a particularly defensive set of businesses; they’ve got exposure to cars, housing, manufacturing, etc. The company did manage to stay profitable throughout the worst recession in recent US history, albeit at a significant earnings reduction. There is global economic risk, from the US, from Europe, and elsewhere. The company faces currency risk as well due to its global exposure. ITW can benefit disproportionally from a continued recovery, but can also be hit hard by continued economic weakness.

Conclusion and Valuation

In conclusion, with an earnings multiple of 12 (which can vary substantially due to the cyclical nature of the business), reasonably shareholder-friendly management, and a strong balance sheet, I’d feel comfortable owning ITW at these prices. The decentralized business model with pooled capital and reliance on acquisitions reduces systemic corporate risk but makes it hard to establish any kind of economic advantage, or moat. So there’s nothing in particular that really solidifies and protects their position over the very long term, although their history is indeed impressive. The company has had strong and robust growth over decades, and remained profitable through the worst recession in recent history. I do think it’s a decent buy for those investors who are interested, and I would consider this to be a solid candidate for a cyclical company in an otherwise large-moat dividend portfolio. I’d stick to buying ITW stock at valuations that offer a dividend yield of 3% or above.

Full Disclosure: I have no position in ITW at the time of this writing.
You can see my portfolio here.

If this article was valuable to you, consider subscribing to get my articles delivered to your email or reader.

Further reading:
General Mills (GIS) Dividend Stock Analysis
McCormick (MKC) Dividend Stock Analysis
International Business Machines (IBM) Dividend Stock Analysis
Diageo (DEO) Dividend Stock Analysis
Exxon Mobil (XOM) Dividend Stock Analysis

Summary

General Mills is one of the largest diversified food processors in the United States.

-Revenue Growth: 5%
-Earnings Growth: 8-13%
-Dividend Growth: 11%
-Current Dividend Yield: 3%
-Balance Sheet Strength: Medium

Overall, while I think General Mills would make an acceptable investment at the current price of a bit over $40, I think there are better options out there.

Overview

General Mills (NYSE: GIS), founded in Minnesota in 1866, is a large international food company. The business controls over 100 leading brands, including Cheerios, Haagan-Dasz, Betty Crocker, Green Giant, Nature Valley, Hamburger Helper, Cocao Puffs, Totinos, and more. In 2011, General Mills acquired a controlling interest in Yoplait, an international yogurt brand that General Mills had already been licensing for years.

The company is one of the largest US food processors, and particularly has a huge set of breakfast cereal brands including the top brand, Cheerios. The majority of General Mills brands, both in cereals and in other categories, hold either the #1 or #2 market position. General Mills has facilities all over the world, including in North America, Asia, Europe, and South America.

US Retail: $10.2 billion in sales
The bulk of the revenue of General Mills comes from the US. Of this $10.2 billion, 23% comes from General Mills cereals, 21% comes from meals, 18% comes from Pillsbury US brands, 15% comes from Yoplait, and the rest comes from snacks and other items.

International: $2.9 billion in sales
Of this $2.9 billion, 31% comes from Europe, 29% comes from Asia, 27% comes from Canada, and 13% comes from South and Central America.

Bakeries and Food Service: $1.8 billion in sales
In addition to selling to consumers, General Mills sells $1.8 billion worth of products to bakeries, restaurants, and other businesses.

Joint Ventures: $1.2 billion in sales
General Mills holds a few joint ventures. They’re part of “Cereal Partners Worldwide”, and also have a joint venture Haagan-Dasz Japan.

Revenue, Earnings, Cash Flow, and Metrics

General Mills has experienced reasonable growth over the last 5 years, and the same can be said when looking further back over a ten year period.

Revenue Growth

Revenue grew by an annualized 5% rate per year, which is decent.

Earnings Growth

The annualized EPS growth rate over this period was a rather impressive 13%. However, over the last seven months, the trailing-twelve-month EPS has dipped down to $2.35, so depending on what precise time frame the EPS growth rate is calculated over, it could differ significantly. If, for example, I calculate the EPS growth rate over a five-year period that goes from 2007 to 2012, using the trailing twelve month EPS as my substitute number for 2012 results (with the fiscal year ending in May), then the EPS annualized growth rate will come out to a bit over 8%, which I estimate is probably more realistic going forward over the long term.

Volatile figures can make calculating growth rates difficult, because different time snapshots will produce different results. Overall, I think a high single digit rate is an accurate reflection of EPS growth, which is reasonable when combined with a 3+% dividend yield to produce low double-digit returns.

Operating Cash Flow Growth

Operating cash flow growth is negative over this period. This, however, is another result of volatility. Over the trailing twelve month period, operating cash flow is back up to $2.081 billion. For the fiscal year ending in 2011, General Mills had a very strong year for earnings, and a weak year for cash flow, because inventory increased (which shows up as income but not as cash flow), and changes in working capital and non-cash were larger than normal, which resulted in the appearance of strong earnings and weak cash flow.

Realistically, cash flow is doing ok, although even with the TTM rebound to over $2 billion, cash flow growth is slow.

Metrics

Price to Earnings: 17
Price to FCF: 17.5
Price to Book: 4
Return on Equity: 28%

Dividends

General Mills has a solid history of consecutive dividend growth, and currently offers a 3.02% dividend yield with a 50% payout ratio.

Dividend Growth

The above numbers are adjusted for the stock split. Over this period, General Mills has grown the dividend by an annualized rate of over 11%. The most recent quarterly increase was a bit under 9%.

General Mills also pays out money for share repurchases. They bought back $1,164 million worth of net stock in 2011, which is more than they paid in dividends. The company has strong free cash flows and uses basically all of it, and sometimes more than 100% of it, to pay dividends and buy back shares. I’m not too happy about huge share repurchases at 17x earnings. There are definitely worse ways to spend that capital, but there are better ways to spend that capital as well, such as in the form of larger dividends.

Balance Sheet

General Mills has a total debt/equity ratio of 1.08, which is a bit on the high side, but acceptable for a company in this rather defensive industry. The total debt levels are about 4.4x annual net income. The interest coverage ratio is approximately 8, which is very comfortable. The shareholder equity that exists, all consists of goodwill from their acquisitions. Overall, General Mills has an acceptable and safe, though not excellent, balance sheet.

Investing Thesis

General Mills is targeting the right groups for growth. They describe their marketing efforts as focused on four key areas: 1) the baby boom generation, which is a population bulge that occurred after World War II, 2) the millennial generation (ages 17 to 34, currently), which are sometimes also called the echo-boomers since they were the offspring of the baby boom generation, 3) “U.S. Multicultural Consumers”, which refers to the growing segment of the US population of people of Hispanic ancestry, and 4) middle-class consumers in emerging markets around the world, where there is a lot of growth.

One can look at where their sales come from to see areas for growth. Asia can grow as a part of their sales substantially, and so can South and Central America.

Over the long term, the company has stated that it targets low single-digit sales growth, high single-digit EPS growth (meaning continued share repurchases), a 2-3% dividend yield, and therefore low double-digit total shareholder returns.

The company, like most corporate food producers, has been on a “health trend” lately. This means that they market a subset of their products as “healthy” (like whole grain cereals, fiber bars, Nature Valley products, and so forth), when in reality, they’re not particularly healthy as a group, but are less unhealthy than their other food offerings. It’s a step in the right direction over a bar that’s recently been set so low. Still, these marketing campaigns are effective and profitable; people see healthier alternatives and go after them. The company does sell some organic products.

It’s worth highlighting the dividends and share repurchases as a general example of why dividend investing works well. If you look at several of the companies out there that have managed to consecutively raise dividends for decades, you’ll notice that if you sum up their dividends and net share repurchases (shares purchased minus shares issued), then you’ll see that the companies in this club, in aggregate, are returning most of their net income or free cash flow to shareholders, while still growing their business at respectable rates. This is because they have achieved a certain status, a certain level of success, where their brand strength, their distribution networks, their patent shields, and their effective marketing campaigns, can grow the business with less capital input. Throwing more money at these growth models wouldn’t produce proportional growth for those dollars, so it’s often better to give them back to shareholders. Successful and established companies can regularly produce large amounts of free cash flow.

I’d prefer, however, for a company like General Mills to pay higher dividends and to keep share repurchases to a smaller sum (like just using them as a sink for extra capital after dividends are paid), or replacing share repurchases with a special dividend that supplements the regular dividends. Share repurchases fuel EPS and dividend growth, but so do reinvested dividends. Share repurchases reserve flexibility for management, makes their EPS numbers better which looks good for the executives and their pay packages, and works as a bit of a hedge against the possibility of dividend tax rates going back up to where they used to be. Larger regular dividends and the introduction of special dividends for extra capital would, in most cases, be better for shareholders, although share repurchases are a bearable alternative. I’m more accepting of share repurchases for companies with P/E ratios of something like 12, not so much at 17.

Risks

Like any company, General Mills has risk. Food companies are rather defensive in nature, but they are vulnerable to increasing commodity costs (food costs, transportation costs, packaging costs, etc). Consumers can also trade down from brand names to generic food items. As an international company, there is currency risk as well. General Mills is in a pretty solid area, with strong brand names and a $26 billion market cap which gives it some scale, but I don’t view the business as having a very robust economic advantage.

Huge amounts of processed corn and wheat are in virtually all American diets these days, as well as in the diets of other developed areas. The US government subsidizes corn, wheat, and soy with billions of dollars per year, which allows farmers to produce those materials cheaply and still make a profit. So General Mills is indirectly subsidized by the US federal government, because should those farm subsidies ever be reduced, altered, or eliminated, the input costs would rise for General Mills, the volume of those materials would likely reduce significantly, and there’s a good chance they wouldn’t be able to pass on the full price increase to consumers.

Conclusion and Valuation

Overall, I think GIS is acceptable at the current price of around $40, but there are better values out there in my opinion. It’s right on the low end of having a 3% dividend yield, the trailing P/E is about 17 and the forward P/E is about 15, growth is reasonable, and so forth. It’s just mediocre to me at these prices. If I’m going to pay 17x earnings, I’d look for a company with a more durable economic advantage. Alternatively, if I’m going to look for a company of a similar level of quality and risk as GIS, I’d look for lower prices (perhaps 15x trailing earnings or so). I doubt anyone would go wrong over the long term with a General Mills investment at these prices, with their diverse portfolio of market-leading brands, but I’d wait for a price dip or look elsewhere.

Full Disclosure: I have no position in GIS at the time of this writing.
You can see my portfolio here.

If this article was valuable to you, consider subscribing to get my articles delivered to your email or reader.

Further reading:
McCormick (MKC) Dividend Stock Analysis
International Business Machines (IBM) Dividend Stock Analysis
Diageo (DEO) Dividend Stock Analysis
Exxon Mobil (XOM) Dividend Stock Analysis
Chevron (CVX) Dividend Stock Analysis

Summary

McCormick (MKC) is a high profit margin spice company with a considerable record of growth.

-Revenue Growth: 5%
-Earnings Growth: 12%
-Dividend Growth: 9%
-Current Dividend Yield: 2.54%
-Balance Sheet Strength: Fairly Strong

Overall, I think MKC would make a decent purchase at under $50. Conservatively, I’d propose investing in dips under $45.

When I analyzed McCormick a year and a half ago, I stated that I believe it would make a good investment at under $40 (it was roughly $38 at the time), and the stock price has since gone up nearly 30%. However, EPS has increased as well, so the valuation is still in the same ballpark as it was when my previous McCormick analysis was published.

Overview

McCormick and Company is a 120 year old spice business. They produce and sell spices, herbs, and seasonings the world-over to both individual buyers and businesses. The company grows both organically, and through acquisitions, and sources product material from 40 countries and sells its products in over 100 countries.

McCormick operates two main segments: consumer and industrial. The consumer segment, as of 2010, accounted for 60% of sales and 79% of operating income, while the industrial segment accounted for 40% of sales and 21% of operating income.

Revenue, Earnings, Cash Flow, and Metrics

McCormick has had solid growth over the last five years, and over a longer time period as well.

Revenue Growth

Revenue grew by an average of almost 5.2% per year over this time period. More recently, in the trailing twelve month period, revenue has grown by another 6.8% compared to 2010 annual revenue.

Earnings Growth

Earnings per Share grew at an average rate of 12% for this five-year period. This is higher than the roughly 8% growth rate for the first half of that decade. EPS has been nearly flat over the trailing twelve month period compared to 2010.

Operating Cash Flow Growth

Cash flow has been static over the last several years. In the trailing twelve month period, cash flow is lower than 2005 levels. Free cash flow is a consistently strong portion of operating cash flow.

Metrics

Price to Earnings: 17.5
Price to FCF: 27
Price to Book: 3.8
Return on Equity: 25%

Dividends

For McCormick, dividend growth has been solid, the payout ratio has remained reasonable, but the moderately high valuation keeps the dividend yield moderately low, at 2.54% currently. The company has increased its annual dividend consecutively for over 25 years.

Dividend Growth

Dividends increased at an annualized rate of over 9%. The most recent quarterly increase was from $0.28 to $0.31, which is a 10.7% increase.

The earnings payout ratio is a conservative 45%, the yield is reasonable but a bit on the low end, and the dividend growth is solid.

Balance Sheet

MKC’s total debt/equity is a bit under 0.8, which is reasonable. Due to acquisitions, most of the shareholder equity consists of goodwill. The interest coverage ratio is a bit over 10, which is quite strong. Overall, I consider McCormick’s balance sheet to be not perfect, but rather solid.

Investing Thesis

Developed countries are becoming increasingly health aware, and due to this, people will be looking for healthy yet flavorful foods more than in the past. Spices and herbs are a great way to add taste to food while keeping the meal healthy, or even increasing the healthiness of the meal.

The company is also aggressively expanding into China and India, and has also completed its largest acquisition in company history a couple of years ago. Asia/Pacific currently accounts for only 8% of McCormick revenue, but it’s growing at a rate that exceeds overall company growth, so there is a tremendous growth opportunity there and they are very keen on tapping into it.

McCormick is particularly interesting as a food company in that their products are rather expensive per unit of weight and volume. Spices only make up a tiny part of a meal. Like most of the food industry, the company faces headwinds from commodity costs, transportation costs, packaging costs, and so forth, but I believe their operations in the spice business may buffer them to some extent from these problems compared with companies that sell cheaper, larger, heavier foods in bigger packaging. The result of this is that McCormick has fairly solid net profit margins of over 10%. The company also has private-label products to capture some of the lower-margin spice purchases. I’m not too excited about investment opportunities in the food industry overall, but McCormick is more attractive than most others, in my opinion.

Risks

Like any company, McCormick has risks. McCormick is a large global company and is subject to international political and currency risks. The entire food industry including McCormick is facing very high cost of goods (food, transportation, packaging), and this may be a substantial long-term trend. The company’s cash flow is not as strong as I would like. Among the most likely of risks is that the valuation could decrease, resulting in a loss of paper value, over a short or medium term. Overall, being a recession-resistant and appropriately leveraged company, and being significantly larger than all of its competitors, McCormick as an investment is likely of below average risk.

Conclusion and Valuation

McCormick offers potential shareholders a relatively low risk, solid-growth, dividend-paying investment opportunity, and could make a solid core holding for a portfolio. It may not be suitable for those looking for higher yielding stocks. I think the valuation of 17.5 times earnings is reasonable, given that EPS growth of above 10% and dividend growth of above 2% can result in double-digit growth from a fairly low-risk food company, but I’d be conservative and look for a lower stock price. At this valuation, a lot of the strengths of the company are already factored into the stock price.

Full Disclosure: I have no position in MKC at the time of this writing. It is on my watch list for possible purchase.
You can see my portfolio here.

Further reading:
International Business Machines (IBM) Dividend Stock Analysis
Diageo (DEO) Dividend Stock Analysis
Exxon Mobil (XOM) Dividend Stock Analysis
Chevron (CVX) Dividend Stock Analysis
Compass Minerals International (CMP) Dividend Stock Analysis

Summary

International Business Machines is a large provider of IT systems, software, and hardware.

-Five-year Revenue Growth: 3%
-Five-year EPS Growth: 15%
-Dividend Yield: 1.58%
-Five-year Dividend Growth: 21%
-Balance Sheet Strength: Medium

I consider IBM to be a reasonable buy at current prices of under $190, but rather than being a “dividend stock”, it’s better described as a large cap company that happens to pay a small dividend. If I were interested in buying the stock, I’d wait for dips.

Overview

IBM is a 100-year-old technology company, focusing on providing business technology. As of 2010, 44% of income comes from software, 39% comes from services, 9% comes from financing, and 8% comes from hardware.

Revenue, Earnings, Cash Flow, and Metrics

IBM has experienced reasonable growth for a large company.

Revenue Growth

Revenue growth has averaged about 3% per year over this period.

Earnings Growth

EPS has grown by over 15% per year, on average, over this period. This is a substantial figure for a large-cap company.

Operating Cash Flow Growth

Cash flow has grown by over 5% per year over this period, on average. The company regularly converts around 75% of operating cash flows to free cash flows.

Metrics

Price to Earnings: 15
Price to Book: 10
Price to CF: 11.5
Price to FCF: 15
Return on Equity: 70%

Dividends

IBM has begun a solid string of dividend increases, but the yield remains well below what dividend investors normally look for. The dividend yield is currently 1.58%. IBM has raised its dividend for 16 consecutive years.

Dividend Growth

Over these last five years, IBM has grown its dividend by over 21% per year, on average. The most recent quarterly growth was from $0.65 to $0.75, which represents growth of nearly 15% for the year.

The dividend payout ratio is under 25%. This results in a safe dividend, but a low yield. Since dividend growth outpaces EPS growth, the dividend payout ratio is increasing, which I think is a good thing for a large, shareholder-friendly company to do. If this continues, IBM should eventually grow a respectable dividend yield like some other large cap tech companies have, but will have a rather low yield for quite some time.

Share Repurchases

IBM maintains a fairly low payout ratio, and puts a considerable amount of cash flow towards buying back their own shares. This has several outcomes:
1) It divides dividend payments and net income over a smaller and smaller pool of shares, therefore accelerating EPS and dividend growth.
2) Increasing EPS should result in increasing stock price unless the valuation decreases.
3) It is good for management pay packages (targets, options, etc)
4) It results in a lower dividend yield than many other large cap companies.
5) It saves some tax for investors that invest in accounts that are not tax-sheltered, but gives investors significantly less freedom to choose what to do with the money that gets sent their way each year.

Overall, I feel that IBM does dividend repurchases better than most companies, since they do them year after year and decrease the number of shares significantly over time, but I would very much prefer a 3% dividend yield or more in exchange for less capital put towards share repurchases.

Balance Sheet

IBM has moderate balance sheet strength. It’s a bit weak in the sense that the total debt/equity ratio is 1.25, and goodwill on the balance sheet slightly exceeds total shareholder equity. This debt makes the return on equity rather high. Part of this somewhat unattractive debt/equity balance has to do with the fact that IBM’s products are basically information. The company produces a lot of software and services, and the hardware that they produce carries good margins due to being complex computing mainframes and such. All of this is to say that IBM doesn’t need much in the way of assets to operate (compared to its total company size, that is), and so debt skews the metrics a bit more than it would for a company that relies on more assets. This is evidenced by the extremely strong interest coverage ratio of 50; bond holders and credit raters view the balance sheet risk as low.

Investment Thesis

IBM has appealing and precise long-term goals. A number of years ago, IBM had the target of $10-$11 in EPS for 2010, and they surpassed that goal through the worst global recession in recent history. The company over the last several years has turned more towards software and services and away from hardware, while holding onto the hardware businesses in which they dominate the market (like mainframes).

Transforming the Business
Over the last decade, IBM transformed itself. Commodity businesses of PCs and hard drives were sold off, and the company made 116 acquisitions, of which a large portion were in the area of software and services. The company received nearly 6000 patents in 2010, of which significantly more than half were software or services related. Today, as a percentage of total IBM income, IBM’s hardware segment generates only a third of the income that it did in 2000 (8% of the total compared to 24% of the total).

IBM has a strong presence in the areas of business. It has its mainframe business for high-end computing, along with servers, operating systems, middleware, IT infrastructure management, and application software and analytics. A lot of this is based on platforms; things you design other applications around that therefore carve long-term niches for themselves (since companies that engineer software for a particular system don’t find it cost-effective to completely overhaul their product or system too often). IBM therefore generates a lot of recurring cash flows. Global volumes of data are now up to inconceivable levels, and large companies like IBM provide billion-dollar solutions to organize it into useful forms. The company markets itself as an integrated provider, meaning that if an enterprise has IT needs, IBM can provide most of them.

2015 Road Map
In 2010, IBM released its 2015 road map, which sets the 2015 EPS target at a minimum of $20. The TTM EPS is about $12.69, so over the next four years, EPS growth would need to be 12% per year on average to reach this target.

There are more specific predictions and explained paths that lead to that number. IBM wants the percentage of its business coming from high-growth countries to be 30% by 2015, up from 21% in 2010 and 11% in 2000. The company expects to continue share repurchases and dividends into 2015, with a summation of $50 billion in share repurchases and $20 billion in dividends for the time period between 2010 and 2015, which comes from the $100 billion in free cash flow they expect to have generated. (Share repurchases were a large component of the 2010 target, and will be a large component of the 2015 target). Another $20 billion is expected to be spent on acquisitions over this period. Revenue from the “cloud” in 2015 is expected to be $7 billion. Revenue from analytics in 2015 is expected to be $16 billion (and global data volume is predicted to multiply in volume by 29 between 2010 and 2020). Revenue from their “Smarter Planet” area is expected to be $10 billion by 2015. Overall, half of earnings are expected to come from software in 2015, with the other half coming from the combination of services, hardware, and financing.

An annual 12% increase in EPS, combined with a 1.5% dividend yield, results in 13.5% annual returns through 2015, assuming the valuation remains constant. This would be superior to historical broad-market returns. Total returns could be increased or decreased if the earnings multiple of the stock in 2015 is higher or lower than the reasonable current earnings multiple of 15. IBM could exceed their targets again, and the valuation could be higher, but I’d propose making more conservative estimates of a lower valuation and a slight miss in EPS targets.

Risks

As a large technology company, IBM faces many risks. Computing has evolved from isolated networks to the world wide web, and is now shifting towards mobile computing, server-based computing (cloud), and using increasingly small and powerful processors to make everything we interact with intelligent; appliances, infrastructure, etc. IBM needs continually update its software offerings and services to be relevant, or continue to use its huge source of capital to make appropriately-valued strategic acquisitions of competitors. Potential slowdowns in high-growth countries, enormous European debt issues, currency risks, or continued American political instability could weigh down success. Business competitors like Oracle or Microsoft may perform better than IBM, or other software companies may enter competitively into the business software industry.

Conclusion and Valuation

IBM has been around for more than 100 years. It has remained dominant even as technology has changed at a rapid pace. This is no guarantee of future success, however. Over the last several years, IBM has transformed itself to focus more on software, more on services, and more on high-margin hardware, which I believe most people consider to be a wise move.

Overall, I think IBM is a reasonable buy at the current price of $190 for those who want exposure to large cap technology in their portfolio. Unfortunately the dividend yield isn’t very rewarding. I’d prefer it if the payout ratio and dividend yield were doubled to over 50% and 3% respectively. Still, if one invests in IBM for a total return perspective rather than a dividend perspective, the risk-adjusted rewards may be reasonable over time.

Full Disclosure: I have no position in IBM at the time of this writing. Like many companies, IBM is on my watch list. I own shares of Microsoft.
You can see my portfolio here.

Further reading:
Diageo (DEO) Dividend Stock Analysis
Exxon Mobil (XOM) Dividend Stock Analysis
Chevron (CVX) Dividend Stock Analysis
Compass Minerals International (CMP) Dividend Stock Analysis
McDonald’s (MCD) Dividend Stock Analysis

Summary

Diageo is a leading producer of spirits, wines, and beers in the world.

-Sales growth over the last four-year period: 7.5%
-Earnings growth over the last four-year period: 8%
-Dividend growth over the last four-year period: 5.4%
-Current Dividend Yield: 3.05%
-Balance Sheet: Weak but Stable

Overall, I think the company would make a decent investment, I but would like to see it at a lower price. The ADR would be a good buy under $75 in my view.

Overview

Formed in 1997 as the result of a merger between Guinness and Grand Metropolitan, Diageo (LGE: DGE, NYSE: DEO) is the world’s largest producer of premium spirits. Headquartered in London, the company is traded on the London Stock Exchange and has an ADR on the NYSE. The ADR represents 4 shares of the company.

Geographic Segments

North America
For 2011, the North American segment accounted for approximately 34% of company net sales. Volume growth was flat for the year, and sales growth was 3%. Marketing expenditure and operating profit increased 7% and 8%, respectively.

International
For 2011, the International segment accounted for approximately 28% of company net sales. Volume and sales were up 9% and 13%, respectively for the year, while marketing expenditure increased 23% and operating profit increased 19%.

Europe
For 2011, the European segment accounted for approximately 26% of company net sales. Volume and sales were down 2% and 3%, respectively, for the year, while marketing expenditure decreased 4% and operating profit decreased by 7%.

Asia Pacific
For 2011, the Asia Pacific segment accounted for approximately 12% of company net sales. Volume and sales were up 9% and 9%, respectively, for the year, while marketing expenditure increased 13% and operating profit increased 13%.

Category Sales

Diageo sells a diverse collection of alcohol types. This is a listing of what percentage of net sales were from each product type.

Scotch: 27%
Beer: 22%
Vodka: 11%
Ready to Drink: 8%
Whiskey: 6%
Rum: 6%
Liqueur: 6%
Wine: 5%
Gin: 3%
Tequila: 3%
Other: 3%

Sales, Earnings, Cash Flow

Revenue, Earnings, and Cash flow have seen fairly consistent growth.

Sales Growth

Net sales have grown by a bit under 7.5% per year on average, over this four-year period.

Earnings Growth

Earnings per share increased by over 8% per year, on average, over this four year period.

Operating Cash Flow Growth

Cash flow growth averaged nearly 6.5% annually over this four-year time period.

Dividends

Diageo pays an interim and a final dividend each year, with the final dividend being the larger of the two. The earnings payout ratio is 53%. As of this writing, the dividend yield on the NYSE ADR for DEO is approximately 3.05%.

Dividend Growth

Over this time period, the company has grown its annual dividend by about 5.4% per year, on average. Actual growth rate in US currency will be based on the actual dividend growth rate, as well as currency conversation changes.

Balance Sheet

The balance sheet is a weak point for Diageo. The company has £7 billion in long-term debt. The Total Debt/Equity ratio is approximately 1.6. The interest coverage ratio is around 4. Less than 10% of equity consists of goodwill, which is solid. Diageo’s dependable, global, defensive business allows it to safely take on this level of leverage.

What this means is that while Diageo’s balance sheet is indeed stable, it’s not particularly flexible. A quarter of operating earnings goes towards paying off interest, and higher debt levels would result in higher interest rates. I usually prefer investing in cleaner balance sheets than this, at least for most of my holdings, and while a balance sheet of this nature is acceptable, it should in my view decrease what the valuation of the stock would otherwise be if it had a stronger balance sheet.

Investment Thesis

Diageo’s market share and brand strength are unparalleled. Diageo holds 27% of the global premium spirits market by volume, which is a larger market share than any competitor.

-Smirnoff Vodka is the best selling premium spirit in the world by volume according to Diageo.
-Johnnie Walker is number one in Scotch, worldwide. (And reported the best 2011 growth out of any other brand of the company.)
-Guinness is number one in stout.
-Captain Morgan is number two in rum.
-Baileys is number one in liqueur.

34% of total sales are from emerging markets, and the company’s “International” segment is by-far their fastest growing segment. Between 2009 and 2011, the percentage of net sales that came from emerging markets increased from 30% to 34%. The company expects that by 2015, approximately 50% of net sales will come from emerging markets.

This is a good type of company for dividend growth investors to look into because the company doesn’t have to change much to grow. It’s not a company that has to spend huge amounts on research and development, or has extremely complex products, or operates in a fast-changing industry. They just make alcoholic beverages in a variety of price ranges, in a variety of categories, with a variety of top brands, and use marketing to try to keep their top position and expand their business. Their size gives them increased distribution efficiency over their competitors which extends to 180 countries, that provides them with a respectable economic advantage. Their focus is on marketing in emerging and developed areas to strengthen or expand their top brands, and to make small or medium sized acquisitions to increase their brand portfolio.

More specifically, the company has the goal to increase core EPS in the low double-digit range, which involves organic growth, margin improvement, and select acquisitions. As far as I know, it’s not a stated goal of the company, but another potential “growth” area would be to pay down some of the debt, which would increase EPS and reduce future interest rates. So there are a lot of areas where Diageo can allocate capital for increased EPS and dividend growth.

Risks

Every company has risk. Diageo has regulatory risk, currency risk, competition risk, commodity cost risk, and more. The company’s large collection of top brands operates in a fairly recession-resistant industry in a globally diverse market, which offers it some safety. Alcoholic beverages can be fairly health-neutral in the right amounts and contexts, but can be dangerous and unhealthy if consumed in the wrong amounts, at the wrong times, or for the wrong reasons. Associating alcohol with status, as Diageo does, can have deleterious effects even if it is good for business.

For investors looking for dividend income from the ADR, a risk is that even if the company raises its dividend in a given year, the dividend in US currency might be lower than the previous year (or the opposite could be true). In addition, the economic weakness in Europe is likely to offset some of the growth from emerging markets as far as DEO’s earnings and sales are concerned.

Conclusion and Valuation

In conclusion, I find this to be a very respectable company at a price that is not too attractive to me at the moment. Although I do think this would make a respectable investment at the current price, with 3+% yield and 5+% dividend growth, I am not too keen on paying a P/E of over 17 for a company with this balance sheet. Either the debt would have to be lower, the growth more impressive, or the price reduced for me to be a buyer of this stock. I would classify it as fair/hold at the current price level.

I do like the company’s vast international exposure in an industry that’s not going away, and their collection of market-leading brands. The dividend yield is solid, the dividend growth is respectable, revenue is climbing, and I can’t particularly envision a large chance of an investment in this company turning sour over the long-term; it likely represents a decent risk-adjusted long term rate of return even at these prices. I’d personally look elsewhere for the time being, however.

Full Disclosure: I do not have any position in DEO at the time of this writing.
You can see my portfolio here.

Further reading:
Exxon Mobil (XOM) Dividend Stock Analysis
Chevron (CVX) Dividend Stock Analysis
Compass Minerals International (CMP) Dividend Stock Analysis
McDonald’s (MCD) Dividend Stock Analysis
Medtronic (MDT) Dividend Stock Analysis