First Newsletter

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

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

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

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

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

Thanks everyone,

-Matt Alden S., founder of Dividend Monk

May 2015: The Market is Overvalued

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

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

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

Diamonds in the Rough: 5 Attractive Stocks

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

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

Brookfield Infrastructure Partners (BIP)

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

bip_operations

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

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

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

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

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

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

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

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

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

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

bip_valuation

Source: Dividend Toolkit Valuation Spreadsheet

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

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

Chevron Corporation (CVX)

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

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

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

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

chevron_production

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

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

solar-price

EU-PV-LCOE-Projection

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

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

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

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

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

chevron_valuation

Source: Dividend Toolkit Valuation Spreadsheet

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

Emerson Electric (EMR)

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

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

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

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

emerson_operations

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

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

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

This is the valuation table:

emerson_valuation

Source: Dividend Toolkit Valuation Spreadsheet

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

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

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

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

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

Oneok Inc. (OKE)

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

To quantify it in this case, here it is:

oneok_distributions

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

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

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

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

Here’s a valuation table:

oke_valuation

Source: Dividend Toolkit Valuation Spreadsheet

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

Kinder Morgan Inc. (KMI)

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

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

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

kinder_morgan_operations

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

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

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

Here’s a valuation table for KMI:

kmi_valuation

Source: Dividend Toolkit Valuation Spreadsheet

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

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

kmi_valuation_2

Source: Dividend Toolkit Valuation Spreadsheet

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

Conclusion

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

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

Regards,
-M. Alden

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Caterpillar – The Right Timing to Buy Tonkas

Caterpillar Inc. is a manufacturer of construction and mining equipment, diesel & natural gas engines, industrial gas turbines & diesel-electric locomotives. Its segments include Resource Industries, Construction Industries and Power Systems. It is highly linked to the mining and home construction industries. stock report

-Seven Year Revenue Growth Rate: 3.78%
-Seven Year EPS Growth Rate: 2.61%
-Seven Year Dividend Growth Rate: 12.84%
-Current Dividend Yield: 3.17%

Overview

While the US housing construction industry finally came back from the dead, the mining industry is falling into a deep sleep due to the lack of demand. Emerging markets are not so emerging anymore and their appetite for resources has slowed down. But this is short term news. The truth is that CAT is highly diversified among the mining, construction & energy and transportation industries. Global energy demand growth will continue to sustain the E&T division while construction won’t slow in the States anytime soon. Since sales and profits have declined over the past 12 months, CAT has tightened its control over inventory and costs. The company is now leaner and stronger. The demand for resources will reappear at one point and the mining industry will benefit from it. CAT is the leader in mining equipment; it will get its share of the cake at that point.

While CAT is a very strong pick for a long term perspective, it might be riskier over a short period such as 12 months. If the mining industry continues to slow down as is the case right now, CAT might not be able to meet its double digit growth projection. For that reason, I think you should take a careful look at this company before going forward.

Ratios

Price to Earnings: 14.17
Price to Free Cash Flow: 13.46
Price to Book: 3.145
Return on Equity: 20.73%

Revenue

CAT Revenue

As previously mentioned, Caterpillar is suffering from the global economic slowdown for resources. Low oil prices reduce the demand for drilling equipment. Then, emerging markets appetite for resources has seriously declined leading the mining industry downward. The US construction environment is doing well, supporting Caterpillar’s revenue at the moment. However, we don’t expect much growth in the upcoming year. CAT is a cyclical company evolving in a tough market at the moment. It may be the right time to invest. Let’s take a look at others metrics.

Earnings and Dividends

CAT earnings and div

Throughout the years, I’ve built a serious investing model including 7 rules of investing. These rules were built based on much stock researches and my 13 years as an investor. Here’s the first rule:

#1 High Dividend Yield Doesn’t Equal High Returns

It has been proven that high yield dividend stocks (over 5%) underperform the market. It’s only normal as companies paying over 5% dividend yield show a high level of risk or limited growth potential when most money is simply redistributed to investors through dividends. Those companies (such as MLP’s) are good for retirees seeking income, but not really interesting for a young investor like me (I’m in my 30s). Let’s take a look at CAT’s dividend yield throughout the years;

Approximate historical dividend yield at beginning of each year:

CAT historic yield

 

 

 

 

 

As you can see, CAT shows a relatively low dividend yield over the past 7 years but recently went over the 3% bar. This places CAT in a good position for dividend investors.

#2 If There is One Metric; It’s Dividend Growth

The second rule is quite simple, but really effective. If there is only one metric you should be looking at, it has to be the dividend growth. If a company grows its dividend year after year, it means profit and sales are also increasing.

While CAT is going through a tougher period at the moment, we can appreciate a strong annualized dividend growth of 12% over the past 5 years. Here again, the company fits my investing criteria.

#3 A Dividend Payment Today is Good, a Payment for the next 10 Years is Better

As previously mentioned; a company increasing its dividend payment year after year must also show revenue and profit growth to sustain its distribution. A good way to see if the company can make it through the next 10 years is to look how the payout ratio has evolved through time. In the previous graph, we see a payout ratio under 50% for the past 4 years. This is a very good indication that the dividend is sustainable.

#4 The Foundation of Dividend Growth Lies in its Business Model

Warren Buffet once said he invests only in businesses he understands. This is crucial to making rational investment decisions. Caterpillar’s economic moat is quite interesting. This business is selling world class equipment for various industries.

The company evolves in cyclical markets and revenues and profits fluctuate over time. However, it’s a leader in its industry and the quality of its equipment is well appreciated around the world.

How Does CAT Spend Its Cash?

The company has well defined priorities for its cash flow:

#1 Maintain financial strength

#2 Growth

#3 Pensions

#4 Dividends

#5 Stock Repurchases

This quote from their last earnings call with management resumes how CAT manages its cash flow:

The top cash deployment priority is to maintain a strong financial position to support our credit rating. As such, the ME&T debt-to-capital ratio was 37.1 percent, down slightly from 37.4 percent at the end of 2014. Our cash and liquidity positions also remain strong with an enterprise cash balance of $7.563 billion as of March 31, 2015. Additionally, cash will be used to support growth, appropriately fund employee benefit plans, pay dividends and repurchase common stock. During the first quarter of 2015, capital expenditures totaled $0.5 billion; funding for defined benefit pension plans was $0.1 billion; the quarterly dividend payment was $0.4 billion; and common stock repurchased was $0.4 billion.

Risks

While CAT is a very strong pick for a long term perspective, it might be riskier over a short period such as 12 months. If the mining industry continues to slow down as is the case right now, CAT might not be able to meet its double digit growth projection. For that reason, I think you should take a careful look at this company before going forward.

The company currently focuses on cost management to maintain its profit while waiting for the next resource driven wave to improve its results.

Conclusion and Valuation

The first valuation method used is a look at the historical PE ratio. It gives me an idea of how the market values the company:

CAT PE Ratio

Due to the economic slowdown, we see CAT losing strength in the valuation multiplier. Not so long ago, the company traded around 18 but it is now back to 14 times the benefits. The company seems slightly undervalued using the PE historic method. Let’s see what it looks like with the Dividend Discount Model:

CAT intrinsic value

Considering a 10 year dividend growth of 5% (considering the current market headwind) and a 7% average dividend growth rate for the future, we get a fair value at $84.59 while the stock is currently trading at $88-$89. I’ve used a discount rate of 10% as the company is very stable and will continue to be a leader in its industry.

In the light of both valuation methods; I can say Caterpillar is a good addition to a portfolio at the current price. What do you think?

Full Disclosure: As of this writing, CAT is part of our DSR Portfolios.

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Microsoft – a Little bit Late for the Party, Still Growth to Come from the Clouds

Microsoft is the best known and most important software company in the world. Along with its famous line of software products, Microsoft also offers various services such as servers (including cloud systems), business solutions (support and consulting), entertainment (Xbox) and other online services.stock report

-Seven Year Revenue Growth Rate: 9.71%
-Seven Year EPS Growth Rate: 8.23%
-Seven Year Dividend Growth Rate: 12.56%
-Current Dividend Yield: 2.55%
-Balance Sheet Strength: Strong

Overview

We all know Microsoft for their Windows operating system and Office Suite. At several occasions in time, we have seen competitors try to steal market share away from the giant. I remember watching an interview with the Microsoft CEO years ago and the reporter asked if he was concerned about the rise of Linux.

Linux what? He answered

I was surprised to see MSFT’s big boss not even consider that a competitor could hurt Windows’ market share. Today, I understand that there is not many competitors can do to battle with the “mother” of computers.

Business Segments

The company is simply divided into two segments:

Devices & Consumer

Here we find all products offered to “regular” consumers.It showed an 8% growth in revenue during the past quarter lead by sales of Office 365. I was also surprised to see how BING posted strong revenue growth (21%) in advertising income.

Commercial

s consumers we all know Microsoft, while MSFT makes the bulk of its income from its commercial segment (12.8 billion this quarter vs 9 billion from consumer segment). Revenue in this segment grew 5% this quarter lead by… the cloud business (+106%). The cloud business is definitely a great part of MSFT’s future. This is especially true when we consider that office suite sales declined during the last quarter. Many companies won’t update their software bundle as fast as MSFT will upgrade them.

Ratios

Price to Earnings: 20.14
Price to Free Cash Flow: 14.93
Price to Book: 4.36
Return on Equity: 22.25%

Revenue

MSFT Revenue

Revenue Graph from Ycharts

Similar to Apple’s revenue depending on how many iPhones versions it launches; Microsoft revenue growth is linked to how many software upgrades it can create. We can see that MSFT is not lazy when it’s time to provide new versions of their famous software. On top of that, MSFT diversified its revenue sources by investing massively in two other business sectors; game consoles with the Xbox and cloud services.

Earnings and Dividends

MSFT earnings and dividendsSource: Ychart

Earnings were temporarily hit by the Nokia adventure. While MSFT usually shows strong abilities investing in new businesses in order to generate growth, I’m not truly convinced it will be able to get something strong out of Nokia. Nonetheless, it seems MSFT doesn’t need Nokia to be profitable since its other businesses are doing well. I guess this is the benefit of being the world leader in software.

Approximate historical dividend yield at beginning of each year:

MSFT historical yield

 

 

 

 

 

As you can see, MSFT became very interesting as a dividend stock not so long ago. Prior to 2011, the yield wasn’t the most appealing. However, now the dividend is constantly increasing and the yield remains around 3%. Considering a relatively low payout ratio (under 50%), we can expect more dividend growth in the future.

How Does MSFT Spend Its Cash?

It’s funny to see a company that didn’t want to pay a dime in dividends a short while ago increase its dividend payment aggressively by 12.56% (annualized) over the past 5 years, right? During the last quarter alone, MSFT redistributed $7.5 billion to shareholders through share repurchases and dividend payments. The share repurchase program is authorized up to 40 billion dollars.

As any other techno companies, MSFT must invest massively into R&D. in 2014, the company spent 11.4 billion, an increase of 1 billion compared to 2013. Share repurchases and dividend payments are great, but I also like the fact MSFT is cautious about reinvesting massively into its operations. While MSFT focuses on improving existing products and services, they also spend lots of money on developing new innovation.

Investment Thesis

Microsoft finds another niche to dominate; here’s why the cloud business will push this giant higher. Both INTC and MSFT surged this year and even share a few points in common; strong demand for PCs in the market and their weakness to enter the mobile market. Microsoft also tried to “buy” its entry into the mobile market with the acquisition of Nokia. Now that they have announced a cut of 18,000 jobs (mainly in the Nokia division), we can wonder why it paid that much to acquire a cheap phone maker. Nonetheless, I prefer Microsoft over Intel for one reason; MSFT has found another niche to dominate with the cloud business. We all know the strength of Microsoft lies with all businesses using their services (Windows, Office series but also servers and business services). Since the cloud is the next big thing for most companies, Microsoft can expect huge growth from this segment in the future.

Risks

A few years ago, I wasn’t as confident in Microsoft’s future; the Xbox wasn’t doing that well, BING seemed like just another Yahoo! trying to compete with Google and Windows’ sales weren’t impressive. However, a few years later, BING generates revenues, Xbox is a strong player in the gaming industry and cloud services came out of nowhere with great growth potential. I guess this summarizes the risk you face while investing in a techno stock.

Overall, I think the risk is minimal since MSFT sits on strong and diversified sources of income. The software business will continue to generate strong cash flow while the growth will come from cloud services and other projects. Still, keep in mind that if MSFT wastes money like it did with Nokia, the future could turn rapidly into a nightmare.

Conclusion and Valuation

Using the historic price-earnings ratio will tell me how the market values MSFT over time:

MSFT PE ratio

My understanding of this graph is that MSFT is catching the attention of Mr. Market recently. The cloud business is a buzz word and it resonates throughout the MSFT valuation. Considering the company used to trade over a 22 multiple and as high as 27, the stock seems underpriced at the moment. Do we have a buy opportunity? The answer is probably yes… about a month ago! Let’s dig further.

Using the Discounted Cash Flow Analysis, we look at MSFT as a simple money making machine. The point is to assess the value of the company by considering its cash flow generation capacity. Considering the cash flow to continuously grow by 5% for the next five years and then by 4% and a discount rate of 10%, we have a stock trading at a 20% discount as the current company’s market value is at 392 billion.

MSFT Intrinsic Value 1

Then, by using the Dividend Discount Model, I keep the 10% discount rate and use a 10% dividend growth for 10 years (definitely supported by the cloud service growth and the upcoming delivery of Windows 10) and a 7% dividend growth rate afterward. Here’s what we get:

MSFT Intrinsic Value 2

According to this chart, the stock is trading at a 10% discount.

Overall, it seems that Microsoft is currently trading at a good price. The perfect time was definitely before its latest earnings report, but I’m fairly confident that the stock will continue to show strong results in the future.

Full Disclosure: As of this writing, I MSFT is part of our DSR Portfolios.

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