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Five Dividend Stocks Buying Back Their Own Shares

Top Dividend StocksWhen management of a company is looking to make good use of incoming capital for shareholders, there are various options.

If they have a good expansion opportunity, or believe stronger advertising can provide good returns, then the money may be beneficially reinvested for organic growth. Organic growth is often the best use of capital, but there’s a limit to how quickly a large company can grow in a given amount of time.

Alternatively, if there is a complementary business that management believes is appropriately priced and will strengthen their company, they can make an acquisition. The downside is that, in many industries, acquisitions are often over-priced empire-building activities rather than truly beneficial to shareholders.

And of course, if a company has a weak balance sheet, some incoming capital can be used to pay off debt and add additional liquidity to the balance sheet.

In addition, there are two more direct ways to give money back to shareholders. The most direct way is to pay a dividend, where a company sends a portion of the profits to shareholders, ideally on a regular basis.

Alternatively, or in addition to dividends, company management might want to use some incoming profits to buy back shares of the company, and thus decrease the number of shares outstanding, and therefore increased the percent ownership of each share. All else being equal, share buybacks boost EPS, and are functionally similar to reinvested dividends, but are treated better than dividends under current tax law. The downside to buybacks is that a lot of companies buy back shares when they are expensive and hold tightly onto their money when times are tough, with the end results being similar to a nervous investor that avoids investing in market bottoms and happily invested in market tops.

There are some companies that pay regular growing dividends, and then use any extra cash flow after that and other options, to buy back some shares. The dividend yield and share buyback yield, put together, are the shareholder yield, which gives the investor a decent idea of what rate of return can be expected merely from taking existing profits and giving them back to shareholders, on top of all other growth prospects.

One of the criticisms about the sustainability of capitalism is that it requires constant growth to function, but that’s only partially true. You can get substantial returns from a company that isn’t growing. When a stock is at the right valuation, then a significant number of share buybacks along with dividends can produce a 10% rate of return even when the company is not growing at all, or only growing due to keeping pricing up to pace with inflation. A good example of that is Chubb Corporation (CB), which has no revenue growth, but has boosted EPS, dividends, book value, and the stock price, over the long term.

This is a non-exhaustive list of five more select companies that are both paying dividends and regularly buying back shares.

Becton Dickinson (BDX)

Becton Dickinson is a global medical device company, producing a variety of medical, diagnostic, and bioscience products, with significantly more than half of company revenue coming from outside of the United States.

The company has over four decades of consecutive annual dividend growth, but due to a modest payout ratio and the recent surge in stock price for 2013, the dividend yield is fairly low at only 2%. Much of the capital goes to buybacks, however. In the past nine years, they’ve bought back nearly 25% of the company’s market cap. Recently, the company has bought back over 7% of its market cap in each of two years, but that has largely been due to taking advantage of low interest rates to increase the corporate leverage. More sustainably over the long-term, the company buys back perhaps 3% of its stock per year, while paying a 2-3% dividend yield, and combining that cash return with solid revenue growth.

I view the current valuation of BDX to be reasonable, if not exactly appealing, compared to many other potential investments on the market currently. A full analysis from earlier this year is available here.

Lowe’s Companies (LOW)

I haven’t published a report on Lowe’s in a few years, primarily due to the low dividend yield of only 1.5% (despite five decades of consecutive annual dividend growth). It’s a good mention in a share buyback list, however, since it couples the dividend with serious regular stock buybacks. The company bought back 30% of its market cap in under 8 years, reducing the share count considerably from over 1.6 billion to well under 1.2 billion. The company offers a decent 5% shareholder yield overall, along with solid core growth.

Overall, I’d classify this home improvement retailer as being a bit pricey at the current time after the 2013 run-up.

J.M. Smucker Co. (SJM)

Smuckers, the maker of Jams and Jelly, is an interesting example. Over the past decade, they went on an acquisition-spree buying brands like Folgers coffee and Jif peanut butter to turn Smuckers into a larger, diversified food company. To afford all of this, the company regularly issued new shares, growing the number of outstanding shares in the process. Over the 2005-2010 period alone, the company doubled its number of shares outstanding. The strategy paid off, as per-share metrics had very strong growth and roughly quintupling the investment of their investors over the most recent 12 year period.

Now, the company is using substantial buybacks and decreasing its share count. The current dividend yield is about 2.16%, with another 2-3% buyback yield. I do feel, however, that the valuation is a bit ahead of itself, and it would be better to watch this one for a while.

Target Corporation (TGT)

It’s tough to dig any sort of moat in retail, which is a low margin and hyper-competitive industry. Being a “middle of the road” retailer, avoiding the bargain or luxury extremes, is a particularly dangerous place to be. Target has found a niche at the high end of the budget space- typically a classier shopping experience than Wal-Mart and membership chains, but still with rather low prices. The company’s four and a half decade streak of consecutive annual dividend increases is evidence of the success of this strategy so far, and the current dividend yield is 2.68%.

Target also buys back shares, having bought back nearly 30% of its market cap in the past decade. The company often purchases up to 5% of its market cap in a single year, although it can vary year to year. I view the company as reasonably valued, but with large retail competitors, bulk membership competitors, and disruptive online competitors, I’d like to see a bigger margin of safety.

Texas Instruments (TXN)

Texas Instruments is the largest producer of analog chips in the world. Their products tend to have long life-cycles and high margins, and they supplement those strengths with a particular focus on their large sales team. The headwind for the company is that they’ve been exiting some commodity product lines to focus in their core analog area, and as can expected this decision has impacted revenue.

The company wasn’t much of a dividend payer until the last few years, where it has quickly grown its dividend to a current yield of 2.89%; fairly high for the tech industry. The company bought back 35% of its market cap in the past decade, and continues to buy back ~4% of its shares each year.

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

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McCormick and Company: Decent Stock But No Margin of Safety

-Seven Year Average Revenue Growth Rate: 6.4% Dividend Stock Report
-Seven Year Average EPS Growth Rate: 10%
-Seven Year Average Dividend Growth Rate: 10%
-Current Dividend Yield: 1.87%
-Balance Sheet Strength: Strong, Stable

At the current price of around $73, McCormick appears poised to offer reasonable long-term returns, but the lack of a margin of safety and the low current yield reduce the attractiveness of the stock unless or until the earnings multiple contracts a bit.

Overview

McCormick and Company (NYSE: MKC) is a 120+ year old spice and herb business. They produce and sell spices, herbs, and seasonings the world-over to both consumers and businesses. The company grows both organically, and through acquisitions, and sources product material from 40 countries and sells its products in over 110 countries.

The company is involved in multiple industries and areas, with 41% of their revenue coming from their “Americas Consumer” segment, 28% of revenue coming from their “Americas Industrial” segment, 14% from “EMEA Consumer”, 7% from “EMEA Industrial”, 5% from “Asia Pacific Consumer” and 5% from “Asia Pacific Industrial”.

Examples of industrial customers include Pepsico, McDonald’s, General Mills, Yum! Brands, Subway, Kraft Foods, Wendy’s, and Sysco.

Consumer brands include McCormick, Old Bay Seasoning, Lawry’s, Simply Asia, and many others. In addition to owning by-far the dominant market position in branded spices and herbs (more than twice as large as nearest competitors), McCormick is also a leading provider of private label spices and herbs.

Valuation Metrics

Price to Earnings: 24
Price to Free Cash Flow: 29
Price to Book: 5.5

Revenue

McCormick Revenue
(Chart Source: DividendMonk.com)

McCormick grew revenue by an average of 6.4% per year over this period, which is impressive. Notably, there was not a single year in 10+ years where revenue was not larger than the previous year. Much of this growth and consistency is due to McCormick’s strategy of making substantial acquisitions a core part of their growth strategy.

Earnings and Dividends

McCormick Dividends
(Chart Source: DividendMonk.com)

The EPS growth rate and the dividend growth rate were both 10% per year, on average, over this period. The current dividend yield is fairly low, at only 1.87%, even though the payout ratio is reasonable for this type of company at over 40%. McCormick has raised its dividend for 27 consecutive years without a miss.

Approximate Historical Dividend Yield at Beginning of Each Year:

Year Yield
Current 1.87%
2013 2.1%
2012 2.5%
2011 2.5%
2010 2.8%
2009 3.0%
2008 2.4%
2007 2.1%
2006 2.3%

 
As can be seen, the yield has been dropping over the past few years even though the dividend is being consistently increased each year. This is because the valuation of the stock has inched upwards, and the result is that despite having a long history of consistent dividend growth and a reasonable payout ratio, the yield is unfortunately low.

How Does McCormick Spend Its Cash?

During the fiscal years 2010, 2011, and 2012, McCormick reported about $890 million in cumulative free cash flow. During the same time period, $450 million was spent on dividends, $300 million was spent on share buybacks, and $490 was spent on acquisitions.

Balance Sheet

The company’s total debt/equity ratio is under 0.8, but 100% of existing shareholder equity consists of goodwill. The ratio of total debt to net income is about 3.3x, and the interest coverage ratio is just over 10x.

Overall, McCormick is making moderate use of leverage while maintaining very healthy interest coverage and credit scores.

Investment 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 with antioxidants.

McCormick expects Herbs and Spices to be the third-fastest growing flavor category after Soy-Based Sauces and Stock Cubes through 2017 (with 10+% total industry growth during that time period), and they have the leading worldwide market share in that industry. By maintaining their existing market share, increasing market share with organic growth or acquisitions, riding the growth of the whole industry, and maintaining decent pricing power, revenue growth can continue to be substantial. In 2012, the company introduced over 250 new products.

The company is also aggressively expanding into emerging markets and China. Asia/Pacific currently accounts for only 10% 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 keen on continuing to tap into it.

I consider McCormick to be in a strong position compared to other food companies because their products are rather expensive per unit of weight and volume. Spices and herbs 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 company also has private-label products to capture some of the lower-margin spice purchases.

Risks

Like any company, McCormick has risks. McCormick is a large global company and is subject to international political and currency risks. Generally the largest risk that companies in the food industry face is rising commodity costs.

McCormick is fairly diverse overall, but has sensitivity to a few large customers. Pepsico is the largest customer for McCormick’s industrial segment, and accounts for 11% of total McCormick revenue. The top three customers for the industrial segment account for over half of the revenue generated by that segment. Wal-Mart is the largest customer for McCormick’s consumer segment, and also accounts for 11% of total McCormick revenue.

Conclusion and Valuation

The company’s long-term goals, as of this writing, are to increase sales by 4-6% per year, increase EPS by 9-11% per year, and maintain a dividend yield of around 2%, although of course they have control of the payout ratio but not the actual yield. This is in line with, and slightly conservative compared to, their historical performance. The result is that the company aims for 11-13% annual shareholder returns, which is higher than the historical S&P 500 average growth rate.

Investor returns, however, are based on two variables. The first is the company growth during the holding period, and the second is the change in valuation between the times when the stock is bought and sold. The longer the stock is held, the less relevant the second variable is, but it always has an impact. Buying an over-priced stock can undermine performance for investors even if the company continued to perform well by steadily reducing the valuation over the holding period. This is what happened to companies like Walmart and Coca Cola over the last decade, where they had strong fundamental performance but flat stock performance because long-term reductions in their earnings multiples were precisely enough to offset the steadily increasing EPS.

If, for example, EPS increases by 9% per year over the next 10 years, and the earnings multiple at the end of the period is only 15 compared to the current figure of 24, then the stock price would be about $108, not adjusting for stock splits. The investor would have also received about $20 in dividends per share, plus approximately $10 in additional value if those dividends were reinvested. Therefore, the rate of return from today’s price of about $73 to the value of roughly $138 ten years later would represent a rate of return of around 6.5%. This would be a less than ideal rate of return, but those are fairly pessimistic estimates about a reduction in earnings multiple from 24 to 15, and company EPS performance of 9% annually, which is on the low end of their 9-11% long-term target.

Repeating the estimate but using 10% EPS/dividend growth, and assuming an earnings multiple of 18 at the end of the ten year period, results in a ten-year stock price of $142, $21 in dividends, and another $11 in value if dividends are reinvested, for a total of $174. The result is a rate of return of over 9%, even though there was a hypothetical reduction in earnings multiple from 24 to 18.

The conclusion I draw is that McCormick is not particularly attractively priced currently because it has no margin of safety. It’s also not likely attractive to many dividend investors even though it has the characteristics of a dividend stock (fair payout ratio, a quarter century of consecutive dividend increases, overall stability) primarily because the high valuation pushes down the current yield. Quantitatively, however, a reasonable positive rate of return can be expected on the current price even if the valuation falls substantially and if the company’s performance clocks in at the low end of its estimated range, and this expected return increases as the estimates become more generous for ending valuation and fundamental performance.

For a defensive company, I view the company as a “hold” at this time.

Full Disclosure: As of this writing, I have no position in MKC.
You can see my dividend portfolio here.

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Digital Realty Trust (DLR): Trap or Value?

-Overall Revenue Growth Rate: 29% Dividend Stock Report
-FFO Growth Rate Per Share: 18%
-Dividend Growth Rate Per Share: 16%
-Current Dividend Yield: 5.5%
-Credit Rating: BBB

Digital Realty Trust appears to offer a compelling combination of dividend yield and dividend growth. There exists some drama regarding differing opinions about the future of the REIT and accounting disagreements, which has brought the price down considerably.

Overview

Digital Realty Trust, Inc. (NYSE: DLR) is a large Real Estate Investment Trust (REIT) that focuses on data centers.

Digital Realty provides a number of services, including turn-key modular data center solutions (accounting for 57% of DLR’s rent income) where Digital Realty does practically all of the work, or powered-base buildings (accounting for 32% of DLR’s rent income) where they focus on the real estate, shell, and electrical/mechanical aspects while the client company focuses on the critical data center aspects. Smaller aspects of the business contribute the remaining revenue.

In terms of geography, Digital Realty Trust has over 120 properties which are leased out to over 600 tenants. The properties are placed in high population states across the United States, as well as several countries in Europe, plus Australia, Hong Kong, and Singapore. Currently, 80% of revenue comes from North America, 18% from Europe, and 2% from Asia.

The tenants are from a number of industries:
29% IT Services
27% Telecom Providers
19% Financial Services
25% Other Corporate Enterprises

The top ten tenants represent about one third of total rent for Digital Realty, with the largest tenant, CenturyLink, representing about 9% of total rent.

Data center shells have a life expectancy of 40-50 years, while the electrical and mechanical systems are far more expensive per square foot and have life expectancies of only 25 and 35 years respectively.

Revenue

Digital Realty Trust Revenue
(Chart Source: DividendMonk.com)

Revenue growth over this period was about 29.5% per year on average, which is explosive. To get that kind of growth, however, Digital Realty continually issues new shares to bring in new equity and expand its base of outstanding shares, so the number of shares outstanding increased by about fivefold over that period.

The rate of revenue growth per share over this time is highly dependent on which time period is used, because a huge relative increase in the number of shares occurred during 2005-2007 and then relaxed to a lower expansion rate. So, the seven year annual revenue growth rate per share (2005-2012) is only 3.4%, but the five year annual revenue growth rate per share (2007-2012) is nearly 12%, and the three year annual revenue growth rate per share (2009-2012) is 10%.

FFO and Dividends

Digital Realty Trust Dividends
(Chart Source: DividendMonk.com)

The FFO growth rate per share over this period was over 18% per year, while the dividend growth rate was over 16% per year. The FFO and dividend growth going forward are going to be lower as DLR is maturing; the dividend increased by 7.3% and 6.8% per year during the previous two years respectively, and the long-term dividend growth potential is ultimately constrained by their revenue growth per share.

The current dividend yield is 5.5%.

Approximate historical dividend yield at beginning of each year:

Year Yield
Current 5.5%
2013 4.3%
2012 4.1%
2011 4.1%
2010 3.5%
2009 4.3%
2008 3.5%
2007 3.3%
2006 4.5%

 

Balance Sheet

Digital Realty currently has BBB credit ratings. The total debt/equity ratio is 1.4x, and the interest coverage ratio is about 4.4x.

Investment Thesis

Data usage continues to explode in volume. Corporate data, social networking, trading platforms, and online retail continue to grow, and telecom services are supplying ever greater numbers of data contracts rather than just cellular phone service. Meanwhile, cloud computing has shifted from being a buzz word to being more and more of the status quo, which means more applications are shifting towards servers and away from clients.

Cisco currently has an estimate for 29% compounded annual global IP traffic growth per year between 2011 and 2016, which means a three or fourfold increase in traffic over a five year period.

In addition, the International Data Corporation’s Worldwide Data Census expects 18% of data centers to be outsourced in 2017, which is nearly a doubling of the current (2013) figure of 10%.

Putting the two projections together, the industry is looking at a multifold increase in global data usage and then a doubling of the percentage of data centers that are outsourced. Digital Realty Trust, being by far the largest at what it does, is poised to continue to capture a healthy chunk of this growth.

Risks

DLR’s data center properties are more specific and technical than many other REITs, so while they may be geographically diversified, they are heavily focused on a few industries, as described in the overview section.

A few months ago, Jon Jacobson gave a damning opinion of the REIT, calling DLR a short opportunity. The varied arguments were that it’s a commodity (no moat) business, the fundamentals are deteriorating, and larger cloud-based competitors like Amazon, Microsoft, or Google can move in as essentially unstoppable larger competitors. The most specific argument was that the REIT substantially understates its real capital expenditures, and when his estimate for the capital expenditures is factored in, then FFO and therefore the fair value is substantially lower than the current trading price.

On the other hand, Gary Brode from Silver Arrow presented a bullish case for the REIT, and countered Jacobson’s short thesis. He provided opposing arguments for some of the arguments that it’s a short, such as stating that Amazon, Microsoft, and Google are not really direct competitors, and pointing out that the estimate for higher capital expenditures is based on faulty assumptions, and that the REIT is in fact properly reporting its real capital expenditures on its income statement.

Conclusion and Valuation

I decided to publish a report at this time due to last week’s earnings release. DLR reported a fair quarter, but dropped in stock price from nearly $64/share to under $57/share, and this is coming after previous drops in price that once priced shares at nearly $80. Overall, DLR shares have underperformed the market during the 2010-2013 period.

This quarterly drop seems to be primarily based on an accounting change, which may be affecting qualitative opinions much more than quantitative opinions. In other words, an accounting change following the Jacobson criticism of their accounting is spooky to some investors, and it resulted in a drop in price.

Investors will have to decide for themselves if the fundamentals of the company appear sound. The industry that this REIT operates in is a quicker-moving one than the typical REIT, so rewards and risks are amplified. Some opinions are that this is a classic example of a falling knife, while others view it as a strong value opportunity.

Applying the Gordon Growth Model with a 10% discount rate (target rate of return), DLR would have to produce compounded 4.5% annual dividend growth for the foreseeable future to make the current price of $57 fair, which is comfortably below the current revenue growth per share rate and the most recent dividend increase of 6.3%.

Therefore, the current price appears to offer a reasonable safety margin for some impact of accounting questions, industry commoditization, or large cloud competitors that short proponents cite as issues, if one is bullish about the industry and believes the fundamentals to be sound.

To increase the margin of safety further, another way to enter a position with DLR is to sell put options at a strike price of $55 for January 2014. As of this writing, this would result in entering the stock at a cost basis of $50.60 if the shares are assigned, or obtaining an 8+% rate of return from premiums over a five-and-a-half month period if they’re not assigned.

Either way, investors interested in exposure to this industry may find Digital Realty at this price to be worth looking further into to see if their view of the fundamentals matches some of the more bullish arguments.

Full Disclosure: As of this writing, I have no position in DLR.
You can see my dividend portfolio here.

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