Monday, October 31, 2016

Four Dividend Champions On Sale

I usually look at dividend growth stocks and their dividend increases every week, as part of my portfolio monitoring process. In this weekly review, I have highlighted four dividend champions, which recently raised distributions. The common denominator behind each of these dividend champions is that they seem attractively valued today.

The reason why these companies appear attractively valued in an otherwise expensive marketplace for securities, is because market participants have doubts about each of these companies and their earnings prospects. It is up to the enterprising dividend investor to analyze those opportunities, and determine if they are appropriate additions for their income portfolios.

As a rule, I try to invest at attractive entry valuations in companies that have a track record of annual dividend increases, which is fueled by earnings growth. The goal is to buy such a company without overpaying for it,to hold on to it, as it earns more, and pays me a dividend to hold to it.

The four companies in question include:

AT&T Inc. (T) provides telecommunications and digital entertainment services. The company operates through four segments: Business Solutions, Entertainment Group, Consumer Mobility, and International. The company raised its quarterly dividend by 2.10% to 49 cents/share. This marked the 33rd consecutive annual dividend increase for this dividend champion. Over the past decade, AT&T has managed to raise dividends at an average annual rate of 3.80%/year. Dividend growth has been slowing down even further in the past five years to a little over 2%/year. Currently, the stock looks attractively valued at 12.80 times forward earnings and an yield of 5.40%. Check my analysis of AT&T for more information.

The stock has been selling off, after announcing its intention to acquire Time Warner (TWX) for cash and stock. Some investors are nervous, because AT&T has been on an acquisition spree recently, and had announced that it was going to focus on reducing debt. Others are concerned that this acquisition is a sign of a bubble in the debt markets, fueled by low interest rates. A third group is comparing the AT&T acquisition of Time Warner with the acquisition of Time Warner by America Online at the height of the dot-com bubble in 2000. That last deal was one of the worst in history. The difference however is that both AT&T and Time Warner have reasonable valuations today. In contrast, America Online was selling at something like hundreds of times earnings in 2000. This is the main reason why the AOL stock price collapsed after it acquired Time Warner – it was simply overvalued. I could argue that AT&T at 12..80 times forward earnings and Time Warner at 16.30 times forward earnings are not really that expensive.

The move by AT&T is likely caused by the company’s desire to diversify its income streams beyond the highly competitive US telecom market. While AT&T and Verizon have enjoyed high profitability, as their next two competitors were struggling, competition seems to be intensifying. This could likely put pressure on profits for a sector that requires a lot in capital spending merely to keep up with the technology.

I have not been very bullish on the telecom sector as a whole due to the competitive pressure discussed before. I do hold shares in Verizon (VZ) and Vodafone (VOD). I have held on some AT&T shares from time to time, mostly because I occasionally sell puts on the stock. If those puts are ever exercised, I obtain the stock and then immediately sell covered calls against the stock so that I get rid of it. I have done well with this strategy, which is perfect for a stock that I do not expect to move much over time.

The fact that the company has been unable to grow earnings per share has meant that future growth in dividends will be limited at best. The lack of earnings growth, coupled with a high dividend payout ratio, and an increase in debt really makes me think twice about the sustainability of the dividend on a go forward basis. There is always the risk that the synergies promised when a deal is announced do not materialize, because integrating business cultures, different systems and different business models is very difficult to achieve.

That being said, AT&T has done a good job integrating acquisitions since it was spun-off as SBC Communications back in 1983 from the original Ma-Bell AT&T. The current AT&T was originally known as SBC Communications, and it was formed in 1983, when the original telephone monopoly AT&T spun-off seven of its subsidiaries. After a series of mergers and acquisitions, SBC Communications acquired AT&T a decade or so ago, and then changed its name to AT&T. Therefore I do have high hopes that the deal stands a higher chance of achieving earnings improvement if it is approved in its current form. While AT&T and Time Warner estimate the deal to be completed by 2017, there is still a high likelihood that the US Government will block that acquisition. If the deal doesn’t go through, the risk of a dividend cut will be much lower in my opinion.

All of that being said, I find the stock to be attractively valued at 12.80 times earnings. I find the forward payout ratio of 69% to be a little high, though I still think that the dividend is sustainable as long as management does not let debt get out of control. Given the fact that everyone is expecting lousy returns from the US stock market over the next decade, and the lack of earnings growth for major US corporations as a whole, AT&T could deliver a 5.40% return to shareholders even if earnings per share never increased, and the stock price stayed stagnant forever. That return would be generated by mere collecting of the generous 5.40% dividend yield, as long as the dividend is maintained. In fact, I may turn even more bullish on AT&T if that acquisition of Time Warner does not close, because there will be less new debt on the books, and we also won’t have to worry about the dilutive effect of new shares that AT&T will have to pay high dividends on.

V.F. Corporation (VFC) engages in the design, production, procurement, marketing, and distribution of branded lifestyle apparel, footwear, and related products in the United States and Europe. The company raised its quarterly dividend by 13.50% to 42 cents/share.

This marked the 44th consecutive annual dividend increase for this dividend champion. Over the past decade, V.F. Corporation has managed to raise dividends at an average annual rate of 17.10%/year. Currently, the stock looks attractively valued at 17 times forward earnings and yields 3.10%.

The company has transformed itself into a designer and marketer of casual lifestyle brands in the US. The company focuses on its Outdoor & Action sports, Sportswear and Contemporary brands lifestyle businesses. Increasingly, I see many people wearing jackets with the “North Face” logo, either at work or in the streets. Another growth factor could be expansion into international markets, as well as strategic shifting of focus to more profitable brands. The company has a history of making acquisitions work, as evidenced by Vans and North Face deals in the early 2000s. The company delivers a quality product at an attractive price point for consumers.

V.F. Corporation has had a strong track record of growing sales, making acquisitions work, and earning more in order to grow the dividend to shareholders.

AbbVie Inc. (ABBV) discovers, develops, manufactures, and sells pharmaceutical products worldwide. It was formed in 2013, as a result of the spin-off from the legacy Abbott Laboratories. I believe that both the new Abbott (ABT) and Abbvie should get credit for the long track record of annual dividend increases from the legacy Abbott. This view is further strengthened by the fact that both spin-offs have kept up the tradition of annual dividend increases. Abbvie recently raised its quarterly dividend by 12.30% to 64 cents/share. The stock is attractively valued at 12 times expected earnings and a dividend yield of 4.40%.

The biggest risk with Abbvie is that the drug Humira that treats rheumatoid arthritis accounts for 64% of revenues, which is very high. This drug is coming off patent protection in the US at the end of 2016 and Europe in 2018. The company claims that due to the biosimilar structure of the drug, and the patents surrounding it, it would be difficult to replicate by competitors until the early 2020s. Management has indicated that they would try to maintain exclusivity of Humira until 2022. The company also has promising new drugs in the pipelines. Two other growing drugs include Imbruvica and Viekira, but they account for less than 16% of sales. The nice thing is that Abbvie is also diversifying its product base by acquisitions. In 2015 it acquired Pharmacyclics, and bought the drug Imbruvica. The sales of this drug are expected to grow from $1.30 billion in 2015 to $5 billion by 2020. Abbvie also closed an acquisition of Stemcentrix, which has several compounds in trials. In general, the company expects double digit growth in earnings per share through 2020, fueled by introduction of 20 new compounds (which are in phase 2 and 3), and protecting its sales of Humira. Depending on how things unfold over the next decade, Abbvie could either look like a steal today or a value trap.

Aflac Incorporated (AFL) is the world’s largest underwriter of supplemental cancer insurance, which it sells through independent and corporate agencies and bank and post offices in Japan. Also sells life, health, Medicare supplement, accident, and long-term convalescent care policies. The company raised its quarterly dividend by 4.90% to 43 cents/share. This action extends the streak of annual dividend increases for Aflac to 34 years in a row. Over the past decade, Aflac has boosted its dividend by 13.60%/year. Over the past five years however, this dividend champion has only managed to boost dividends at a rate of 6.70%/year. It is attractively valued at 11.20 times earnings and a current yield of 2.50%. Check my analysis of Aflac for more information.

Dividend growth has been slowing down for Aflac in recent years, due to softer earnings per share. Since 70% of the company’s business originates in Japan, its US dollar earnings are susceptible to fluctuations in the Japanese Yen. The other challenge for Aflac is investing its insurance premiums in the low interest environment worldwide. Negative interest rates in the land of the rising sun are not helping out either. If interest rates increase, this would definitely help Aflac grow its bottom line much faster. On the other hand, the company’s future growth will also be dependent on new product offerings and expanding its distribution channels in order to sell more policies (while also maintaining a focus on policy profitability as well).

The last company is not attractively valued by any measure. In fact, a lot of investors believe the company to be massively overvalued. Nevertheless, I am including this company, because it is a widely held dividend champion which recently raised its quarterly dividends. This move defied investor expectations. I have observed many investors who sold out of the stock earlier this year after oil prices declined, because they probably allowed negative news and fears of a possible dividend cut to influence them into selling. The company is Chevron (CVX). It recently raised its quarterly dividend by a penny to $1.08/share. Chevron is a dividend champion, which has managed to boost dividends for 29 years in a row. Given the earnings estimates of $1.19/share for 2016 and $4.45/share for 2017, I view the stock as overvalued. When energy prices are low, earnings per share are also depressed from one-time asset impairments. From an operational perspective however, low energy prices could provide the opportunity to acquire producing assets at a value price.

My historical analysis of Exxon showed that those ugly financials may not be a good reason to sell an integrated energy company, due to the cyclical nature of prices. In other words, when financials look ugly, this is after prices have fallen. If prices rebound, the financials will likely look better. That being said, if energy prices stay low, companies like Chevron may have to do the unthinkable and cut distributions. Even using the optimistic earnings of $4.45 for 2017, the dividend is not well covered. I would continue holding on to Chevron, but would allocate dividends elsewhere. Unfortunately, the 4.20% yield is not sustainable at current levels. If you buy the stock today, you’d better hope for higher oil prices down the road.

Thank you for reading!

Full Disclosure: Long VFC, AFL, ABBV, CVX, ABT, XOM, VOD, and short AT&T puts

Relevant Articles:

What can we learn from Exxon in the 1980s and 1990s
Does entry price matter to dividend investors?
How I Manage to Monitor So Many Companies
Should I invest in AT&T and Verizon for high dividend income?
Selling Puts: Pros and Cons for Dividend Investors

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