Wednesday, July 10, 2013

Business Relationships Can Deliver Solid Dividends to Shareholders

We live in a service- oriented economy. As a result, a large portion of the economic output is based upon purchases of services, rather than the purchases of pre-fabricated tangible products. Using an example from everyday life, a haircut is a service. Many people living in small communities across the United States go to a barber shop or a hair salon every few weeks or so. After a few months of trial and error, consumers generally tend to find a place to have their hair cut and stick with it. The service provider lures in the customer with quality of service, and builds a long-term relationship of repeat purchases that might last for years if not decades. So why should dividend investors care about haircuts and services?

The answer is simple – there are dividends to be made from service oriented companies.

While corporations are not people, they tend to consume services on a regular basis. One of the biggest assets that corporations might have are the intangible relationships that they have built over the years. For example, many public companies tend to keep their audit or law firms for years if not decades, which translates into millions of fees for the latter. The corporations are satisfied with the quality of service offered, and know that the service providers have their best interests at heart. The service provider strives to provide outstanding service, in order to keep the relationship going and generate extra billing opportunities when the right time comes. As a result, it could be argued that offering an outstanding service on a consistent basis could be a source of a wide moat, or a strong competitive advantage.

The areas to focus on include repeat purchases from service providers. A few of those include:

Automatic Data Processing, Inc. (ADP) provide business outsourcing solutions, such as payroll processing. Payroll is an important aspect of a small business. One small error could be bad for business and employees morale. As a result, businesses tend to keep service providers like ADP, even if prices tend to increase over time. The hassle of switching to a new provider makes this service sticky, as long as quality of service is maintained. As a result, this dividend champion has managed to boost dividends for 38 years in a row. Currently, the stock is a little pricey at 23.90 times earnings, although the yield is attractive at 2.50%. Check my analysis of ADP.

International Business Machines Corporation provides information technology (IT) products and services worldwide. The company has transformed itself from a major hardware producer to a service provider. It provides consulting services to clients across the globe. Major corporations are willing to pay large sums of money in order to improve operations, and companies like IBM are there to help. Once companies are comfortable with the services offered by IBM, this relationship will keep on delivering dividends as long as quality of execution is maintained. After all, chances are that a company would ask for IT services only from service providers they are comfortable with. They get comfortable with service provider only after a business relationship is built and maintained over time. A competing firm would have a lot of trouble making a new relationship with an IBM client, since they would have to prove themselves first. Even if they undercut prices, the fears that they might not deliver, since no relationship exists, would likely deter clients from leaving their service providers. This dividend achiever has been able to boost dividends for 18 years in a row, while also being one of the largest and most consistent share repurchasers in the world. The stock is cheap at 13.30 times earnings, although the current yield is low at 2%. Check my analysis of IBM.

One of IBM's competitors is Accenture (ACN), which provides management consulting, technology, and business process outsourcing services worldwide. This international dividend achiever has increased dividends for 8 years in a row. The company has a five year dividend growth rate of 28.70%/year.  Currently, the stock is trading at 16.30 times earnings and yields 2.30%. I would try to post a more detailed analysis of the firm over the next few weeks.

As a result, businesses that manage to build and maintain relationships with clients have an inherent advantage that is as close to a wide moat as possible. It would be very difficult for competitors to steal an existing client, as long as an adequate level of service is offered. This wide moat also provides pricing power, which could translate into higher profits and provide the necessary cash to boost dividends over time.

Full Disclosure: Long ADP, IBM

Relevant Articles:

Check Out the complete Archive of Articles
IBM (IBM) Dividend Stock Analysis
Automatic Data Processing (ADP) Dividend Stock Analysis
Seven wide-moat dividends stocks to consider

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