Utility dividends for current income

Electric, Gas and Water utilities have always been traditionally regarded as income stocks by investors. Their high current yields, and the relative stability of their distributions made them a preferred choice for investors who are seeking current income from their assets.

Utilities typically pay out a large portion of their earnings as dividends, which explains their slow dividend growth and high dividend yields. Most utilities operate as natural monopolies, which guarantees almost no competition in their specific geographic areas. It would be very costly to run two separate electrical grids, and such investment could take many decades to pay off. Thus utilities tend to generate stable earnings and revenues in any economic conditions, as people keep using water, gas and electricity in their daily lives no matter what.

A main risk factor for many utilities is government legislation in regards to greenhouse gases, which could increase their costs over time. Such legislation could force utilities to purchase CO2 pollution allowances, which could cut into earnings. The heavy government regulation could be the driving force behind future growth however. A recent phenomenon has been the smart grid initiative.

The smart grid initiative integrates information and communication technology into electricity generation, delivery, and consumption, making systems cleaner, safer, and more reliable and efficient. While it would be costly to modernize electric grids, there is some stimulus available from the department of energy. The department of energy plans to distribute $3.9 billion in Recovery Act funds for smart grid projects through two funding opportunities. The first provides $3.3 billion for deploying and implementing smart grid technologies across the country. The second provides $615 million for smart grid pilot projects. (Source: Yahoo Finance)

Because of the stability of their cash flows, utilities could afford increasing their dividends for long periods of time. Most utilities that I have stumbled upon have had a history of dividend increases, followed by a steep dividend cut, which is then followed by another string of dividend increases. More often than not however, dividend cuts in the Utilities Sector are followed by dividend increases for several years until the dividend payment reaches or exceeds the previous levels. Because of this cyclical nature of utility dividends I view the sector as more suitable for current income generation that for solid dividend growth. Thus for a younger investor who has more than 2 decades until they plan on living off their dividend income in retirement, I would not recommend a high exposure to utilities.

While current yields on utilities tend to be higher than the yields on S&P 500, dividend growth is much slower, which could erode the purchasing power of your utility dividend income over time. I view utilities stocks similarly to fixed income, as they are very sensitive to interest rates and have stable distributions.

Utility stocks typically lag during strong bull markets as investors chase higher growth prospects. In flat or bear markets however utility stocks do not decline as much and they are further helped by their generous dividend yields.

While it is true that some utilities don’t have a strong history of raising distributions, there are several utilities, which have raised their distributions for more than 25 consecutive years, and thus are part of the dividend champion’s list:

It is important to look at the dividend payout ratios, the EPS trends and the EBIT to interest expense ratio in order to gauge the sustainability of the dividend payment over time. The EBIT to interest expense or coverage ratio is an important indicator which shows whether utilities could afford servicing their debt obligations. While some investors focus only on the debt to asset ratios, I view the ability to service interest payments as an important factor that shows how sustainable the company’s ability to operate as a going concern actually is.

Because of the slow dividend growth, I would not consider initiating a position in utilities stocks yielding less than 4% to 5%.

Full Disclosure: Long ED

This post was included in the :The Carnival of Personal Finance #226 – The AFM Turn’s 5 Edition

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McDonald’s Delivers Strong Dividend Growth

Several companies raised distributions last week. The most notable raiser was fast food chain McDonald’s (MCD), which surprised investors with a 10% dividend increase. This marked the 33rd consecutive annual dividend increase for this Oak Brook, Illinois based dividend aristocrat.

McDonald's Chief Executive Officer Jim Skinner said, "So far in 2009 we've returned nearly $4.0 billion to shareholders through dividends and share repurchases, bringing total cash returned since the beginning of 2007 to about $15.5 billion. With today's dividend increase, we expect to end the year near the high end of our three-year, $15 billion to $17 billion total cash return target."
Skinner continued, "This achievement reflects the success of our better, not just bigger strategy, which has helped drive sales, profits and, ultimately, cash from operations. Going forward, our philosophy on our use of capital remains unchanged. Our first priority is to reinvest to grow our business and enhance shareholder value. After these investment opportunities, we expect to return all of our free cash flow over the long term through dividends and share repurchases -- while maintaining a strong financial foundation. Today's dividend increase underscores our confidence in the long-term strength of our business and ongoing commitment to returning cash to shareholders."

The golden arches have definitely weathered the economic storm relatively unscattered, with monthly sales consistently marking comparable gains. I recently added to my position in McDonald’s (MCD), as I believe that the company posseses strong dividend growth characteristics. The company has more than doubled its dividends since 2006.

Several other companies announced increase in distributions:

Lockheed Martin Corporation (LMT), Lockheed Martin Corporation engages in the research, design, development, manufacture, integration, and sustainment of advanced technology systems, products, and services in the United States and internationally., increased its quarterly dividend by 10.50% to 63 cents per share. Lockheed Martin Corporationi has increased its quarterly dividend in each of the past six years. The stock currently yields 2.90%.

Sanderson Farms, Inc. (SAFM), which Sanderson Farms, Inc., an integrated poultry processing company, engages in the production, processing, marketing, and distribution of fresh, frozen, processed, and prepared chicken products in the United States., increased its quarterly dividend by 7% to 15 cents per share. Sanderson Farms, Inc. doesn’t follow a path of regular annual dividend increases that I prefer in a dividend stock.

ConAgra Foods, Inc. (CAG), which operates as a food company in North America and internationally, increased its quarterly dividend by 5% to 20 cents per share. This is the third dividend increase for ConAgra Foods, Inc. since the company cut its distributions in 2006. The stock currently yields 3.50%.

Chimera Investment Corporation (CIM), which invests in residential mortgage backed securities (RMBS), residential mortgage loans, real estate-related securities, asset backed securities (ABS), increased its quarterly dividend by 50% to 12 cents per share. Chimera Investment Corporation is a relativelyshort dividend history, which started in 2007. The dividend payment seems to be fluctuating a lot, which is not something to have when you try to live off your income streams. The stock currently yields 11.80%.

Hatteras Financial Corp. (HTS), which invests in adjustable-rate and hybrid adjustable-rate single-family residential mortgage pass-through securities guaranteed by a U.S. Government agency or issued by a U.S. Government-sponsored entity, increased its quarterly dividend by 4.5% to $1.15 per share. Despite the fact that Hatteras Financial Corp. has only been around since 2008, its dividends have been pretty stable. The stock currently yields 13.90%.

Triangle Capital Corporation (TCAP), which is a private equity and venture capital firm specializing in buyouts, change of control transactions, acquisitions, growth financing, and recapitalizations in lower middle market companies, announced that its board has approved a 2.5% increase in dividends to 41cents/share. Triangle Capital Corporation has increased quarterly dividends since ever since it went public in 2007. The stock currently yields 14.10%.

I would be careful with the last three stocks mentioned, as they distribute most of their earnings out to shareholders, and thus have to depend on stock sales in order to keep growing the business. More stock sales dilute existing shareholders’ interests and could spell trouble if the capital markets freeze for one reason or another. Successful dividend investing is more than just chasing the highest dividend stocks – it’s more about finding a stock that has adequately covered dividends, whose business model could support future dividend increases.

Full Disclosure: Long MCD

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Toronto-Dominion Bank (TD) Dividend Stock Analysis

Toronto-Dominion Bank, through its subsidiaries, engages in the provision of retail and commercial banking, wealth management, and wholesale banking products and services in North America and internationally. It operates through four segments: Canadian Personal and Commercial Banking, Wealth Management, U.S. Personal and Commercial Banking, and Wholesale Banking. This international dividend achiever and Canadian Dividend Aristocrat has raised dividends for 15 years in a row.

Over the past decade this dividend growth stock has delivered an average total return of 13.20% annually.

The company has managed to deliver a 5.60% average annual increase in its EPS between 1999 and 2008. Analysts expect Toronto-Dominion Bank to earn $4.98 share next year, followed by a 4% increase to $5.17/share in the year after that.

The Return on Equity has recovered from its 2003 lows of 26% and is at a very impressive level at 42%. Rather than focus on absolute values for this indicator, I generally want to see at least a stable return on equity over time.

Annual dividends have increased by an average of 20.50% annually since 1999, which is higher than the growth in EPS. Most of the dividend growth came from the expansion in the dividend payout ratio, which more than tripled from 15% in 1999 to 48% in 2008.
A 20 % growth in dividends translates into the dividend payment doubling every three and a half years. If we look at historical data, going as far back as 1973, Toronto-Dominion Bank has actually managed to double its dividend payment every six years on average. The company last raised its dividends in 2008.

The dividend payout ratio has more than tripled from 15% in 1999 to 48% in 2008. In 2002 the company lost money, which is why it is at zero for the year. A lower payout is always a plus, since it leaves room for consistent dividend growth minimizing the impact of short-term fluctuations in earnings.

Currently the Toronto-Dominion Bank is attractively valued at 17 times earnings, yields 3.50% and has an adequately covered distribution. The main issue with this dividend investment is that it has failed to increase its distributions for five quarters in a row. The company has until the last quarter of 2010 to raise its dividend, or otherwise it would lose its dividend achiever status. In the meantime it is a solid hold for me. That is unless you are looking for some exposure to the financial sector for your dividend portfolio. As such TD could be a nice small starter position to consider.

Full Disclosure: Long TD

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Dividends Stocks versus Fixed Income

Many retirees who are seeking current income from their assets invest in fixed income securities, most of which provide a stable stream of income. Fixed income investments do have some disadvantages relative to stocks that pay dividends, and thus retirees which fail to account for these, could end up with no income at the worst time possible .

First, while typical fixed income securities provide a dependable income stream, its purchasing power is typically eroded by inflation. Even at 3% per annum, the purchasing power of one dollar decreases by 50% in 24 years. Double that inflation rate to 6% annually and now the purchasing power of one dollar is down by 50% in 12 years and by 75% in 24 years. Stocks that pay rising dividends provide the best inflation proof source of income. Dividend based distributions can grow, interest based distributions usually don't. Unless interest income is reinvested, the interest income cannot grow over time to compensate for the eroding value of inflation.

Second, right now qualified dividend income is taxes at 15% for the highest tax bracket in the US, which is almost half the top tax for interest income in the States. In Canada dividend income also received a preferential treatment relative to fixed income.

Third, bonds typically don’t increase their interest payments if the business is doing well. Stocks, which represent partial ownership of companies, tend to share higher profits with shareholders either through dividend increases or through stock buybacks. Thus stocks tend to provide higher total returns over time as they could provide higher capital gains and higher dividend incomes.

Stocks have disadvantages as well however.

First, if a company goes under and declared bankruptcy, fixed income holders are the only ones that get at least some return of their investment. Stockholders on the other hand typically receive nothing when the company emerges from bankruptcy.

Second if a company faces financial difficulties it could easily afford to cut or eliminate its dividends, but it would have to go through huge hurdles before it could get bondholders to agree to reduce or eliminate their interest payments.

Fixed income securities guarantee a return of your investment some time in the future, whereas stocks don’t provide that.

That being said I do believe that the best strategy for long-term investors is to have an allocation to both stocks and bonds. Fixed income tends to provide dependable income even in the worst bear markets. In addition to that fixed income investments provide diversification in bear markets and are the only asset to provide returns to investors during deflationary periods.

Stocks are great vehicles to own during average and high inflationary periods, and they could provide investors with rising inflation adjusted streams of dividend income over time. There are companies which have long records of raising their distributions. The possibility of receiving rising dividends from stocks, make equities a preferred method of investment for many investors. Some early holders of stocks like Johnson & Johnson (JNJ), Exxon Mobil (XOM), and Altria (MO) are now enjoying double or even triple digit yields on cost on their original investments, even without reinvesting their dividends. Similar investments even in the safest highest yielding fixed income securities would still be generating the same incomes, provided that they have not matured.

Currently I like several dividend stocks, which have the best prospects to grow their distributions over time.

Johnson & Johnson (JNJ) has increased dividends for 47 consecutive years. Johnson & Johnson engages in the research and development, manufacture, and sale of various products in the health care field worldwide. Check my analysis of the stock.

Mcdonald’s (MCD) has increased dividends for 32 consecutive years. McDonald’s Corporation, together with its subsidiaries, franchises and operates McDonald’s restaurants in the food service industry worldwide. Check my analysis of Mcdonald’s.

Chevron (CVX) has increased dividends for 22 consecutive years. Chevron Corporation operates as an integrated energy company worldwide. Check my analysis of Chevron.

Abott Labs (ABT) has increased dividends for 37 consecutive years. Abbott Laboratories manufactures and sells health care products worldwide Check my analysis of the company.

Clorox (CLX) has increased dividends for 32 consecutive years. The Clorox Company manufactures and markets a range of consumer products Check my analysis of the stock.

Full Disclosure: Long ABT, CLX, CVX, JNJ, MCD, MO

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Eight Dividend Increases in the news

The market continued going higher, despite all concerns about valuations, unemployment and the recession. Most analysts are divided on whether the 6 month advance is over or not. Dividend investors on the other hand however are not so concerned about the overall state of the market, as long as dividends are being paid indeed. The main problem with a rising market however is that it leaves fewer attractively valued stocks to enter or reinvest dividends. If you find the right dividend growth stocks however, which tend to raise distributions every year or so, one does not need to rely on dividend reinvestment for growth in their passive income.

Several such prominent dividend players announced that their boards of directors have approved distribution raises for stockholders.

Realty Income Corporation (O), which engages in the acquisition and ownership of commercial retail real estate properties in the United States, increased its monthly dividend to $0.1426875 per share from $0.142375 per share. Realty Income Corporation is a dividend achiever, which has increased its quarterly dividend in each of the past fifteen years. The stock currently yields 6.20%.

Tom A. Lewis, Chief Executive Officer of Realty Income commented, "We are pleased that, despite challenging economic conditions, our operations allow us to once again increase the amount of the dividend we pay to our shareholders. With the payment of the October dividend we will have made 471 consecutive monthly dividend payments."

Philip Morris International (PM), which manufactures and sells cigarettes and other tobacco products in markets outside of the United States of America, increased its quarterly dividend by 7.4% to 58 cents per share. Philip Morris International was spun out of Altria Group (MO) in 2008. Since then the company has raised distributions twice. The stock currently yields 4.90%.

Texas Instruments Incorporated (TXN), which engages in the design and sale of semiconductors to electronics designers and manufacturers worldwide, increased its quarterly dividend by 9% to 12 cents per share. The stock currently yields 1.80%.

W. P. Carey & Co. LLC (WPC), which provides long-term net lease financing for companies, increased its quarterly distributions by 8% to 50 cents per share. This marks the 34th consecutive distribution increase for this dividend achiever. The stock currently yields 7.00%.

The Kroger Co. (KR), which operates as a food retailer in the United States, increased its quarterly dividend by 5.6% to 9.5 cents per share. Kroger began raising dividends in 2006. The stock currently yields 1.70%.

Corporate Office Properties Trust (OFC), which is a real estate investment trust (REIT) that engages in the acquisition, development, ownership, management, and leasing of suburban office properties., increased its quarterly dividend by 5.4% to 39.25 cents per share. Corporate Office Properties Trust is a dividend achiever, which has increased its quarterly dividend in each of the past thirteen years, which it has more than doubled since 2004. The stock currently yields 4.10%.

Agree Realty Corporation (ADC), which is a real estate investment trust (REIT), that engages in the ownership, development, acquisition, and management of retail properties, which are primarily leased to national and regional retail companies in the United States, increased its quarterly dividend by 2% to 51 cents per share. Agree Realty Corporation does not have a consistent history of dividend increases, although it hasn’t cut distributions either since 1994. The stock currently yields 9.30%.

Full Disclosure: Long PM, MO and O

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