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Summary
  • Robust presence in the global Diabetes care market, with 27% market share
  • Extensive geographical presence, strong product pipeline and 90 years of R&D expertise
  • Emerging market and new products are key growth drivers

This article has been written by Sneha Shah for The Dividend Guy.

Investment Thesis

Healthcare stocks offer a safe dividend stream for investors given their nearly recession-proof nature. The sector offers immense potential owing to a growing senior population that drives demand for medical products.

Novo Nordisk is a leading global pharmaceutical company having a strong leadership position in diabetes care.  About 27.7 million people use its diabetes care products worldwide. The company has developed strong R&D expertise and a strong product pipeline pumping out market leading medicines. It is also slowly but steadily expanding its footprint in emerging markets, given the pricing challenges that healthcare companies are currently facing in the USA.

Given Novo Nordisk’s leadership, the company stands in a good position to benefit from a growing population suffering from chronic diseases like diabetes, obesity and others.

Understanding the Business

Novo Nordisk is a global healthcare company. Headquartered in Denmark, Novo Nordisk has operations in 79 countries and markets its products in more than 170 countries. The company has over 90 years of experience in diabetes care and other serious chronic conditions such as haemophilia, growth disorders and obesity.

By geography, North America constitutes its largest market accounting for 52% of total sales in 2017, followed by Europe (19%), AAMEO region (11%), China (10%), Japan, Korea (5%) and Latin America (3%).

By product line, diabetes care is the largest revenue generator accounting for 81% of 2017 revenues, followed by haemophilia (9%), growth hormones (6%), obesity (2%) and other biopharmaceuticals (2%).

Revenues

Source: Ycharts

Novo Nordisk commands a 27% market share in diabetes care and 45% in insulin volume market share. It is the only company with a full portfolio of novel insulin and GLP-1 products. Diabetes care and obesity have become widespread in the U.S., with an increasing diabetic population in the U.S. and Novo Nordisk stands to benefit from this trend.

Tresiba and Victoza (drugs for diabetes care) are the largest growth drivers, growing by 85% and 18% respectively. Its semaglutide product, Ozempic, also received FDA approval and should further fuel growth of its diabetes-care line of products. Saxenda, which is a global leader in the anti-obesity market is also showing good growth. Further, Novo Nordisk is also investing to roll out a new generation insulin portfolio.

More than 90 years of research and an extensive geographical presence are Novo Nordisk’s other strengths. International operations, which cover more than 190 countries, grew by 5% last year. The company is adopting a ‘market fit’ approach to grow this business. Emerging markets also present a compelling growth opportunity for Novo Nordisk as can be seen from the graph below:

Management expects sales growth of 2%-5% (in local currency) in 2018.

Earnings

Source: Ycharts

The diabetes care and obesity segments accounted for 78% of the total operating profit while the biopharmaceuticals segment constituted the remaining 22%.

Sales and distribution are the biggest cost and accounted for nearly 30% of sales in the most recent quarter.

The company is making investments in additional production capacity and expenses to support the commercialisation efforts for the launch of Ozempic. In addition, Novo Nordisk is also expanding its R&D efforts into other serious chronic diseases with unmet medical needs. It is developing stem cell therapy for type 1 diabetes, and developing a biological medicine in a tablet.

Novo Nordisk is targeting an operating profit growth of 5% on average and expects to convert 90% of its earnings into cash for shareholders. The company is expecting to drive margins through continuous cost control measures and sales growth. It has a strong pipeline of medicines which should further fuel growth.

Dividend Growth Perspective

Source: Ycharts

Source: Novo Nordisk

Novo Nordisk is a shareholder friendly company offering a dividend yield of 2.35% along with large share buybacks every year. The company has paid uninterrupted dividends for 20 years in a row. Once you bring NVO’s cash dividend in its currency, you can see that the company could make the Achievers list if it was a U.S. company.

The company’s next payout is expected to increase by 3%, with a reasonable payout ratio of 50% indicating room for further growth.

The company has a good cash balance and management has the flexibility to take on debt in case of any cash shortfalls.

Source: Ycharts

Investors have reasons to be happy as the company also announced a new share repurchase programme of up to DKK 14 billion (US$ 2.24 billion) for the year.

Potential Downsides

Novo Nordisk faces competition from generic drug companies. Teva Pharmaceuticals’ new generic drug poses a big threat to Novo Nordisk’s flagship diabetes drug Victoza, which is one of its biggest brands.

Moreover, U.S. healthcare budgets and prices will continue to remain under pressure as healthcare costs in the country are quite high as compared to other nations. There is tremendous pressure on the healthcare system to lower cost. This might adversely affect sales growth and profitability.

New products from competitors and competition for older drugs also affect volumes and create pricing pressure.

Having a large international presence, Novo Nordisk is also sensitive to currency fluctuation. In fact, the company reported disappointing FY 17 results owing to the fact that almost every currency in the world declined against the Danish krone in 2017.

Valuation

Source: Ycharts

NVO is trading at P/E of 19.48x which is lower than the industry average of 29x. Its debt to equity is also lower at 0.03, when compared to the industry median.

Final Thought

The International Diabetes Federation (IDF) estimates that the number of diabetic people will increase to 629 million by 2045 from 425 million today. Novo Nordisk has a huge growth potential as only 6% of the diabetes population is being treated with its products. Even though growth has slowed in recent times, Novo Nordisk remains profitable given its heavy R&D expenditure, expansion into other therapy areas and partnerships. The company has a good long term visibility given its dominant position in the diabetes market. The recent correction offers a good entry point for investors with a long term horizon.

Disclosure: I do not hold NVO in my DividendStocksRock portfolios.

Additional disclosure: The opinions and the strategies of the author are not intended to ever be a recommendation to buy or sell a security. The strategy the author uses has worked for him and it is for you to decide if it could benefit your financial future. Please remember to do your own research and know your risk tolerance.

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Summary
  • Apple just finished another record year
  • Haters gonna hate
  • Shareholders gonna smile

I remember the first time I purchased shares of Apple (AAPL). At first, it was supposed to be a short-term investment as there was a timely opportunity. I bought my first shares before the split, when the stock was trading under $400 (therefore, under $57 after the 1:7 split). At that time, many rumors were going around.

“Apple’s iPhone is going to be eaten-up by Samsung’s smartphone”

“The company is a one trick pony”

“We have reached Apple’s full potential; it will only go down from now on”

A few years and over 100% return later, Apple is struck by similar bad mouth sayings.

“The iPhone X is a failure”

“Apple’s battery sucks”

“The company is programming smartphones obsolescence, Apple is evil”

It’s funny to see that for each Apple fan, there is probably a hater. It’s only fair. But as a serious investor, you should neither be a fan or a hater. Emotion has no place when it’s time to take a look at a stock. Now that we have set our feelings aside, let’s take a deeper look at Apple.

Understanding the Business

Apple has been called a one trick pony for several years and this is not entirely false. Apple is one of the largest smartphone makers in the world. But there is more than that. While AAPL iPhone represents about half of Apple’s sales, the company is building a strong “services” segment.

As you can see, Apple’s financial performances are still highly dependent on the next generation of iPhones. You can see what happens when there is a new phone on the market; quarterly sales more than doubled from Q4 2017 to Q1 2018.

The company continues to sell iPads and Macs but it’s definitely not part of the core business model anymore. The company’s main strength relies on the quality of their product and the ecosystem it builds around them. I think the Internet of Things (IoT) term come from all Apple’s devices talking to each other!

An Eye on the Latest Quarter

Non-GAAP EPS of $3.89, up by 16%, beat estimates by $0.04

Revenue of $88.3B, up by 12.7%, beat estimates by $670M.

Dividend of $0.63/share, no increase.

What the CEO Said

“We’re thrilled to report the biggest quarter in Apple’s history, with broad-based growth that included the highest revenue ever from a new iPhone lineup. iPhone X surpassed our expectations and has been our top-selling iPhone every week since it shipped in November,” said Tim Cook, Apple’s CEO. “We’ve also achieved a significant milestone with our active installed base of devices reaching 1.3 billion in January. That’s an increase of 30 percent in just two years, which is a testament to the popularity of our products and the loyalty and satisfaction of our customers.”

What I Say

I’m not surprised by this record quarter. I expected strong sales for Apple’s new iPhone. There is definitely a continuous interest for premium products (at a premium price!). It seems it’s never enough for some specialists, but I will gladly hold my shares. I’m more interested to see Apple repatriate its offshore cash and how it will use it in the upcoming months.

Growth Vectors

Source: Ycharts

Wow… have you seen this graph? Both revenues and earnings are going higher and higher at the same pace! Apple first growth vector remains its iPhone. Each time there is a new model coming out, the market goes a little crazy. Off course, it’s not the same hype as it was when Apple launches its iPhone 4 for example. Still, there is a continuous interest for new versions.

Second, Apple is growing its services division at a double digit pace. During their most recent quarter, this segment posted at +18% year over year growth. Services such as Apple Pay, Apple Music and Apple TV are just the beginning. The more people buy iPhones, the more they are inclined to use services attached to them.

Third, the Tax bill will make additional money available for Apple to use. I expect additional shares repurchase and dividend increase. This is definitely a plus if you are a shareholder!

Dividend Growth Perspective

Apple shows 5 years of consecutive dividend growth. This makes it half way of making the elite Dividend Achievers list. The Dividend Achievers Index refers to all public companies that have successfully increased their dividend payments for at least ten consecutive years. At the time of writing this article, there were 265 companies that achieved this milestone. You can get the complete list of Dividend Achievers with comprehensive metrics here.

Source: Ycharts

During this 5 years period, AAPL shows a +66.42% total dividend growth for a 10.72% CAGR. With strong sales growth and consistent earnings progression, I expect the company to keep up with a double-digit dividend growth commitment for several years. Don’t be fooled by the 1.50% yield as the company will double its payment every 7 years going forward. AAPL meets my 7 dividend growth investing principles.

Source: Ycharts

Both payout and cash payout ratios are very low. This is another reason why I believe in a double-digit dividend growth policy for the next decade. Apple’s business model is based on generating tons of cash flow on a quarterly basis. This is exactly what I’m looking for as a dividend growth investor.

Potential Downsides

To be honest, I don’t see that many dark clouds coming over Apple’s head at the moment. The company enjoys strong growth vectors and whatever haters say about AAPL’s new iPhones or watch, the company keeps showing strong sales.

However, there are no techno companies sheltered from innovation. I think Apple protects its core product with a strong product ecosystem and additional services. Yet, the coming of a new popular phone hurting AAPL sales is always a possibility.

Valuation

What is the right price to enter in a position in AAPL? My guess would be today is the best moment after yesterday. The worst timing is tomorrow.

Source: Ycharts

The company continues to trade at reasonable levels considering its growth potential. When I use the DDM, I get a current price being slightly undervalued right now:

Input Descriptions for 15-Cell Matrix INPUTS
Enter Recent Annual Dividend Payment: $2.52
Enter Expected Dividend Growth Rate Years 1-10: 10.00%
Enter Expected Terminal Dividend Growth Rate: 8.00%
Enter Discount Rate: 10.00%
Discount Rate (Horizontal)
Margin of Safety 9.00% 10.00% 11.00%
20% Premium $389.63 $193.54 $128.23
10% Premium $357.16 $177.41 $117.54
Intrinsic Value $324.69 $161.28 $106.86
10% Discount $292.22 $145.15 $96.17
20% Discount $259.75 $129.02 $85.48

Please read the Dividend Discount Model limitations to fully understand my calculations.

I can’t really use a strong dividend growth rate at the moment. However, the moment management announce their 2018 dividend raise; the stock will appear undervalued by 10%.

Final Thought

As I mentioned earlier in this article, the right timing to buy Apple is always today. I think the company will continue to thrive in the upcoming years and its shareholders will be rewarded with juicy dividend raise year after year. Don’t wait until AAPL pays a 3% yield to jump on the train.

Seriously, if you made it this far, it’s because you liked what you read. Don’t be a stranger; leave a comment and tell me what you think! I’m asking you one more thing; click on “follow” button (it’s orange, you can’t miss it!) and you will get notified each time I write a great piece like this one.

 

Disclosure: I do hold AAPL in my DividendStocksRock portfolios.

Additional disclosure: The opinions and the strategies of the author are not intended to ever be a recommendation to buy or sell a security. The strategy the author uses has worked for him and it is for you to decide if it could benefit your financial future. Please remember to do your own research and know your risk tolerance.

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Summary
  • Diageo is a leader in premium spirits industry, it will surf the current economic tailwind.
  • Emerging markets start to get some traction as middle class seeks recognitions and claim a higher status through their lifestyle.
  • Unfortunately, DEO is overpriced right now.
Investment Thesis

DEO will benefit from the good standing of the current economy. Consumers around the world are optimistic in their future, and they are more willing to spend. DEO enjoys strong pricing power, and its brand portfolios are protected with premium names. Diageo also invests in an important sales team in order boost its product’s popularity at all times. The company will continue to pay a solid 2.50% dividend. Finally, the rising income in emerging markets will eventually lead to additional customers for Diageo and its premium spirits. Unfortunately, the DDM calculation doesn’t justify the current price.

Understanding the Business

Diageo is another “sinner’s club” dividend stock. The company, based in England, evolved as the result of a massive merger of Grand Metropolitan and Guinness back in 1997. DEO is a global spirits and beer marketer and distributor. Diageo largest products are scotch, beer and vodka. The company manages over 200 brands served in 180 countries. In other words, if you drink alcohol in any form, you have definitely tasted one of Diageo brands. Famous names such as Guinness, Smirnoff, Johnnie Walker, Captain Morgan and Baileys are among a long list of brands owned by Diageo. Here’s an idea of what they sell across the world:

Source: DEO 2017 Annual Report

Revenues

Source: Ycharts

Keep in mind that all graphs are in USD, but the company reports their figures in British pounds. As you can see I the following graph, both currencies had their share of fluctuation over the past 10 years:

Source: Ycharts

A clearer version of their sales can be found in their 2017 annual report where the company showed strong organic growth last year:

Diageo is not only a leader in the spirit industry, it is also benefiting from premium brands. In a world where your status can be determined by what you drink, owning well-known and pricey brands are a key element against your competitors. DEO protects its market shares through strong branding and enjoys pricing power. With its wide brand portfolio, it has become a great partner in the retail business (bars and restaurants are looking for Diageo’s products).

Earnings

Source: Ycharts

Then again, here are the past year’s performance in DEO main currency:

Diageo went through a difficult couple of years where EPS decreased since 2013. Management worked harder to improve their margin and their marketing teams put additional focus on sales. After spending nearly £1 billion in marketing during their latest interim period, DEO is back to solid organic growth.

Source: DEO 2018 interim result presentation

It will be interesting to follow DEO earnings in the upcoming years to see if it was just a temporary rebound, or a new trend. My guess is that the economy will continue to push DEO higher in the future.

Dividend Growth Perspective

Diageo pays dividend twice a year. Unlike most American companies, DEO pays 2 different amounts each year. This explains the roller coaster graph you are about to see:

Source: Ycharts

DEO shows 6 consecutive years with a dividend increase, according to Dividend.com. This makes it 4 years a part of making the elite Dividend Achievers list. The Dividend Achievers Index refers to all public companies that have successfully increased their dividend payments for at least ten consecutive years. At the time of writing this article, there were 265 companies that achieved this milestone. You can get the complete list of Dividend Achievers with comprehensive metrics here.

DEO is in a similar position to BUD. Both companies pay semi-annual dividends in another currency. This creates an additional fluctuation in your portfolio. DEO shows a solid dividend growth policy, and a payout ratio under 50%. You can expect additional increases in the years to come… unless DEO makes more acquisitions and slows down its dividend growth policy. If business remains basically the same, we expect DEO to increase its payout by mid-single digits over the upcoming years.

Source: Ycharts

Potential Downsides

The spirit industry is more cyclical than the beer business. Since DEO has a great niche in premium brands, those are more affected during economic downturns. The company is also subject to additional regulations and taxes coming from governments. On one side, people like alcohol, but on the other, some push for stronger regulations. There is always a risk of contamination or fire in its ageing facilities. Finally, as the bulk of DEO expenses is in British pounds, the fact that England is leaving the Euro may create additional volatility in its financial statements.

Valuation

Diageo is a solid company with a solid reputation. Unfortunately for potential new shareholders, DEO stock hasn’t been trading at a discount recently. DEO has jumped by about 34% between January 2016 and January 2018 and most of the gain is due to PE expansion.

Source: Ycharts

Digging deeper, I’ve used the dividend discount model to find a fair price for DEO. I’ve used a 5% dividend growth rate for the first 10 years and increased it to 6% as a terminal rate. DEO is a leader in an industry where brand names mean everything. It will be very difficult for any company to match the Diageo brand recognition (and marketing budget to do so).

Input Descriptions for 15-Cell Matrix INPUTS
Enter Recent Annual Dividend Payment: $3.21
Enter Expected Dividend Growth Rate Years 1-10: 5.00%
Enter Expected Terminal Dividend Growth Rate: 6.00%
Enter Discount Rate: 9.00%
Discount Rate (Horizontal)
Margin of Safety 8.00% 9.00% 10.00%
20% Premium $187.13 $125.19 $94.20
10% Premium $171.54 $114.76 $86.35
Intrinsic Value $155.94 $104.32 $78.50
10% Discount $140.35 $93.89 $70.65
20% Discount $124.76 $83.46 $62.80

Please read the Dividend Discount Model limitations to fully understand my calculations.

Unfortunately, DEO is not showing as a screaming buy right now. I obviously don’t think DEO price will fall by more than $30 in 2018 to meet the DDM fair price. However, I highly doubt there is lots of growth potential for a dividend growth investor.

Final Thought

Diageo manages an impressive brand portfolio of spirits and alcohol products. Their names and the money the company keeps spending each year to maintain their standards make it almost impossible for new competitors to enter this market. The upcoming years look bright, but it is already priced in. While Diageo is a solid company, I will wait before I have another glass.

Disclaimer: I do not hold DEO in my DividendStocksRock portfolios.

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Summary
  • After its merger with SAB Miller, Anheuser-Busch InBev has proven to the world that it will “own the beer market” across the world.
  • The company is dominant in many countries with 50%+ market share in Brazil, Latin America and Belgium.
  • Unfortunately, the dividend perspectives don’t justify the current price.
Investment Thesis

Do you remember those BUD-WEIS-ER frogs in the company’s commercial a long time ago? I’m not sure I was old enough to drink beer back then but I surely enjoyed the frogs. In fact, Anheuser-Busch InBev (BUD) always had this magic touch to create viral ads. Over the years, the beer maker has expanded its brand portfolio to the limit of the world.

BUD is a leader in a stable market that is not ready to decrease. The company is producing over 500 million of hectolitres (as compared to 204 million for Heineken) and enjoys economy of scale. The brewer will continue to grow through acquisitions and will also increase its presence in emerging market, notably in China. BUD is a solid dividend payer with a 3.50% yield offering income seeking investors the opportunity to invest in a well-diversified company. Unfortunately, BUD seems overvalued at this time.

Image source

Understanding the Business

If you like beer, chances are you have drunk something coming from the world largest brewer. BUD dominates much of the market with 18 brands selling over $1 billion per year. Brand such as Budweiser (BUD shows 48% of US market share), Stella Artois (Belgium) and Corona are well known across the world. For the record, my own favorite beer is Hoegaarden.

With a production of over 500 hectolitres of beer per year, Budweiser sells more than twice the amount of beer Heineken sells. BUD is everywhere in the world:

Source: BUD 2017 Q3 investor presentation

Revenues

Source: Ycharts

BUD shows a strong history of growth by acquisition. Their latest one propelled the whole business to new heights. With such a large operation, BUD obviously benefits from large economy of scale. It is also the first brewer to be able to acquire another brewer (such as SAB Miller in 2016 in a +$100 billion deal). Through acquisition, BUD increases its leadership position, boosts new brands through its well-developed network and enjoys additional synergies. Through its 62% stake in Ambev, BUD is a leader in many Latin American countries such as Brazil (64% market share) and Argentina (77% market share).

Earnings

Source: Ycharts

The key for BUD in the upcoming year will be to develop premium beers such as Michelob Ultra and Stella Artois and focus on craft & imports. Unfortunately, there is a very limited growth potential for brands such as Budweiser & Bud light as they literally own the market in the U.S. Therefore, profitability will be found across premium pricing on “sophisticated beers”. This is not only a way to ensure profit growth, but also to protect BUD’s market share. There is a definite growing interest for craft and import beers as consumers enhance their taste for beer.

Another growth vector for the upcoming years will definitely be Latin America. While BUD is already the leader in those countries, the recent economic rebound should invite more consumers to celebrate and have a “cold one”. Both revenue and profit were up in those countries during Q3 by +8.9% and +13.1% (West), +8% and +16+.7% (North), +22.1% and +17.3% (South) respectively. BUD will need to work on its margin expansion in the upcoming years as the SAB Miller merger has already generated over $1 billion in synergy.

Source: Ycharts

Dividend Growth Perspectives

The fact that the BUD dividend is paid in euroes generates additional variations. According to Divdiend.com, BUD shows 8 consecutive years with a dividend increase. Considering the latest acquisitions and the current debt level, I don’t think we will see much dividend increase in the upcoming years. BUD shows a strong business model, but its tastes for acquisitions doesn’t give it the perfect dividend growth profile.

Source: BUD 2017 Q3 investor presentation

Source: Ychart

That is unfortunate as BUD was very close to becoming a Dividend Achiever. The Dividend Achievers Index refers to all public companies that have successfully increased their dividend payments for at least ten consecutive years. At the time of writing this article, there were 265 companies that achieved this milestone. You can get the complete list of Dividend Achievers with comprehensive metrics here.

At this point, I still consider BUD as a dividend paying stock, but I don’t put too much fate into future dividend growth perspectives.

Potential Downsides

First, it is hard to grow when you are that big. One problem with BUD is that many of its brands have nowhere to go in terms of market share. It is hard to imagine Budweiser increasing its market share. In fact, it’s having a hard time against other imported beer and smaller or local microbreweries.  While the company generated synergies with SAB Miller, it is still a big pill to swallow. Its long term debt totals over $120 billion at the moment. Finally, as the company makes about 50% of its revenue offshore and has a strong presence in Latin America, BUD is subject to additional volatility (from both currency and unstable Latin America markets).

Valuation

It is hard to determine the real valuation of BUD at the moment. With the important acquisitions, all numbers are a little bit skewed, starting with the EPS. At the moment, BUD has never been that highly valued in the past decade:

Source: Ycharts

I also tried to use the Dividend Discount Model to determine a fair value for BUD. The problem is that I’m not sure there will be much dividend growth in the upcoming years. I’ve used a 5% growth rate as I felt generous. The immediate dividend growth may not happen, but management showed the ability of doing major dividend hikes in the past. This could very be the case in a few years from now.

Input Descriptions for 15-Cell Matrix INPUTS
Enter Recent Annual Dividend Payment: $4.07
Enter Expected Dividend Growth Rate Years 1-10: 5.00%
Enter Expected Terminal Dividend Growth Rate: 5.00%
Enter Discount Rate: 9.00%
Discount Rate (Horizontal)
Margin of Safety 8.00% 9.00% 10.00%
20% Premium $170.94 $128.21 $102.56
10% Premium $156.70 $117.52 $94.02
Intrinsic Value $142.45 $106.84 $85.47
10% Discount $128.21 $96.15 $76.92
20% Discount $113.96 $85.47 $68.38

Please read the Dividend Discount Model limitations to fully understand my calculations.

Unfortunately, even with generous numbers, BUD is still overvalued. Keeping this in mind, I don’t think it’s a good candidate for my dividend growth portfolio.

Final Thought

When I started this analysis, I was relatively optimistic about BUD. It’s global presence and leadership in many markets made me like the company… a lot. BUD benefits from strong economy of scale and a wide distribution network. That makes it easier for it to acquire other brewers and push new products through its lines of business. Unfortunately, BUD just swallowed a big piece and will need some time to recover. I don’t think we can call it a hangover just yet, but when you have a few beers, this is certainly not the right time to start sprinting. I will leave BUD on the side for now.

Disclaimer: I do not hold BUD in my DividendStocksRock portfolios.

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Summary

#1 Consolidated Edison is a classic play in the utility sector with growth vectors in the natural gas distribution business.

#2 ED shows 43 consecutive years with a dividend increase making it a dividend aristocrat.

#3 While the company and its dividend are solid, the stock is definitely overvalued.

Over the past 30 days, Consolidated Edison’s (ED) stock has been evolving in red territories. The utility company shows a loss in value of about 10% between December 2017 and January 15th 2018. After a fabulous run in the current bull market, most utilities are slowing down. I think it’s time to take a look at Consolidated Edison to see if the current stock drop is a buy opportunity.

Understanding the Business

Consolidated Edison is a classic utility company operating in the New York State. It operates under 4 different segments:

Electric (71% of revenue)

Gas (14% of revenue)

Steam (5% of revenue)

Non-Utility (10% of revenue)

November ED presentation

While the chart above shows a whole segment for clean energy, the company generates only 4% of its revenue from this business segment. The core business remains it regulated utilities activities with 93% of its revenues.

Revenues

Source: Ycharts

Utility stocks aren’t the fastest growing companies on earth. They are more of a “hold & get paid steady” type of holdings. Revenue usually grows with regulations pushing energy prices higher. Besides that, ED has little growth vector. Management expects its utility revenues (gas and electric) to increase at a CAGR of 5.5% through 2019.

However, it has a 12.5% stake in a 303-mile pipeline called the Mountain Valley Pipeline. The MVP is a joint venture of EQT Midstream Partners (EQM), NextEra Energy (NEE), Con Edison, WGL Midstream and RGC Midstream.

Source: MVP

This natural gas pipeline is expected to start working toward the end of 2018. ED is also another participant in another natural gas pipeline named Stagecoach Gas Service.

Earnings

Source: Ycharts

The company has show steady earnings with a small uptrend since 2012. That is because ED is investing in its energy transmission and clean business in order to generate additional growth in the future. As you can see in the next chart, both are yet to become important contributors.

Management looks at the future with a smile as both segments are expected to support ED’s growth for many years. I agree pipeline projects are promising as they are never built without a strong economic demand behind it. Therefore, once they are operational, pipelines translate into a steady cash flow stream.

Dividend Growth Perspective

Consolidated Edison shows a stellar dividend growth sheet. With 43 consecutive years with an increase, ED is part of elite Dividend Aristocrats and Dividend Achievers lists. The Dividend Achievers Index refers to all public companies that have successfully increased their dividend payments for at least ten consecutive years. At the time of writing this article, there were 265 companies that achieved this milestone. You can get the complete list of Dividend Achievers with comprehensive metrics here.

Source: Ycharts

Unfortunately for income seeking investors, ED doesn’t pay a juicy 5%+ yield anymore. After all, ED’s stock price has jumped by 44% over the past 5 years. During the same period, the company increased its payout by 12%… and I’m not writing CAGR… just 12% total.

Source: Ycharts

The problem is that the company’s projects require lots of money and ED can’t afford to share too much wealth with investors. A 3.50% yield is appreciated, but don’t expect much growth in the upcoming years.

Potential Downsides

In my view, the company shows two important downsides. The first one is based on the current valuation. As you will see in the final section of this analysis, ED is clearly overvalued. The latest stock price run has made it vulnerable for additional volatility. The beginning of the year has been particularly painful for ED and I expect more potential losses.

ED has been raising lots of debt in the past 5 years and it may catch up to it now that the interest rates are increasing.

Source: Ychart

This situation will not put the dividend payment in jeopardy, but that’s just another reason to not expecting much growth in the upcoming years.

Finally, the rise of interest rates will also convince parts of income seeking investors to cash their juicy profit in this industry and move back to bonds eventually. This should slow down the hype around this sector and potentially slow down their stock potential for a few years.

Valuation

As previously mentioned, ED seems overvalued on all sides. First, the company has never traded at such high multiple:

Source: Ycharts

I know that using the PE ratio for a utility stock could be tricky. After all, the nature of their business requires lots of adjustments to get the real picture of their earnings. However, if you use the same metric for the past 10 years and get the highest points now; it’s a sign of an overhyped stock.

Digging deeper, I used the dividend discount model. I couldn’t use more than a 3% dividend growth rate in this case. After all, ED has increased its dividend by a CAGR of 2.29% over the past 5 years. Therefore, even 3% is a generous figure.

As for the discount rate, I never use under 9%. In this case, even if I use an 8% discount rate, I will get a stock that is highly overvalued.

Input Descriptions for 15-Cell Matrix INPUTS
Enter Recent Annual Dividend Payment: $2.76
Enter Expected Dividend Growth Rate Years 1-10: 3.00%
Enter Expected Terminal Dividend Growth Rate: 3.00%
Enter Discount Rate: 9.00%
Discount Rate (Horizontal)
Margin of Safety 8.00% 9.00% 10.00%
20% Premium $68.23 $56.86 $48.73
10% Premium $62.54 $52.12 $44.67
Intrinsic Value $56.86 $47.38 $40.61
10% Discount $51.17 $42.64 $36.55
20% Discount $45.48 $37.90 $32.49

Please read the Dividend Discount Model limitations to fully understand my calculations.

I’m not saying ED’s stock price will drop like a rock. However, I don’t think this is the type of company that fits my 7 dividend growth investing rules.

Final Thought

I understand the need for utility stocks in one’s portfolio. They are steady income generators with some decent yield. However, the fact that the price for most utility stocks jumped along with the current bull market makes them unattractive for new investors at this time. ED is definitely a good example of this situation.

Disclaimer: I do hold NEE in my DividendStocksRock portfolios.

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Summary

#1 I believe financials will continue to be strong in 2018 and TROW will be part of the party.

#2 TROW is a dividend aristocrat with 31 years of dividend increase under its belt.

#3 In 2018, TROW will reach 1 trillion dollars in assets under management.

I must admit, I rarely let one fly under my radar. But this time, I feel that T. Rowe Price (TROW) did the trick. While the stock has remained dormant for about 4 years, 2017 was a big wake-up for investors. Between January 2013 and January 2017, TROW lagged the S&P 500 by about 40% (15.58% vs 56.98%). However, TROW jumped by 40% in 2017. It seems the asset manager is unlocking value after being ignored by the market for a while. Is it the result of an overheating bullish market looking for new preys or is it really because TROW has shown some impressive results since the very beginning but we just didn’t see it? After all, TROW has been a model of performance since its IPO back in 1986:

Understanding the Business

T. Rowe Price is one of the world largest asset managers with $991 billion in assets under management (as at November 30th 2017). What really matters for assets managers is obviously how much they manage (Assets Under Management, AUM) as they are making fees on investors nest egg. By comparison, Blackrock (BLK), the world largest asset manager, shows 5.7 trillion.

T.Rowe Price shows a classic model with a wide variety of investing products going from fixed income to equity. The bulk of its business is done through financial intermediaries (third parties such as financial institutions selling its products) and institutional investors.

2017 Investor day presentation

Revenues

Source: Ycharts

TROW has been quick in focusing on retirement products and started defined contribution plans back in 1982. Now that most employers shifted retirement planning in the hand of their employees, TROW is well positioned to surf on this tailwind. As population ages and the need to plan for retirement have become crucial, TROW will definitely be an active player in the upcoming years.

Another growth vector comes from TROW past performances. WE all know that past performance is not a guarantee of future returns, but if you have to invest $2 on a pony, you will take one that already won a few races, right? As at its latest quarter (Sept 30th, 2017) TROW shows a remarkable performance:

Finally, TROW benefits from a large interest for its target-date fund. As retirement planning is taking importance, TROW offers a mutual fund that modifies its asset allocation going toward a target date. In other words, the fund adapts automatically its strategy to stay in line with the client’s age.

Earnings

Source: Ycharts

TROW success comes from a long history of performance and partnerships with third parties. Since 2009, TROW surfed on the strongest tailwind any asset managers can hope for: a never-ending bullish market.

Since TROW makes money based on how much money it manages (AUM), an ever-growing market naturally pushes revenue and earnings higher year after year. By building a strong brand through its financial intermediaries and institutional clients, TROW has one of the stickiest investing brand products around. After all, which institutions would drop highly performing asset managers? You don’t trow history in the trash can that easily.

Dividend Growth Perspective

What I like about TROW is that it is not its first bull ride. The company has successfully gone through many cycles and maintained its dividend increase streak alive. Today, TROW shows 31 consecutive years with a dividend raise. This makes it part of the elite Dividend Aristocrats and Dividend Achievers list. The Dividend Achievers Index refers to all public companies that have successfully increased their dividend payments for at least ten consecutive years. At the time of writing this article, there were 265 companies that achieved this milestone. You can get the complete list of Dividend Achievers with comprehensive metrics here.

Source: Ycharts

While the stock stagnated prior to 2017, we can see that T. Rowe kept increasing its dividend which pushed its yield to 3%. Now that the stock has surged, TROW offers a 2% dividend yield to investors. While this is not an astronomic distribution rate, TROW meets my 7 dividend growth investing principles.

Source: Ycharts

TROW has been an example among dividend payers for the past 30 years. Over the past 5 years, TROW has increased its dividend by 50% or 8.45% CAGR. Besides the special dividend paid, TROW has maintained a low payout ratio. There is no doubt the company will push its dividend increase streak to 32 this year.

Potential Downsides

One must remain cautious when looking at TROW numbers. While the company has gone through other market crashes, it doesn’t mean TROW won’t suffer during the next one. As the market goes up year after year, this pushes AUM higher. Then, revenues and earnings are rising naturally without any efforts. For example, TROW Q3 AUM increased by $44.3 billion. Out of this number, only $5.9 billion were net cash inflows. This means that as soon as the market enters in correction mode, the AUM will follow accordingly. As about 80% of TROW revenue comes from management fees, there will be an immediate effect on the stock price. Keep in mind the stock surged by 40% in 2017.

The company also started to reduce fees charged on some mutual funds. While this type of investment vehicle is still popular, the major trend is toward ETF investing. In order to remain competitive, TROW has no other choices but to modify its fee structure. This could hurt its profitability.

Valuation

I was quite curious about TROW’s latest run on the market. When I looked at its PE history,  I noticed the market simply brought back its previous multiple:

Source: Ycharts

I guess the market shares the same fear as I do when I think of TROW. While the company is very strong right now, the bulk of its business model is not geared toward ETF investing. The mutual fund industry is slowly dying, this is not a secret for anybody. However, TROW has successfully found a way out of this issue with target-fund and strong performances.

In order to have a better idea, I’ve used a double-stage dividend discount model. I used a 8% dividend growth rate for the first 10 years and reduced it to 6% afterward.

Input Descriptions for 15-Cell Matrix INPUTS
Enter Recent Annual Dividend Payment: $2.28
Enter Expected Dividend Growth Rate Years 1-10: 8.00%
Enter Expected Terminal Dividend Growth Rate: 6.00%
Enter Discount Rate: 9.00%
Discount Rate (Horizontal)
Margin of Safety 8.00% 9.00% 10.00%
20% Premium $172.37 $114.18 $85.12
10% Premium $158.00 $104.66 $78.02
Intrinsic Value $143.64 $95.15 $70.93
10% Discount $129.28 $85.63 $63.84
20% Discount $114.91 $76.12 $56.74

Please read the Dividend Discount Model limitations to fully understand my calculations.

I’m now surprised to see TROW being overvalued right now. At the same time, I hardly see how I could give TROW a strong dividend growth rate. As for the discount rate, I never go under 9%. As I often say, there is a price to pay for quality.

Final Thought

While TROW shows some real strengths and good numbers, I’ll have to pass on this one. I don’t think TROW will continue to do that well in the upcoming years. Its business model is still heavily geared toward fees charged on mutual funds. The current bull market shows everybody under their best day. I think TROW’s star will pale upon the next market correction.

Disclaimer: I do not hold TROW in my DividendStocksRock portfolios.

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Summary

#1 SJM is particularly strong in the breakfast category with peanut butter, coffee and fruit spread strong brands.

#2 The company shows 15 consecutive years with a dividend increase.

#3 Unfortunately, there aren’t enough growth vectors to justify the current valuation.

Investment Thesis

We rarely have the opportunity to pick a losing stock in 2017. It always catches my attention when a dividend growth company is down while the market is surging. Is there a buying opportunity or is it a falling knife? JM Sucker (SJM) shows a strong business model and owns many #1 brands in the food business. The company continues to innovate and aim for additional growth through acquisitions. What’s wrong with the company? Let’s take a deeper look to see is SJM could fit your portfolio.

Understanding the Business

JM Smucker is a packaged food company for both human and pets. The company is particularly strong in the breakfast category their peanut butter (Jif), fruit spreads (Smucker’s) and coffee (Folgers & Dunkin’ Donuts). The business counts many #1 and #2 brands:

Source: 2017 SJM annual report

In 2017, the business divisions reported net sales as follow:

Author’s chart, 2017 SJM annual report data

Revenues

Source: Ycharts

SJM bought Big Heart for $6 billion back in 2015. The idea was quite simple; becoming a key player in the pet foods industry. With dominant brands like Milk-Bone and Meow Mix, SJM added a business with a similar pattern (a strong brand in a dominant market).

As the taste for coffee at home and peanut butter rises in the U.S., SJM is also well positioned to capture this growth. Management used Jif’s popularity to introduce snack bars, nut butter and powders.  Plus, SJM doesn’t slow down on innovation when it comes down to reinvent the food we eat. Among their original foundation, I particularly like the idea of bacon pancake sticks and cheesy taco pizza!

Earnings

Source: Ycharts

Unfortunately, all those strategies to improve revenues didn’t do much on earnings. In fact, over the past 5 years, EPS has increased by a meager 5% (not annualized… total!). With fierce competition in the food industry and limited shelf space, margins get hurt upon multiple promotions and price rebates. Fruit spreads aren’t as popular as they were before leaving SJM with less option for future growth.

Also, the expected synergy with Big Heart acquisition may be smaller than expected. The high price paid for the pet food company weighs an important role in the company’s profitability.

Dividend Growth Perspective

SJM has been a shareholder friend stock for many years. Management has successfully increased its payouts for the past 15 consecutive years. This makes it apart of the elite Dividend Achievers list. The Dividend Achievers Index refers to all public companies that have successfully increased their dividend payments for at least ten consecutive years. At the time of writing this article, there were 265 companies that achieved this milestone. You can get the complete list of Dividend Achievers with comprehensive metrics here.

Source: Ycharts

As you can see, there was a lot more movement around the stock price than the dividend payment. Over the past 10 years, SJM shows a dividend CAGR of 10.03%. However, the company is slowing down its growth policy with a CAGR of 8.45% over the past 5 years, 6.85% over the past 3 years including a small 4% increase this year.  The fact that management has constantly reduced its guidance over the past 4-5 quarters isn’t a good sign.

Source: Ycharts

Nonetheless, SJM shows payouts ratios well under control. SJM does meet my 7 dividend growth investing principles. However, I would not expect a high single to double-digit dividend growth rate in the future. I think it is more reasonable to expect something in the 5-6% range.

Potential Downsides

When a company advertises pancake-bacon sticks and cheesy tacos pizza, I can tell that my stomach gets excited but not my investors’ instinct. While I enjoy junk food once in a while, I’m part of the healthy movement where I replace beef by lens once in a while. I think SJM is making a mistake by ignoring the healthy food movement and focusing on packaged savory, but yet unhealthy, foods.

Fruit spreads trend will continue to go down while overall competition in the food business will grow stronger. Both will affect SJM bottom lines. I am not worried about the future of the company, but I don’t see incredible strong growth vectors to push the stock at higher prices either.

Valuation

While the stock market will finish the year with a 20%+ growth, SJM will be part of the black sheep with a negative return. The worst part is that the company’s PE doesn’t look cheap either:

Source: Ycharts

I don’t like seeing a classic food company with a solid but mature business model being traded at such a high price. Going further, I’ve used the dividend discount model to see if there is an opportunity for dividend growth investors. While the latest dividend increase was disappointing (4%), I picked a 5% dividend growth rate for the first 10 years and increased it to 6% as a terminal rate. To be honest, I tried to be generous in my valuation to see where it could get as my original calculations were giving me a fair value at $80….

Input Descriptions for 15-Cell Matrix INPUTS
Enter Recent Annual Dividend Payment: $3.12
Enter Expected Dividend Growth Rate Years 1-10: 5.00%
Enter Expected Terminal Dividend Growth Rate: 6.00%
Enter Discount Rate: 9.00%
Discount Rate (Horizontal)
Margin of Safety 8.00% 9.00% 10.00%
20% Premium $181.89 $121.68 $91.56
10% Premium $166.73 $111.54 $83.93
Intrinsic Value $151.57 $101.40 $76.30
10% Discount $136.42 $91.26 $68.67
20% Discount $121.26 $81.12 $61.04

Please read the Dividend Discount Model limitations to fully understand my calculations.

Unfortunately, even in a “best case scenario”, SJM isn’t trading at an interesting value. I guess this is the price to pay for 8 years of a bullish market!

Final Thought

I appreciate the dividend and the cash cow behind SJM business model. However, I don’t think there is any upside potential for SJM in 2018. There is an obvious reason why the stock lagged the market in 2017 and I think it will continue going forward.

Disclaimer: I do not hold SJM in my DividendStocksRock portfolios.

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Summary

#1 Nucor shows 45 consecutive years with a dividend increase.

#2 Nucor is the largest steel producer and recycler in the U.S.

#3 The stock lags the market, but it’s not enough to convince me to pull the trigger.

Investment Thesis

Nucor (NUE) is a fascinating company. It is one of the rare basic materials company to show stability in a volatile environment. Nucor is a leader in the steel industry and it is also a dividend aristocrat with 45 consecutive years with a dividend increase. With the Trump administration’s plan to invest massively in infrastructure in the upcoming years, NUE will be among the first company to benefit from this tailwind. Unfortunately, the stock lagged the market in 2017 and it is still overvalued in my view. Let’s dig deeper to see if NUE fits your portfolio.

Understanding the Business

Nucor is the largest producer of steel in the U.S. The company, showing a production capacity of 27 million tons each year, is also the U.S. largest recycler. NUE operates 200 facilities and employs 23,900 workers.  Their main business is their steel mills with 70% of their net sales. NUE also sell steel products (23%) and raw materials (7%).

Source: Nucor 2016 Annual Report

If you wonder what steel mills produce, here’s an idea coming from last year’s performances:

As you can imagine, Nucor’s financial performances are highly dependent on the price of its main commodity. As emerging markets’ (especially China) appetite for steel has diminished (there is a limit of ghost towns China could built!), it has been a rough couple of years for any basic materials company.

Revenues

Source: Ycharts

After two difficult years, NUE is on pace to show impressive growth. During their latest quarter, the company reported a +20.5% revenue increase year-over-year. This was good news as sales didn’t increase due to a stronger commodity price, but rather because Nucor produced more steel.

One of Nucor strengths remains in its wide variety of products. This enables NUE to meet clients demand in various markets and enjoy a more stable revenue stream compared to its peers.

Earnings

Source: Ycharts

Management is well aware of its variable profitability level according to steel price. It worked on this issue by going into a natural gas drilling program partnership with Encana (ECA). Nucor uses electric furnaces as opposed to blast furnaces (like 70% of steel producers). Having a direct link to natural gas drilling is a key component in their business model. Through the acquisition of David J. Joseph, one of the largest ferrous scrap metal brokers in the U.S., it also reduced pricing volatility.

In the upcoming years, NUE may benefit from Trump’s infrastructure program. As a classic way to stimulate the economy, the Trump administration has the intention of investing massively to improve their current infrastructure. This will automatically raise the demand for steel product. What best company than the largest steel producer to profit from this situation?

Dividend Growth Perspective

Management’s commitment toward its shareholders is quite obvious. With 45 consecutive years with a dividend increase, Nucor is among the rare basic materials company to rank among the dividend aristocrats and dividend achievers. The Dividend Achievers Index refers to all public companies that have successfully increased their dividend payments for at least ten consecutive years. At the time of writing this article, there were 265 companies that achieved this milestone. You can get the complete list of Dividend Achievers with comprehensive metrics here.

Source: Ycharts

Being able to increase its dividend for such a long streak is quite a feat considering the highly volatile market NUE has to deal with. Unfortunately, we are not talking about a strong dividend grower. The company paid a quarterly dividend of $0.3675 five years ago and we are now at a $0.38/share. I appreciate the stability, but once I’ve finished my plate, I’m still hungry!

Source: Ycharts

As you can see, Nucor’s mediocre dividend growth rate doesn’t come from business difficulties, but rather because management must deal with a highly cyclical environment. It’s not rare to see one of the payout ratios to bust completely off chart. Nucor does meet my 7 dividend investing principles, but I’m not excited about its dividend growth perspective.

Potential Downsides

While it’s nice to be the largest player in the U.S., Nucor is also limited to this market. In fact, NUE activities are concentrated solely in its country. This make Nucor dependant on both steel price and the U.S. economy.

I truly admire the company for making numerous efforts to become greener and also to preserve its workforce during tougher periods. However, this is another factor that reduces the company’s ability to increase its dividend in a significant way. As you will see in the upcoming section, there is no interest in buying NUE at the current price.  It’s not like the company is about to surge and management will remain cautious with its dividend policy.

Valuation

It is never easy to put a dollar value on a company that evolves through a highly cyclical environment. The company valuation goes up and down like a roller coaster. However, many investors are willing to be patient due to Nucor’s solid business model and reputation.

Source: Ycharts

Therefore, the use of the PE history is useless in this case. A PE of 18 doesn’t tell me much about the current situation. When I use the Dividend Discount Model, I don’t get concluding results either. I’ve used a 3% dividend growth rate for the first 10 years and increased it to 4% afterward.

Input Descriptions for 15-Cell Matrix INPUTS
Enter Recent Annual Dividend Payment: $1.52
Enter Expected Dividend Growth Rate Years 1-10: 3.00%
Enter Expected Terminal Dividend Growth Rate: 4.00%
Enter Discount Rate: 9.00%
Discount Rate (Horizontal)
Margin of Safety 8.00% 9.00% 10.00%
20% Premium $43.71 $35.07 $29.31
10% Premium $40.06 $32.15 $26.87
Intrinsic Value $36.42 $29.23 $24.43
10% Discount $32.78 $26.31 $21.99
20% Discount $29.14 $23.38 $19.54

Please read the Dividend Discount Model limitations to fully understand my calculations.

I really don’t think NUE will drop to $30 any time soon. In fact, this doesn’t really reflect the true value of the company. However, I can find interesting picks in this market using similar numbers.  What the calculation tells me is that NUE should not be part of my portfolio as there isn’t enough growth vector to support such valuation.

Final Thought

When I noticed that this aristocrat lagged the market for over a year, I really hope to find a hidden gem. Unfortunately, there are good reasons why the company lags behind everybody else. While Nucor shows a robust business model, its growth perspectives are limited and its dividend growth isn’t enough to make me pull the trigger. Sorry, but I’ll pass.

Disclaimer: I do not hold NUE in my DividendStocksRock portfolios.

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Summary

#1 Revenue increases, but not earnings.

#2 CAH is looking outside its business model to find growth.

#3 The company remains a leader in its market and a Dividend Aristocrat

What Makes Cardinal Health (CAH) a Good Business?

Cardinal Health is one of the three leaders in pharmaceutical distribution with AmerisourceBergen (ABC) and Mckesson (MCK). CAH operates under 2 business segments; the Pharmaceutical segment (89% of revenue) distributes branded and generic pharmaceutical, specialty pharmaceutical, over-the-counter healthcare and consumer products and the Medical segment (11% of revenue) distributes a range of medical, surgical and laboratory products, and provides services to hospitals, ambulatory surgery centers, clinical laboratories, and other healthcare providers. CAH operates in 60 countries and is a key player in the healthcare industry.

CAH presentation

However, this industry is hit by a serious decrease in drug pricing. In a world where margins are already close to 0, the whole business model is put to a serious test.

Source: Ycharts

Revenue

Revenue Graph from Ycharts

Cardinal Health benefits from a natural growth coming from the current demographic situation. As the population is aging and insurance covering is increasing, there are more drugs to be distributed across the healthcare network.

The rise of speciality drugs also acts as a growth vector. CAH has combined its generic sourcing operation in a partnership with CVS Health (CVS). I expect CAH revenue to continue growing for another decade as the population ages.

How CAH fares vs My 7 Principles of Investing

We all have our methods for analyzing a company. Over the years of trading, I’ve been through several stock research methodologies from various sources. This is how I came up with my 7 investing principles of dividend investing. Let’s take a closer look at them.

Principle #1: High Dividend Yield Doesn’t Equal High Returns

My first investment principle goes against many income seeking investors’ rule: I try to avoid most companies with a dividend yield over 5%. Very few investments like this will be made in my case (you can read my case against high dividend yields here). The reason is simple. When a company pays a high dividend, it’s because the market thinks it’s a risky investment… or that the company has nothing else but a constant cash flow to offer its investors. However, high yield hardly comes with dividend growth and this is what I am seeking most.

Source: data from Ycharts.

CAH has been flying under the radar of many income seekers as it offered a yield under 2% during a good part of the past decade. The recent shift in the industry (cost of generic drugs dropping on price pressure), pushed the stock down by 32% since January 1st, 2016 (as of December 6th). This had the opposite effect of boosting CAH yield over 3%. Yet, keep in mind there is a good reason why the stock is dropping. I’ll get back to it in a moment.

CAH meets my 1st investing principle.

Principle#2: Focus on Dividend Growth

Speaking of which, my second investing principle relates to dividend growth as being the most important metric of all. It proves management’s trust in the company’s future and is also a good sign of a sound business model. Over time, a dividend payment cannot be increased if the company is unable to increase its earnings. Steady earnings can’t be derived from anything else but increasing revenue. Who doesn’t want to own a company that shows rising revenues and earnings?

Source: Ycharts

Cardinal Health is part of the elite group of Dividend Aristocrats (25 years + with dividend increases) with 32 consecutive increases. While the past 5 years dividend growth rate is quite impressive (10.95 CAGR), the company only raised it by 3% in 2017. This is a situation that doesn’t worry me for now, but is a good reason to put CAH on the watch list.

CAH meets my 2nd investing principle.

Principle #3: Find Sustainable Dividend Growth Stocks

Past dividend growth history is always interesting and tells you a lot about what happened with a company. As investors, we are more concerned about the future than the past. This is why it is important to find companies that will be able to sustain their dividend growth.

Source: data from Ycharts.

While CAH’s dividend growth has slowed down in 2017, the dividend is far from threatened. With a payout ratio around 50% and a cash payout ratio of 30%, shareholders can expect CAH to maintain its dividend raise streak for many years to come.

CAH meets my 3rd investing principle.

Principle #4: The Business Model Ensures Future Growth

CAH occupies a crucial role in the pharmaceutical business. It is a key element of the healthcare industry. Pharmaceutical wholesalers have built a solid fence around their business model. Thanks to their efficient network and their buying capacity, it is nearly impossible for new competitors to enter this market. ABC, MCK, and CAH dominate this market now and will continue to do so in the future.

This is how each company can generate sustainable earnings and cash flow regardless of their thin margins. We are in a volume game here and no other players are invited to the table.

In order to pursue additional growth, management decided to look outside their pharmaceutical distribution business. CAH recently acquired Medtronic’s Patient Care, Deep Vein Thrombosis, and Nutritional Insufficiency business for $6.1 billion. I am not convinced CAH should take away its focus from pharmaceutical to improve its medical segment revenue. However, if it succeeds, it will definitely be a growth vector for years to come. It’s just that razor-thin industries don’t allow much room for mistakes.

CAH still shows a strong business model and meets my 4th investing principle.

Principle #5: Buy When You Have Money in Hand – At The Right Valuation

I think the perfect time to buy stocks is when you have money. Sleeping money is always a bad investment. However, it doesn’t mean that you should buy everything you see because you have some savings aside. There is a valuation work to be done. In order to achieve this task, I will start by looking at how the stock market valued the stock over the past 10 years by looking at its PE ratio:

Source: data from Ycharts.

Considering the overall market, I’d say that a 17.5 PE ratio and a forward PE of 12 looks like a decent deal for me. Now, it’s more a matter of knowing if the market sees something we don’t.

Digging deeper into this stock valuation, I will use a double stage dividend discount model. As a dividend growth investor, I see companies like big money making machine and assess their value as such. I decided to go “rough” and use a 5% dividend growth rate for the upcoming 10 years and a 6% afterward. Here are the details of my calculations:

Input Descriptions for 15-Cell Matrix INPUTS
Enter Recent Annual Dividend Payment: $1.85
Enter Expected Dividend Growth Rate Years 1-10: 5.00%
Enter Expected Terminal Dividend Growth Rate: 6.00%
Enter Discount Rate: 9.00%
Discount Rate (Horizontal)
Margin of Safety 8.00% 9.00% 10.00%
20% Premium $107.83 $72.13 $54.28
10% Premium $98.84 $66.12 $49.75
Intrinsic Value $89.86 $60.11 $45.23
10% Discount $80.87 $54.10 $40.71
20% Discount $71.88 $48.09 $36.18

Source: how to use the Dividend Discount Model

In the light of my calculation, it appears that CAH trades at fair value. If I had used the past 5 years CAGR, we would have gotten a nice bargain. However, I would rather look toward the future than look back.

CAH meet my 5th investing principle and currently trades at fair value.

Principle #6: The Rationale Used to Buy is Also Used to Sell

I’ve found that one of the biggest investor struggles is to know when to buy and sell his holdings. I use a very simple, but very effective, rule to overcome my emotions when it is time to pull the trigger. My investment decisions are motivated by whether the company confirms my investment thesis. Once the reasons (my investment thesis) why I purchase shares of a company are not valid anymore, I sell and never look back.

Investment thesis

Investing in CAH is picking up a stock that has been hit hard during a bullish market. My take on this year is that investors get greedy and look for immediate results. Since CAH is more a long term type of holding and will reward shareholders over the long run, it doesn’t fit the “quick rich trade” many search for in the market. Since CAH is a dominant player in a key sector in the healthcare industry, I don’t see any reason to worry about the dividend payment or future cash flow generation.

I think many downsides have been factored in the price as of now. The market is well aware of the generic price pressure all wholesalers must face. This situation confirms that margins will remain at a minimum for years and earnings growth will be difficult. CAH will have to show other growth vectors at some point in time if it wants to continue raising its dividend.

CAH shows a solid investment thesis and meets my 6th investing principle.

Principle #7: Think Core, Think Growth

My investing strategy is divided into two segments: the core portfolio built with strong & stable stocks meeting all our requirements. The second part is called the “dividend growth stock addition” where I may ignore one of the metrics mentioned in principles #1 to #5 for a greater upside potential (e.g. riskier pick as well).

Cardinal Health evolves in an oligopoly where there is a natural growth coming from the current demographic. However, don’t expect any distributors in any business to come with a major breakthrough that will make their business model explode. For this reason, CAH is a solid dividend payer, but definitely not a growth oriented company.

CAH is a core holding.

Final Thoughts on CAH – Buy, Hold or Sell?

There are lots of changes going around the healthcare industry. Companies like ABC, MCK and CAH are not the only one affected. Pharmacy such as Walgreens Boots Alliance (WBA) and CVS Health (CVS) also have to manage throughout this evolving industry. At the moment, I’m not convinced CAH is a buy. It looks undervalued, but the growth vectors are not obvious enough to become a screaming buy either.

Disclaimer: I do not hold CAH in my DividendStocksRock portfolios.

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The market is more expensive today than it was a year ago.

We all hear that, but do we really know what they are talking about? When we read about the average market Price-Earnings Ratio (PE Ratio) going up, what does that really mean? You pay more than you used to. This phenomenon is called “PE expansion.”  I’ve built this small guide to tell you what it is and why it has an impact on your portfolio.

A quick review of the PE Ratio

The PE ratio refers to the number of times you pay the profit per share of a company. For example, if a company reports earnings of $1 per share and the stock trades at $11, this means you pay 11 times its profit. In other words, the value of the company is equal to 11 times its profit today. If you own all shares of that company, you would need 11 years to get all of your money back, assuming profit doesn’t change.

What happens when you pay more

Imagine the same company with the same earnings suddenly trades at $13. An affluent of new investors want to buy shares of this company and they are ready to pay a more expensive price ($13). At that time, we are looking at the same company with the same profile and earnings. The only difference is that it costs $2 more per share. The only reason why you pay more today for the stock is because there are more people wanting it.

This could be because they think the company will go through a major breakthrough and that earnings will go up. This could be because interest rates are low and investors are ready to pay a higher price for a solid dividend payer (hence, pushing the yield lower at the same time).

A real-life example

Let’s use 3M Co (MMM) as an example. Here’s a graph showing MMM stock price along with its earnings per share (EPS):

Source: Ycharts

A quick look at such graphs and everything looks normal. The price goes up as the EPS goes up. This would falsely lead us to think that both metrics go up following the same trend. After all, it’s only normal to pay a higher price for a stock that shows a higher EPS, right? When we take both metrics, but look at the normalized variation, we have a totally different landscape:

Source: Ycharts

As you can see, the stock price is going up a lot faster than the earnings. You can also see how high MMM PE ratio goes over the past decade:

Source: Ycharts

10 years ago, MMM used to trade at 14 times its earnings. Today, it is around 26 times. If MMM was a money making machine it would have required 14 years to recoup your investment if you would have purchased it in 2007. Today, if you buy the upgraded money making machine model (it is upgraded as it makes more money than it used to 10 years ago), you would need 26 years to recoup your investment.

I am not talking about the price paid here, but rather the number of years before the company can technically reimburse you for your investment. If you buy MMM today, you would need to wait 12 more years than if you would have bought it 10 years ago. Does the new money making machine looks attractive compared to the old model? Not really.

Potential opportunities

From time to time, there are opportunities on the stock market where a stock is trading at a lower PE based on fears and false assumptions. A good example would be Apple (AAPL):

Source: Ycharts

Based on the thesis that Apple would not be competitive in the smartphone industry, AAPL stock dropped close to a 9 PE ratio back in 2013. It happened again in 2016 when investors lost interest in the company. However, paying only 9 times the revenue of a company as solid as Apple is definitely a bargain. It becomes less obvious when it trades around 19 times its earnings.

You can then purchase a stock based on a lower PE ratio in the hopes that there will be a PE expansion. On the other side, you can always buy a stock at a higher PE ratio in the hopes that the company will make more profit in the future and bring down this valuation metric.

Potential risk

When the PE expansion is too important and happens without a good rationale, it could become highly dangerous. When faith in the market starts to fade, higher valued companies will be the first to plunge. Technically, they are the ones that are the farthest to their intrinsic valuation.

As you can see, MMM used to trade over a 26 PE ratio before the latest crisis. You can also note how fast the stock price dropped during the financial crisis:

Source: Ycharts

How to prevent it – Using other valuation models

The PE ratio is one valuation model among many others. In order to have a clear view of how the market looks at a company, I like to use a 10 year history. This shows me the PE fluctuations through a longer period and helps me find the most accurate multiplier for that investment. But this is only good to give me a hint about where to look. I rather use a more precise model such as the Discounted Cash Flow and the Dividend Discount Model to find the stock intrinsic value.

By using those models, I am able to not only find a fair value before I make a purchase, but I can also calculate a margin of safety. This is particularly useful when you invest in such a highly valued stock market as today.

Final thoughts

Depending on when you invest and the overall market sentiments, PE ratios could be high or low. The current bullish market has been supported by an unprecedented low interest rate environment and massive cash flow injected by central banks. It is hard to determine if we will enter into a PE contraction phase at one point or if this is now the new norm. As long as there will be faith in the stock market, the bull will continue to ride. In the meantime, I stay invested in strong dividend growth stocks as they always tend to perform well in the long run!

Disclaimer: I’m long MMM & AAPL

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