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When it comes to high-quality dividend growth stocks, investors naturally gravitate to blue chips like dividend aristocrats and dividend kings. After all, no company can increase its dividend for at least 25 or 50 years in a row without a certain combination of highly admirable characteristics.

These traits tend to include stable and predictable cash flows, strong competitive advantages, good profitability, modest amounts of debt, and of course a very shareholder-friendly corporate culture.

In addition, Warren Buffett, history’s greatest value investor, has made his fortune buying “wonderful companies at a fair price.” So naturally, any company that Berkshire Hathaway (BRK.B) owns a large position in (Coke is 9.5% of Berkshire’s portfolio) is seen as a defacto high-quality blue chip.

Investors can review analysis on all of Warren Buffett’s dividend stocks here.

While Coca-Cola (KO) does indeed possess many admirable qualities, including 55 consecutive years of rising dividends, that doesn’t necessarily mean that this popular dividend growth stock is a good fit for most income portfolios right now.

Let’s take a look at the pros and cons of Coke to see if its best days are behind it, and more importantly if today’s valuations means investors could be better off not adding the company to a diversified dividend portfolio at this time.

Business Overview

Founded in 1886 in Atlanta, Georgia, Coca-Cola has grown to become the world’s largest drink purveyor and the fifth most valuable brand in the world. It markets over 3,900 products through over 500 brands in more than 200 countries.

In fact, Coca-Cola is so geographically diversified that the US market accounts for less than 20% of its overall sales volumes.

Source: Coca-Cola

The vast majority of the company’s sales and profits come from a strong core of $1 billion+ brands that the company produces in about 900 plants around the world and markets through 24 million global retail outlets.

Source: Coca-Cola

Business Analysis

Coca-Cola is the epitome of a wide moat company, meaning it has numerous competitive advantages that allow it to command strong pricing power. The two biggest advantages are its leading global scale and unbeatable brand strength.

Coke generally spends about 8% of its revenues on advertising around the world, in order to make its products universally known and loved in almost every nation on earth. However, the true power behind Coke’s global beverage empire is owning the largest distribution network on earth.

In the consumer food and beverage market, distribution is everything. Having the best product in the world is meaningless if you can’t get it on the shelf and into the hands of consumers. Coke has spent 132 years and an absolute fortune to build the largest distribution and logistics chain in the industry.

This, combined with its very strong brand loyalty, means that Coke has dominant shelf positions in over 24 million retail outlets around the world. This giant reach also allows the company to achieve impressive economies of scale, which lead to above average margins and impressive free cash flow to consistently pay higher dividends.

Coca-Cola Trailing 12-Month Profitability 

Source: Morningstar, Gurufocus, CSImarketing

Of course, long time Coke shareholders know that the past few years have not been easy for the beverage giant. Sales and earnings have actually been in decline because of several factors, including declining soda volumes, negative currency effects (more on this later), and the company’s major strategic shift.

Source: Simply Safe Dividends

Specifically, Coca-Cola plans to become a much more profitable company by refranchising its bottling operations around the world.

Source: Coca-Cola Investor Presentation

Coke’s plan is to sell its bottling operations (other than the super high-margin concentrate business) to its current global partners. The logic behind this is that it will make the company much less capital intensive and send margins and returns on capital soaring.

Coca-Cola North American Bottling Refranchising Plan

Source: Coca-Cola Investor Presentation

Management expects that, starting in 2019 when the global bottling refranchising plan is complete and it finishes its $3.8 billion cost cutting initiative (from 2016 to 2019), the company’s operating margins will rise from 22% to 35%.

Of course, cost cutting and financial engineering may boost profitability substantially, but ultimately Coke needs to grow its sales, earnings, and free cash flow if its dividend is to continue growing as it has every year since 1962. Fortunately, Coke also has a plan for how to not only maintain its market share but even grow it, just like it has for many decades.

Source: Coca-Cola Investor Presentation

The first step is the continued transition from Coke’s namesake soda brands into trendier alternatives, such a: bottled water, juices, milk, energy drinks, and teas. Coke plans to devote about 50% of its resources to growing this side of its business.

Source: Coca-Cola Investor Presentation

Specifically, Coke has been very good at making bolt-on acquisitions of fast-growing non-soda brands, such as its recent acquisitions of:

  • A 16.7% stake in Monster Beverage (MNST), which posted 15.4% revenue growth in Q3 2017
  • Fuse
  • Vitamin Water
  • Honest Tea
  • A large stake in Keurig Green Mountain which was later bought out by a private company for $13.9 billion
  • At its most recent investor day, management outlined a potential plan to enter the craft beer market

Going forward, Coke says it plans to scale back its buybacks in order to focus more on these investments and bolt-on acquisitions. That makes sense since Coke’s marketing and distribution machine are so strong that its number of billion-dollar brands has more than doubled since 2007.

Coke is also planning on being more efficient with its advertising and brand marketing campaigns in the future. Specifically, management wants to focus less on traditional 30 and 60-second TV commercials and instead use more online advertising (currently generates 1% of sales) to try more efficient and targeted campaigns.

The company also wants to transform itself into a more powerful local market of all major beverages. This means using advanced data analytics (machine learning and AI) to determine which products are most in demand in any given city, state, or region.

The end goal, according to management, is to help Coke continue to use its massive financial, marketing, distribution networks to gain market share in the $110 billion global beverage market, which is expected to grow 4% annually through at least 2019.

Source: Coca-Cola Investor Presentation

In fact, management believes the company can achieve long-term 4% to 6% revenue growth and 6% to 8% earnings growth, thanks to its tried and true model of acquiring up-and-coming brands and then accelerating their growth rates by plugging them into its global distribution system.

While Coke is indeed making many smart strategic moves to finally return to sustainable top and bottom line growth, that doesn’t necessarily mean the company’s rosy projections will come to fruition.

Key Risks

Coca-Cola is likely to remain a low-risk dividend stock for the foreseeable future, but that doesn’t mean there aren’t several risks to be aware of.

First, because Coca-Cola derives the vast majority of its sales and earnings from overseas, the company has a lot of currency risk. For example, in 2017 the company estimates that negative currency effects will be a 3% to 4% headwind. That’s despite the US dollar depreciating against numerous other currencies such as the Euro, British Pound, Japanese Yen and Canadian dollar.

This is a challenge for two reasons. First, usually when the dollar weakens it actually helps boost a multi-national’s bottom line because the value of foreign sales and profits ends up translating into more US dollars when it comes to reporting earnings and paying dividends.

However, Coca-Cola’s specific currency mix is very complex because they operate in virtually all currency markets. So whereas most global corporations enjoyed a profit boost in 2017, Coke was one of the few to actually suffer.

What’s worse is that accelerating economic growth in the US means there is a stronger probability that US interest rates could rise faster than rates around the world. If that happens, the US dollar could reverse course in the coming years and potentially appreciate relative to other currencies, which would result in even greater currency headwinds.

That in turn means that Coke’s planned sales and profit growth of about 5% and 7%, respectively, might not be so achievable, creating a problem for dividend investors because the company’s restructuring plan means that Coke will be a much more profitable but smaller business going forward.

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While fast-growing momentum stocks might get the headlines, some of the best long-term investments are often far less exciting dividend growth stalwarts such as 3M (MMM).

This industrial powerhouse has made countless investors amazingly wealthy over the years (12.9% total returns vs 9.1% for the S&P 500 over the last 22 years) thanks to its disciplined and steady growth strategy, which includes 59 straight years of dividend increases at a double-digit annualized rate.

Let’s take a look at what has made this venerable dividend king one of the best choices for almost any long-term income growth portfolio and if 3M’s valuation looks attractive today.

Business Overview

Minnesota Mining and Manufacturing, or 3M, was founded in 1902 in St. Paul, Minnesota. The global industrial conglomerate markets over 60,000 products used in homes, businesses, schools, and hospitals in over 200 countries around the world. The company has five main business segments.

Industrial: tape, sealants, abrasives, ceramics, and adhesives for automotive, electronic, energy, food, and construction companies.

Healthcare: Infection preventions supplies, drug delivery systems, food safety products, healthcare data systems, dental and orthotic products.

Electronics & Energy: insulation, splicing and interconnection devices, touch screens, renewable energy components, infrastructure protection equipment.

Safety & Graphics: Personal protection and fall protection equipment, traffic safety products, commercial graphics equipment, commercial cleaning and safety products.

Consumer Products:  post-it notes, tape, sponges, construction & home improvement products, indexing systems, and adhesives.

3M is a highly diversified company with industrial products representing its largest business unit, while healthcare is its most profitable segment by far.

Source: 3M Earnings release

Geographically 3M is also diversified, with a large amount of international sales:

  • US: 62% of sales
  • Asia & Pacific: 18%
  • Europe, Middle East, Africa: 11%
  • Latin America & Canada: 9%

Over time, 3M’s international exposure will only grow given that its foreign sales are growing much faster than its US revenues.

Source: 3M Earnings Presentation

Business Analysis

The industrial components industry has a lot of factors that might make it seem unattractive for dividend investors. After all, it’s a cyclical and highly capital intensive industry, with relatively low barriers to entry.

In addition, most industrial products are highly commoditized, meaning that it’s hard to maintain strong pricing power and good margins over time.

However, 3M has managed to carve out a very wide moat and has shown an incredible ability to continue growing its earnings and cash flow over time, despite the occasional industry downturn such as 2015 and 2016 (due largely to tumbling commodity prices).

Source: Simply Safe Dividends

The key to 3M’s success is largely thanks to its conservative management and disciplined long-term focus. CEO Inge Thulin has been with the company for 38 years and understands that the key to 3M’s growth lies in its continued dedication to strong R&D and new product development.

Over the past 115 years, 3M has obtained over 100,000 patents thanks to one of the industry’s highest R&D budgets (as a percentage of revenue). The company is constantly improving its existing product range and introducing new ones. In fact, about 33% of 3M’s sales are from products launched in just the past five years.

Source: 3M Investor Presentation

Another benefit 3M has is that about 50% of its products are consumables, meaning that customers need to continually repurchase them. This creates a far more stable cash flow stream for the company. Finally, 3M benefits from selling many specialized, mission critical, but still relatively low cost products to industrial customers.

This means that the components it makes represent a small fraction of the total cost of goods, and because of their industry-leading reliability and performance characteristics, industrial customers are less likely to switch to competing products.

Or to put it another way, 3M has a very sticky product line that allows it to steadily increase its prices each year while retaining strong customer loyalty and a rising market share. This is why its industrial segment has historically grown at 1.5x the rate of the global manufacturing components industry.

Finally, 3M has been among the most adaptable industrial companies in the world, with a great track record of investing in a disciplined manner into the industries and markets that offer the best growth potential.

For example, 3M is investing heavily into products that serve the needs of the rapidly evolving automotive industry. That means a focus on adhesives, connectors, and cooling systems for driverless and electric cars. In addition, 3M is rapidly gaining market share in data center cooling systems, which is an industry that is expected to grow strongly for decades.

3M Market Priorities

Source: 3M Investor Presentation

3M has also proven its ability to successfully enter and win market share in emerging economies, which are growing at double the rate of mature, developed markets. This includes entering China in 1984, where 3M now has nine factories and six R&D centers (it has 60 R&D centers global R&D facilities in total).

Source: 3M Investor Presentation

3M’s China business is its fastest-growing unit, with 23% sales growth in Q3 of 2017 and 10% to 15% projected revenue growth in 2018.

Sales growth is great, but at the end of the day, dividends are paid out of cash flow. This means that profitability is very important for a dividend growth stock. 3M excels here as well, with industry-leading margins and returns on capital.

3M Trailing 12-Month Profitability

Source: Morningstar, Gurufocus, CSImarketing

High returns on capital are a good proxy for long-term management’s capital allocation skills, and as you can see, 3M’s figures are much higher than the industry’s average. There are three key factors to good capital allocation.

First, 3M has excellent capital discipline, meaning it has struck a near perfect balance between returning cash to shareholders but also investing for future growth.

Source: 3M Investor Presentation

This includes numerous small, bolt-on acquisitions, as opposed to large and often overpriced mergers that many of its rivals pursue.

Source: 3M Investor Presentation

In fact, in the past five years, 3M has only purchases six small firms and divested $1.4 billion in underperforming non-core assets, making for net acquisitions of just $4.2 billion in that time. This shows that 3M is dedicated to growing organically, rather than risking overpaying for big splashy deals to increase the top line at the risk of lowering overall profitability.

3M’s impressive organic growth is courtesy of two things. Lavish R&D spending, and highly disciplined capital investment. For example, not only does 3M’s high R&D spending help the company maintain an edge in product quality and premium pricing power, but the firm’s surprisingly low capital spending (4.5% to 5% of revenue historically) is put to work with laser-like focus.

Source: 3M Investor Presentation

Specifically 3M has been investing heavily in recent years in efficiency improvement, including more advanced quality control testing procedures based on automation, wireless internet sensing, and data analytics.

The result has been a tripling of quality control testing speed, while achieving an 80% decrease in product defects. This is just one example of 3M’s rigorous data and statistics driven management culture. In fact, the compamny has retrained 77,000 employees and completed 110,000 efficiency improvement programs since 2001, resulting in $17 billion in cost savings.

3M is currently in the late stages of a corporate restructuring it undertook in 2015 during the last industry recession. The goal was to streamline the company’s businesses and organization to maximize efficiency and cut costs wherever possible.

Source: 3M Investor Presentation

Management also set a goal to improve the company’s economies of scale, via its global supply chain, to minimize its costs of raw materials. This has led to a steady decline in costs of goods sold and rising operating margins and returns on invested capital.

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While interest rates are slowly rising, they remain at historically low levels. As a result, many income-focused investors continue to search for the best high dividend stocks to meet their long-term investing needs.

High dividend stocks can be an appealing way to fund a portion of retirement through dividends rather than the selling of shares, but high-yields can sometimes be a warning that a company’s business model is broken and best avoided.

In other words, some beaten-down, high-yield stocks are value traps with poor dividend security, making them unacceptable for a retirement portfolio.

Let’s take a look at Tupperware (TUP), whose 4.6% dividend yield and track record of paying uninterrupted dividends for more than 20 consecutive years may at first make it seem like an appealing choice for high-yield investors (it’s a famous household brand after all), to see if this company’s dividend is suitable for low-risk income investors.

Business Overview

Tupperware Corporation was founded by Earl Tupper in 1946 in Orlando, Florida, and incorporated in 1996. In 2005, after a series of large-scale acquisitions of different product segments, the company changed its name to Tupperware Brands.

Today, Tupperware is a global direct-to-consumer marketer of numerous household goods, including containers, cookware, knives, microwave products, microfiber textiles, water-filtration related items, and an array of on-the-go consumer products.

The company’s business model is heavily reliant on social marketing, also called multi-level marketing, in which customers become Tupperware consultants (3.2 million at the end of Q3 2017) who market to friends and family via its famous group demonstrations (such as the famous “Tupperware parties”).

Source: Tupperware

The company has also diversified into skin and hair care products, cosmetics, bath and body care, toiletries, fragrances, jewelry, and nutritional products via its acquisitions of numerous brands: Avroy Shlain, NaturCare, Nutrimetics, Fuller, BeautiControl, Armand Dupree, Fuller Cosmetics, Del Baul de la Abuela, Natural Forte, Fuller Royal Jelly, Nutri-Rich, NC Express, and Nuvo.

Tupperware is a geographically diverse company. For example, in 2016 approximately 91% and 100% of Tupperware’s sales and net profits, respectively, were from outside the U.S., with 66% of sales coming from fast-growing emerging markets such as Mexico, Brazil, India, and China.

Source: Annual Report

Business Analysis

It’s been a rough few years for Tupperware, with the company facing declining sales, earnings, and cash flow since 2013.

Source: Simply Safe Dividends

The company announced a major restructuring in July 2017, shutting down its North American Beauticontrol business, which has been suffering from declining sales and profitability.

This will mean that going forward, even less of the company’s sales will come from North America, and management expects to see cash costs of $90 to $100 million associated with the restructuring through the end of 2019 ($25 million in 2017).

The restructuring is also designed to consolidate the supply chain, in order to decrease annual marketing expenses by $35 million per year.

However, this restructuring means that, while growing overseas sales have halted the top line decline, earnings and free cash flow are likely to remain depressed over the next few years.

Source: Tupperware earnings presentation

This will likely mean a decline in the company’s margins and returns on capital, which on the plus side have historically been above the industry average (Tupperware sells premium, high margin products).

Sources: Morningstar, Gurufocus, CSImarketing

The big concern for dividend investors is that declining free cash flow, which is what funds the dividend, could put the current generous payout at risk, especially given the company’s plans to aggressively de-leverage its balance sheet (pay down debt).

Now the good news is that management has a multi-pronged long-term international growth strategy it calls “Vision 2020”.

The strategy calls for more aggressive international expansion (sales force is up 4% this year), but also:

  • Increased consultant support, including greater training and company sponsored weekly events
  • Move from brochure-based sales to more one-on-one demonstrations (except kitchen products)
  • Kitchen products demonstrations moving from one-on-one to group presentations
  • Creation of “experience centers” where consultants can do more interactive hands-on demonstrations
  • Greater use of social media and a bigger push for business to business sales (such as selling to restaurants)
  • Reaching out to former sellers in an effort to make them “brand ambassadors”

Source: Tupperware investor presentation

In addition, the company plans to launch over 100 new products in the coming years, which it can use to more fully stock its upcoming brick and mortar stores.

However, there are numerous problems with Tupperware’s long-term strategy, including a potentially fatal flaw in its core business model.

Key Risks

First, because 91% of sales (and 100% of profits) come from outside the U.S., Tupperware has large foreign currency exposure.

This means that when the US dollar rises against other currencies (such as when U.S. interest rates rise relative to rates in other countries, as is happening now), local sales end up translating into fewer dollars, and thus create profit and dividend growth headwinds.

A stronger dollar also makes Tupperware’s products more expensive (and less competitive) overseas, which is literally where more than 100% of growth is expected to come from in the future.

That’s because mature markets, such as the U.S., Canada, Europe, and Australia are seeing declining sales and earnings over time, even in newer and more trendy business segments such as cosmetics and health supplements (which is why Beauticontrol was shut down).

But what about fast-growing emerging markets? These have much larger populations, rapidly expanding economies, and booming middles classes. Could not these, when combined with 100 new products in development and a more hands-on (traditional retail) focus help Tupperware grow strongly as it has in the past?

While this is certainly possible, there are two main risks to the company’s turnaround plan.

The first is that while Tupperware sells branded products, those operate in highly competitive industries, such as cosmetics (one of the highest margin businesses in the world) and nutritional supplements.

The problem is that major competitors with far larger economies of scale (i.e. lower production costs), huge marketing budgets, and greater distribution channels (shelf space monopolies) offer competing products in more mainstream (and often more successful) ways, such as through grocery stores, big box chains (like Wal-Mart), specialty stores, and online.

In other words, Tupperware’s approach, which is also known as multi-level marketing (MLM), is a very limited business model, which the company’s plans for brick-and-mortar stores is an admission of.

Also keep in mind that not only are physical stores expensive to open and maintain (much higher fixed costs in the company’s future), but the entire brick-and-mortar retail industry is undergoing massive upheaval right now due to the rise of e-commerce.

In fact, between January 1, 2017, and October 25, 2017, more than 6,700 U.S. retail stores closed (on pace for 8,600 this year), which is far worse than the 6,163 store closings in 2008 during the worst financial crisis and recession since the Great Depression.

Or to put it another way, physical retail is currently undergoing massive disruptive changes in which even the most successful retailers are struggling to maintain sales and market share. Thus Tupperware’s plans to incorporate brick-and-mortar into its existing MLM business model could very well prove to be a mistake.

Perhaps the biggest threat to Tupperware is that even if it can achieve strong growth in emerging markets, which is hardly a given (Malaysian, Indonesian, and Indian sales dropped by 2%, 17%, and 32% in Q3 2017, respectively), that might not make Tupperware a sustainable company.

That’s because the MLM business model has is basically a hybrid franchise model, pioneered by companies such as Amway, Tupperware, Herbalife, Avon, Mary Kay and The Pampered Chef.

The business model calls for sellers to recruit customers themselves to sell the products, with the recruiting associate then getting a percentage of any sales these recruits generate.

For example, a Tupperware consultant may recruit five people to also sell Tupperware-branded products, and each of those try to recruit five people, who then recruit five more each, resulting in a total of 125 consultants selling the product.

The first person in the chain then benefits from a large and growing stream of recurring revenue (generally consultants have to sell a minimum amount of merchandise each month or quarter or buy it themselves).

The company benefits because each consultant in the distribution network represents guaranteed sales, for as long as they remain a part of the program.

Of course this sounds awfully close to a pyramid scheme (which are illegal in all 50 states as well as violate federal trade laws), which many MLM companies have been accused of. In fact, in 1979 the Federal Trade Commission investigated Amway to determine whether or not its MLM business model violated federal laws.

The FTC determined that MLM companies are not necessarily illegal pyramid schemes as long as the focus remains on actually selling reputable products, rather than merely recruiting new sellers.

Specifically, the FTC established three key provisions for determining the difference between a legitimate MLM model and a pyramid scheme, which today are knowns as the Amway rules:

  • The 70% Rule: Requires that a distributor sell 70% of his or her purchased inventory to customers each month.
  • The Ten Customer Rule: Requires distributors to make at least one retail sale to each of 10 different customers each month.
  • Inventory Buy Back Program: Requires the company to buy back any unused and marketable products a distributor can’t sell.

However, the stigma of MLM remains, which is why such companies have rebranded themselves as network marketing companies, affiliate marketing organizations, or social networking firms (which is how Tupperware refers to itself).

Fortunately for Tupperware, the FTC, which has launched investigations against 26 MLM companies since 1975, has never accused Tupperware of violating the Amway rules.

In other words, Tupperware’s business model is, at least legally speaking, legitimate. However, that doesn’t mean that it’s one that can sustainably grow in the long-term or support safe and steadily growing dividends.

Here’s how it works. A new Tupperware consultant pays $99 for a starter kit.

Source: Tupperware Recruitment Brochure

You can either pay upfront, or $30 for a first installment, with the remaining $69 waived if you sell $900 of product within the first 60 days.

Consultants are paid entirely on commission, receiving 25% of sales, which rises to as much as 35% if they hit certain monthly sales volumes.

  • Base compensation: 25% of sales
  • $1,500-$9,999 per month in sales: 30% of sales
  • $10,000+ per month: 35% of sales
  • Minimum sales per 4-month period (including your own purchases): $250

Because Tupperware doesn’t directly pay consultants or require them to recruit new sellers, it is within current U.S. trade laws.

However, in order to become a top seller (achieving 35% sales commissions, including in your recruited network) and qualify for perks such as “exotic trips, use of a new cars, diamonds, and cash bonuses,” consultants will need to establish a rather large network of sellers beneath them. Consultants only receive credit for sales of sellers three levels beneath them.

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Wide moat industrial stocks, such as defense contractor Lockheed Martin (LMT), often make excellent long-term dividend growth stocks.

In fact, Lockheed Martin is a dividend achiever with 15 straight years of consecutive dividend increases under its belt. Even better, the stock has managed to grow its payout at an impressive average annual rate of 10% over the past 30 years.

While Lockheed’s steady dividend increases have historically made it an attractive offering, past performance is not indicative of future results.

In addition to taking a look at the level of income growth investors can expect from Lockheed in the future, let’s also review the company’s competitive advantages and current valuation to see if Lockheed Martin could be a timely blue chip stock to consider for a diversified dividend growth portfolio.

Business Overview

Founded in 1909 in Bethesda, Maryland, Lockheed Martin is the world’s largest defense contractor and the biggest supplier of fighter aircraft. However, while the company best known for the F-35 joint strike fighter, Lockheed Martin actually has four major divisions:

Aeronautics (39% of sales and 41% of operating profits year-to-date): designs, manufactures, and maintains combat and air mobility aircraft,  including fighter jets (F-22, F-35, and F-16), military transport planes, and unmanned air vehicles.

Missiles and Fire Control (14% of sales and 21% of operating profits): provides air and missile defense systems, tactical missiles and air-to-ground precision strike weapon systems.

Rotary and Mission Systems (28% of sales and 17% of operating profits): builds and maintains military and commercial helicopters. Also designs ship and submarine mission and combat systems, including mission systems and sensors for rotary and fixed-wing aircraft, sea and land-based missile defense systems as well as radar systems, the Littoral combat ship, simulation and training services, and unmanned systems and technologies. This division also offers government cyber security services and specializes in military communication solutions.

Space Systems (20% of sales and 21% of operating profits): designs and builds satellites, strategic and defensive missile systems, and space transportation systems. This division is also where Lockheed designs its classified systems and services in support of national security.

Overall, Lockheed Martin generates 60% of its sales from the U.S. Department of Defense, 20% from U.S. government agencies, and 20% from international militaries.

Business Analysis

Many of the best dividend growth stocks generate growing and recurring sales, earnings, and cash flow, which are made possibly by durable competitive advantages that allow a company to protect its margins and returns on shareholder capital over time.

As an industrial company, and one that’s essentially 100% reliant on world governments for its business, Lockheed’s top line sales can be somewhat cyclical.

Source: Simply Safe Dividends

While the company operates in a highly capital intensive industry, the nature of its military and government contracts also locks in relatively high profitability, resulting in cyclical but relatively stable and generous profits and returns on shareholder capital.

Stepping back, the nature of defense contractors can create substantial moats for some businesses. The highly complex and very expensive development costs of these weapons systems, as well as the Department of Defense’s (DOD) conservative approach to whom it works with (company trust, expertise and reputation are everything in this business), mean that smaller, less well capitalized rivals are essentially locked out of the market.

In fact, many of Lockheed’s DOD contracts are non-competitive, meaning the U.S. military has no choice but to use Lockheed because there are no other qualified bidders. In 2012, for example, Lockheed obtained $17.4 billion worth of non-compete contracts from the U.S. DOD, representing about 37% of that year’s revenue.

And thanks to its $9 billion acquisition of Sikorsky Aircraft in 2015, Lockheed now has a massive business building and servicing UH-60 Blackhawk helicopters, of which the U.S. military maintains a fleet of 2,000. Replacing, maintaining, and servicing this large sunk cost for the DOD means Lockheed enjoys large switching costs in military rotary aircraft as well.

The deal essentially added the world’s largest military helicopter maker by sales to Lockheed’s combat jet and missile-defense businesses. When combined with Lockheed’s divestiture of lower-margin government IT and services businesses, these moves further concentrated the company on military businesses with greater competitive advantages and improving growth prospects.

Lockheed’s moat is especially wide in manned combat fixed wing aircraft, where it’s likely to be the U.S. military’s sole supplier by 2025, thus ensuring a steady stream of high margin sales and cash flow.

Another benefit Lockheed has is that it sells internationally to allied militaries, very few of which have the expertise or desire to take the time and money required to design their own homegrown weapons systems.

In other words, relatively small nations find it much easier to outsource their defense needs from U.S. contractors. As a result, once a major weapons contract, such as the F-35 joint strike fighter, is obtained from the DOD, Lockheed essentially gains a near monopoly of fighter aircraft not just in the U.S., but also in the majority of the free world.

In fact, Lockheed is currently close to signing a deal with the DOD and 10 allied nations for delivery of 440 F-35s that would be worth $35 to $40 billion.

However, it’s also important to note that the highly complex nature of these weapons systems is also a double-edged sword. That’s because it’s monstrously complex to build these jet fighters, including numerous subcontractors in a process that often takes decades of R&D and upgrades.

For example, the F-35 program, which Lockheed won the contract for in 2001, actually dates back to the late 1980’s. The $1.5 trillion program is designed to run through 2070, making it the most expensive military contract in history.

And while it offers Lockheed immense long-term profit potential, the program has also been plagued by various setbacks, including being more than a decade behind schedule and highly over budget, with cost overruns eating into Lockheed’s profits.

This is partially why the company’s margins are below industry average, with integration of its latest big acquisition, Sikorsky, also contributing to lower-than-normal profitability.

Lockheed Martin Trailing 12-Month Profitability

Sources: Morningstar, Gurufocus, CSImarketing

Fortunately, management is working with the DOD on its Blueprint for Affordability for Production (BFA) program, announced in 2014, to dramatically cut costs (by 35%) and maintenance expenses.

Lockheed also has a second cost saving program, the Sustainment Cost Reduction Initiative, in which it and its partners are investing $250 million in order to eventually cut annual expenses to build the F-35 by $200 million.

More importantly, Lockheed believes it can now profitably deliver F-35’s for just $75.4 million, which is $4 million lower than Boeing’s (BA) $79 million F/A 18 Super Hornet.

Still, the F-35’s cost per plane is 25% above what was originally planned for, which has caused numerous budgetary watchdog groups to lambast the program as the largest defense boondoggle in history.

In fact, a 2013 report from the RAND corporation concluded that it would have been much cheaper for the Air Force, Navy, and Marines to have designed their own custom planes, which would have also been far more capable than the F-35, which was burdened with the need to serve all branches simultaneously.

In other words, because the F-35 was designed to be a jack-of-all-trades, it has run into incredibly costly overruns and manufacturing delays.

That being said, Lockheed has spent the last few years ironing out the kinks in producing the jet, which accounted for 23% of all company sales in 2016, and expects ramped up and smoothed out production in the coming years to result in steady growth in its top and bottom lines.

That’s because the DOD plans to eventually purchase more than 2,400 of the jets. In fact, analysts expect Lockheed’s profits to grow by about 50% by 2020 due to the ramp up of F-35 production and delivery.

Since U.S. allies are similarly committed to the DOD’s “too big to fail” project, Lockheed’s strong backlog of orders ($103.6 billion at the end of 2016, with $46.9 billion in new orders last year), is likely to remain large and robust.

In fact, Lockheed’s backlog now represents about 2.5 years of total sales, meaning it has far more cash flow predictability than in its past.

Source: Lockheed Martin investor presentation

Lockheed’s book-to-bill ratio (new orders/deliveries) has been steadily climbing over time as well, increasing from about 1.0 in 2016 to 1.2 YTD 2017 and almost 2 in the most recent quarter. This means that the order backlog, already at record highs, is likely to only grow over time.

In the meantime, the company is still generating strong returns on shareholder capital, as well as a solid free cash flow margin to support its steadily rising dividend.

Better yet, Lockheed’s management has proven to be one of the most shareholder-friendly teams in the industry, with the company returning 100% of free cash flow (cash left over after running the business and investing in its growth) via buybacks and dividends in 2016.

Lockheed has returned 72% of free cash flow thus far in 2017, showing its dedication to returning the vast majority of cash to its owners.

Source: Lockheed Earnings Presentation

As a result, Lockheed, while sure to face substantial challenges in the future (as will all U.S. defense contractors), is likely to continue to be a solid long-term dividend growth investment.

Key Risks

While Lockheed’s very long-term contract for the F-35 means that it has essentially guranteed itself a lot of future growth, there are nonetheless numerous risk factors to keep in mind.

First, because of its large reliance on DOD contracts, Lockheed is very susceptible to any changes in military spending. For example, currently the DOD’s budget is operating under a continuing resolution (CR) from last year (meaning spending will be the same).

However, Congress is working on a 2018 budget (to pave the way for tax reform), and in December the CR will expire. Unless Congress can pass a budget, Lockheed might find itself facing military budget cuts under the previously passed sequestration legislation.

Speaking of tax reform, that could prove to be both a help and a hinderance to the company. That’s because the effective tax rate for Lockheed is 25%, meaning that the 20% corporate tax rate being proposed would only marginally boost earnings.

However, one of the proposals for tax reform is to eliminate debt interest deduction, and thanks to large scale acquisitions in the past few years, Lockheed’s debt levels have been gradually climbing (more on this later).

Depending on how the tax reform is structured (assuming it passes), Lockheed could find itself with a gradually phased in lower corporate tax rate (won’t drop to 20% until 2022) that is more than offset by a potentially immediate loss of interest deduction.

Next, all defense contractors face some amount of political risk, especially when defense platforms go wrong (as they usually do at some point).

For example, President Trump has publicly lambasted Lockheed for the cost overruns of the F-35, as well as the fact that the plane has badly failed to live up to expectations.

That’s because the plane was specifically designed to be stealthy (but only to certain radar signatures), but the trade-off has been reduced maneuverability and fighting ability.

In fact, in a 2015 mock battle with F-16’s (the plane the F-35 is meant to replace that was designed in the 70’s), the F-35 proved to be less maneuverable and capable of dog fighting, even though it was unencumbered by external weapons mounts or fuel tanks.

The much older F-16s, which did have large external fuel tanks, were still able to fly circles around the state-of-the-art fighter, calling into question whether or not the next generation aircraft is a worthy replacement at all, or merely an overpriced and over designed (the avionics alone require 24 million lines of code vs the F16’s 135,000) boondoggle that the DOD can’t undo.

Since almost all DOD contracts are now fixed cost, any cost overruns are mainly paid for by Lockheed, meaning that if it runs into unexpected problems delivering on weapons systems, its earnings can be badly affected. In fact, back in the 1970’s and 1980’s, several defense contractors nearly went bankrupt due to such issues.

The F-35 is hardly the only issue for Lockheed. For example, its Sikorsky acquisition has not gone as smoothly as expected, with cost synergies coming along slower than anticipated. In addition, Sikorsky sales are expected to be essentially flat for the year as it faces increasing competition from Airbus Helicopters, Augusta Westland, and Bell in the commercial helicopter space.

Meanwhile, missile systems are only expected to generate small growth, more than offset by the lagging space systems division (which is projecting double-digit declines).

Lockheed has enjoyed a duopoly position in missiles (with Raytheon) and space (United Launch Alliance joint venture with Boeing) for a long-time; however, increased competition from Elon Musk’s SpaceX and Jeff Bezos’s Blue Origin could threaten to undermine lucrative satellite delivery contracts with the DOD, which represent 15% to 20% of this division’s sales.

Lockheed has responded with a plan to cut the price of launching government satellites by 25% in the next few years, but SpaceX is now successfully using self-landing, reusable rockets that Lockheed might find difficult to match unless it can design its own reusable models. That’s a highly complex and expensive endeavor, and one that Lockheed has no guarantees of success since its moat is much shallower in this industry.

Fortunately, about 50% of the Space System’s business is in building DOD satellites, which are highly classified and in which Lockheed faces little competition. The same is true for the ballistic nuclear missile business, where Lockheed and Raytheon have the market locked up for supplying U.S. intercontinental ballistic missiles (ICMBs).

The bottom line is that Lockheed may have a near global monopoly on fighter aircraft and strong moats in its military helicopter, military satellite, and nuclear missile businesses.  This will likely ensure it modest growth in the coming years and decades.

However, its other divisions are struggling and enjoy much smaller competitive advantages.  This could drag on long-term sales growth, which is why investors may not be able to rely on the company being able to grow its dividend at the impressive double-digit pace enjoyed over the past 30 years.

Lockheed Martin’s Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend..

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Real Estate Investment Trusts, or REITs, are a popular way for regular investors to participate in commercial real estate.

Generous yields, relatively low volatility, and steady dividend growth can make certain REITs some of the best high dividend stocks for investors seeking retirement income and capital preservation.

This is why larger, famous REITs, such as Realty Income (O), are often core holdings in high-yield income portfolios.

However, the world of REITs is a large one, which is why sometimes it’s worth taking a look at smaller names, such as STORE Capital (STOR).

Let’s take a look at STORE to see why its strong fundamentals have attracted the attention of none other than Warren Buffett, history’s greatest investor, who recently purchased a 10% stake in the company. Investors can review Buffett’s dividend portfolio here.

Specifically, learn if this small but fast-growing REIT may have what a diversified, high-yield portfolio needs, especially at today’s valuations.

Business Overview

STORE Capital (which stands for Single Tenant Operational Real Estate) is a relatively new triple net lease REIT, having gone public in 2014.

However, it’s led by a management team with 35 years of experience in the industry, having built three previous triple net lease REITs (tenants pay all taxes, maintenance, and insurance costs) with a total of 9,100 properties.

Today, STORE owns 1,826 properties in 48 states leased under long-term contracts (average remaining lease is 14 years) to 382 companies in 102 industries.

STORE’s rent is derived from:

  • 69% services (restaurants, daycare centers, fitness centers, movie theaters)
  • 18% retail
  • 13% manufacturing (business parks)

Source: STORE Investor presentation

Business Analysis

There are three keys to most successful dividend growth stories in real estate: a stream of dependable cash flow, a strong balance sheet, and a long-term focused, conservative management team whoknows how to balance growth and dividend safety, as well as adapt to shifting industry conditions.

When it comes to triple net lease retail REITs (such as Realty Income and STORE), many investors have become worried over the large number of retail bankruptcies and store closings (the most since the financial crisis), which the media has dubbed “the retail apocalypse”.

Source: Bloomberg

In fact, according to Fung Global Retail, in the first half of the year, 29 retail chains announced they were closing 4,381 stores across the U.S. However, while such headlines might scare Wall Street, quality retail REITs such as STORE actually appear to be well insulated from the carnage.

That’s because they have extremely diversified property portfolios, with very little exposure to distressed retail.

In fact, the vast majority of STORE’s rental revenue is derived from service-oriented businesses, which are largely immune from the disruptive growth of e-commerce.

The remainder of STORE’s properties are similarly Amazon (AMZN) resistant because even the company’s small amount of retail exposure is largely in areas that continue to thrive, such as furniture, farm supplies, and hunting and fishing stores.

In addition, STORE’s management team, which has decades of experience running triple net lease REIT portfolios, has taken a highly disciplined approach to the types of tenants it targets so that 75% of its tenants are investment grade (only 46% of Realty Income’s (O) tenants can say the same).

Such conservatism reduces the risk of tenants being unable to pay their rent and makes them more capable of accepting rent increases over time.

Additionally, STORE is very careful about making sure that each store’s tenant is financially healthy, targeting conservative unit level fixed charge coverage ratios (tenant cash flow over fixed charges including rent) of 2.0 or greater.

In other words, STORE management is highly disciplined in its growth approach, making sure to only rent to tenants who are unlikely to fail and stop paying rent. This is why its occupancy rates have not only been among the highest in the industry, but highly stable for several years, including during the recent retail industry downturn.

However, what’s even more impressive about STORE is that, despite management’s exceedingly high acquisition standards, the REIT operates in a massive and highly fragmented market, which means plenty of opportunity to grow through acquiring new properties and renting them out to rock solid tenants over time.

In fact, of the $2.6 trillion commercial real estate market, publicly traded triple net lease REITs own only about 4%. STORE’s management team has located approximately $12 billion in potential acquisitions, which represents about 10 to 12 years of growth potential for the company.

The key to STORE’s success has been not just fast growth, including adjusted funds from operations or AFFO (the REIT equivalent of free cash flow) per share (10.1% annually since IPO) and the dividend (8.6% annually), but management’s Warren Buffett-like dedication to not overpaying for new properties.

Management’s deep industry connections mean that the company can source new acquisitions from private markets at far lower prices than many other REITs, resulting in cash yields on new properties that are significantly higher. For example, so far in 2017 STORE’s cash yield has been 7.8% compared to Realty Income’s 6.5%.

That may not sound like much, but in the highly levered world of commercial real estate, such small differences can add up. In this case, STORE is the most profitable REIT in its industry.

There are two drivers of to this impressive profitability. First, management has the patience and connections to source highly profitable acquisitions at above-average cash yield rates.

However, the other factor is the disciplined approach the REIT takes to paying out its dividend. Specifically, STORE Capital retains a larger than average proportion (most peers retain just 10% to 20%) of AFFO to fund growth.

Sources: Earnings Release, management guidance, Fast Graphs, Gurufocus

There are three reasons why STORE benefits so much from this high percentage of retained cash flow. First, it’s important to remember that REITs, by law, must payout 90% of taxable income (not the same as AFFO) as dividends to avoid paying corporate taxes.

In other words, REITs are high-yield pass-through stocks, designed to distribute the majority of cash flow to shareholders. However, that means that in order to grow, REITs must constantly access external capital markets (i.e. issue debt and sell new..

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When it comes to safe and consistent dividend growth, few companies have done it better than the dividend aristocrats, S&P 500 companies with 25+ consecutive years of payout increases under their belt.

Of these impressive dividend growers, AT&T (T) stands tall above all the rest with a 5.9% dividend yield. When combined with the company’s 33 straight years of dividend increases, AT&T could deserve consideration as one of the best high dividend stocks.

One of the reason’s AT&T’s yield is so high is because the company’s stock price has dropped by more than 15% over the past month. That’s a surprisingly big move for a stock that is held by most investors for its safe income and defensive qualities.

With concerns growing over AT&T’s pay-TV subscriber losses, uncertainty over the Time Warner (TWX) merger gaining final regulatory approval, and the company’s massive debt burden, some of the stock’s underperformance seems justified.

Let’s take a closer look at the issues affecting Ma Bell to see if the stock’s dividend yield, which sits near its highest level since 2011, appears to be attractive for a diversified income portfolio or is instead a sign that AT&T is becoming a value trap.

Business Overview

Founded in 1983 as SBC Communications (the company bought AT&T in 2005 and adopted the more famous moniker), AT&T is a telecom and media conglomerate that operates four business segments:

Business Solutions (43% of 2016 sales): offers wireless, fixed strategic, legacy voice and data, wireless equipment, and other services to over 3 million business, governmental, and wholesale customers, as well as individual subscribers.

Entertainment (31% of 2016 sales): provides video entertainment and audio programming channels to approximately 25.3 million subscribers; broadband and Internet services to 12.9 million residential subscribers in over 240 markets; local and long-distance voice services to residential customers, as well as DSL Internet access services. This division has connections to over 60 million locations nationwide.

Consumer Mobility (20% of 2016 sales): offers wireless services to over 136 million U.S. customers and wireless wholesale and resale subscribers, such as long-distance and roaming services, on a post and pre-paid basis.

This segment also sells a variety of handsets, wirelessly enabled computers, and personal computer wireless data cards through company-owned stores, agents, or third-party retail stores, as well as accessories, such as carrying cases, hands-free devices, and other items.

International (4% of sales): offers digital television services, including local and international digital-quality video entertainment and audio programming under the DIRECTV and SKY brands throughout Latin America. This segment also provides postpaid and prepaid wireless services to approximately 13.1 million subscribers under the AT&T and Unefon brands; and sells a range of handsets.

Business Analysis

The key to AT&T’s ability to generate such high and growing dividends over time is the wide moat created by the extremely capital intensive nature of the industries in which it operates.

For example, AT&T spent more than $140 billion between 2012 and 2016 on maintaining, upgrading, and expanding its networks, including over $22 billion in 2016 (13.4% of revenue).

Few other companies can afford to compete with AT&T on a national scale. Only Verizon (VZ), T-Mobile, and to a lesser extent Sprint (S) have the resources to operate networks that offer similar levels of connectivity.

To make matters even more challenging for new competitors, most of AT&T’s markets are very mature. The number of total subscribers is simply not growing much.

In other words, it would be almost impossible for new entrants to accumulate the critical mass of subscribers needed to cover the huge cost of building out a cable, wireless, or satellite network.

In addition to covering network costs, AT&T’s scale allows it to invest heavily in marketing and maintain strong purchasing power for equipment and TV content. Smaller players and new entrants are once again at a disadvantage.

Barring a major change in technology, it seems very difficult to uproot AT&T. It’s much easier to maintain a large subscriber base in a mature market than it is to build a new base from scratch.

While AT&T’s wireless division is its most consumer-facing business, the company’s strong presence in hundreds of broadband internet markets, as well as its expansion into pay-TV, via the $67 billion acquisition of DirectTV in 2015, have helped it continue growing despite a highly saturated U.S. market in both wireless and internet service.

Source: AT&T Earnings Presentation

In addition, DirectTV has allowed AT&T to bundle many of its offerings to customers, helping it fend off the worst of the cord-cutting trend that has plagued so many of its rivals.

In fact, AT&T showed continue improvement in phone churn and has seen satellite churn drop by 50% when bundled with wireless. More of its pay-TV customer base is also using the company’s wireless plans compared to two years ago.

Source: AT&T Earnings Presentation

With plans to acquire Time Warner, the media content juggernaut, in an $109 billion mega-acquisition (including debt), AT&T hopes to better leverage its various platform offerings to remain competitive in the cutthroat wireless industry.

For example, thanks to T-Mobile reviving the popularity of unlimited data plans, once price insensitive rivals such as Verizon have been forced to reduce their wireless plan prices to $80 per month for unlimited data (first line).

In contrast, AT&T offers a $90 unlimited plan that continues to gain subscribers thanks to the company bundling a $25 pay-TV discount, as well as offering free HBO (a Time Warner company).

In fact, thanks to the popularity of these bundled unlimited data plans, AT&T’s postpaid churn rate (what percentage of subscribers leave each month) hit a record low for the third quarter of 0.84%, and the wireless segment’s EBITDA margins have risen to a record high of 42%.

In other words, AT&T’s track record of expanding into media and related industries appears to be bearing some fruit, including hitting its synergistic cost saving targets and leveraging its new platforms and properties to strengthen its existing core offerings.

That in turn has allowed it to achieve higher-than-average profitability in a massively capital intensive industry not known for its impressive margins or returns on shareholder capital.

AT&T Trailing 12-Month Profitability

Sources: Morningstar, Gurufocus

AT&T could also be poised to see very strong growth in free cash flow (what funds and grows the dividend) due to ongoing vertical integration efforts and the economies of scale that go with it.

If the Time Warner acquisition goes through, AT&T would enjoy a higher-margin business (Time Warner’s operations are relatively much less capital intensive) that is also growing faster, helping fuel a continued rise in AT&T’s free cash flow.

That in turn could accelerate AT&T’s long-term dividend growth and total return potential, once AT&T uses the additional free cash flow to pay down the debt it’s taking on to fund the deal.

Meanwhile, while still not itself a needle-moving business segment, AT&T’s international divisions are continuing to grow nicely thanks to AT&T successfully gaining new customers in Mexico.

That’s a market it entered in 2014 with its $4.4 billion purchases of lusacell and Nextel Mexico to gain access to a fast-growing region; one in which the population is expected to grow 32% between 2010 and 2050 to reach 156 million people.

Management has previously stated that they believe AT&T’s Mexican operations could eventually grow to be at least 25% of the size of its U.S. wireless business over the long-term, and subscribers grew 29% year-over-year last quarter.

In other words, while international may still be a small fraction of sales, AT&T’s strong presence in Latin America means that it also offers long-term double-digit organic growth potential.

At the end of the day, AT&T seems to enjoy a strong economic moat due to its ability to provide customers with their video, data, and communication needs anytime, anywhere, and on any device. Few companies have the financial firepower and brand strength to effectively compete.

However, the telecom industry and consumer preferences are constantly evolving, making incremental earnings growth more challenging for the large incumbents.

Key Risks

While AT&T has historically been a relatively low risk stock, there are nonetheless several major risks to be aware of.

Domestically, AT&T’s organic growth has basically stalled because of the saturated nature of the markets it operates in.

Source: Simply Safe Dividends

On the wireless side, smartphone saturation and the rise of T-Mobile (TMUS) have intensified competition for existing subscribers. The major players have been forced to offer unlimited data plans to maintain their subscriber bases, losing out on lucrative data overage fees.

While there was hope of industry pricing becoming more rational with T-Mobile and Sprint (S) appearing likely to merge, the chances of a deal have taken a hit in recent weeks.

There’s also hope that the “internet of things” could bring new wireless data growth opportunities in areas such as smart cars and automated homes, but these categories are much smaller than the total revenue generated from smartphones today.

If growth in the wireless market remains weak and there is no further consolidation, the battle for existing subscribers could intensify between carriers, pressuring the industry’s strong margins.

Perhaps more concerning, AT&T’s big bet on DirecTV has shown some cracks in recent quarters. You can see that DirecTV satellite subscribers declined during the second quarter and saw an even larger drop during the third quarter.

Source: AT&T Earnings Release, Simply Safe Dividends

Craig Moffett, an industry analyst for Moffett Nathanson LLC, said in a Bloomberg Radio interview that DirecTV is now probably only worth about half what AT&T paid for it ($67 billion)!

The rise of over-the-top streaming services could be winning over traditional pay-TV subscribers at an increasing pace. AT&T launched its own streaming service, DirecTV NOW, and has seen it grow to more than 800,000 subscribers in less than a year (compared to company-wide TV subscribers of about 25 million).

However, DirecTV NOW is at a much lower price point than satellite TV and is far less profitable. It also risks cannibalizing AT&T’s higher-margin, traditional pay-TV subscribers.

Given some of these pressures, the company’s domestic sales, earnings, and free cash flow are almost entirely dependent on continued large-scale acquisitions.

For example, while AT&T reported strong double-digit growth in 2015 and 2016, that was entirely due to the DirecTV acquisition. Once those favorable comparison quarters passed, the growth rate basically returned to zero.

While the Time Warner deal has the potential to once again boost growth, investors need to realize two important risks about that transaction.

First, a successful integration of Time Warner is far from assured. After all, due to overpaying and failed synergistic cost savings, approximately 87% of large acquisitions fail to generate shareholder value. These are two companies with very different cultures and lines of business.

In addition, The Wall Street Journal recently reported that the U.S. Justice Department is preparing a potential lawsuit challenging AT&T’s planned acquisition of Time Warner if the government and companies cannot agree on a settlement.

Should the Department of Justice block the acquisition, then not only would AT&T lose an excellent opportunity to boost its overall profitability and growth prospects, but it would also incur a $1.73 billion breakup fee and face greater strategic uncertainty with plans for its existing businesses.

Meanwhile, when it comes to AT&T’s organic growth potential in its international segment, success is similarly uncertain.

That’s because while AT&T’s Mexico wireless business is growing strongly, the company is by far the smallest fish in the Mexican wireless sea, facing off against far larger and very well-capitalized rivals such as Telefonica and America Movil.

Even if AT&T does manage to gain market share in Mexico, keep in mind that it’s far from certain that it will be able to do so while generating the same kinds of impressive 40+% EBITDA margins as its U.S. wireless business does.

After all, Mexico is still a developing economy where per capita wealth is far lower than in the U.S., meaning more price-sensitive consumers.

AT&T’s Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

Dividend Safety Scores range..

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Omega Healthcare (OHI) announced third quarter results last night that took many investors by surprise, sending the stock down as much as 10% in early trading this morning.

For those who are unfamiliar with the company, Omega Healthcare is a real estate investment trust (REIT) that provides financing and capital primarily to skilled nursing facilities (SNFs). In fact, Omega is the largest SNF-focused REIT and generates 84% of its revenue from SNFs.

Patients discharged from hospitals are sent to SNFs when they still require care or rehab before they can be sent home. Compared to hospitals, SNFs can provide short-term care on a more affordable basis to save healthcare costs.

Several of Omega’s tenants are under financial pressure, which caused the company to place one of them (Orianna Health Systems) on a cash basis for accounting purposes after the operator continued missing its budget and failed to pay its monthly rent obligations.

In other words, Omega Healthcare will only recognize revenue from this operator as it receives cash. Omega plans to move some or all of Orianna’s properties to new operators over the next six months or so, but annual contracted rent from the properties is expected to decrease from $46 million to a range of $32 million to $38 million once the transition is complete.

In addition to Orianna, management commented that Signature, the company’s third-largest operator (6.7% of annualized third quarter revenue), was facing liquidity challenges to pay rent on a timely basis.

Signature fell further behind schedule during the third quarter, although the vast majority of its rent due is covered by a revolving credit agreement.

Omega was also looking at deferring 10% of total rent from Signature (around 0.67% of company-wide rent) for three years, so this doesn’t seem to be a huge concern for now.

Regardless, when combined with Orianna, these two tenants accounted for close to 12% of annualized contractual rent during the third quarter.

Source: Omega Healthcare Earnings Release

Omega Healthcare also placed a non-top 10 operator, Daybreak, on a cash basis in September due to a short-term liquidity crunch the company faced; however, Daybreak is expected to pay full rent starting in January and is not comparable to Orianna’s situation.

Signature does have a restructuring plan in place that involves some potential asset sales, and management is taking more powerful steps to right-size performance with the Orianna portfolio, but it’s discomforting to know that important tenants are struggling.

That’s especially true in light of fears that have surrounded the SNF industry for several years. More specifically, skilled nursing generally has higher reimbursement risk than other areas of healthcare because SNFs depend more on Medicare and Medicaid reimbursements from the government.

In fact, private pay only accounted for 12.2% of Omega’s operator revenue mix as of June 30, 2017, with Medicaid (51.9%) and Medicare / Insurance (35.9%) accounting for the remainder.

As a result, changes in federal policies and increased scrutiny over billing practices of SNF operators have potential to materially impact the ability of Omega Healthcare’s tenants to meet their lease obligations.

Lengths of stay have already been declining under alternative payment models such as bundling and managed care, for example.

While the company’s percentage of revenue from private payers has been gradually climbing over time, thanks to management’s decision to decrease its reliance on government healthcare funding, Omega’s prosperity is unfortunately at the mercy of Washington for the foreseeable future.

Here’s what Fitch noted earlier this year:

“SNF margins are being pressured by increasing coverage under Medicare Advantage, Department of Justice investigations potentially influencing billing practices, and pilot programs for bundled payments and coordinated care. While the Trump administration appears to be in favor of slowing the growth of bundles and making participation voluntary, we believe the long-term demographic and economic factors will continue to drive the market towards these programs over the long run. We view these as long-term headwinds that stronger operators should be able to manage given they are fairly well-telegraphed.”

Investors were growing worried about the SNF industry even before the various health and tax bills proposed this year.

You can see that the SNF industry has faced declining industry profitability and EBITDAR coverage (earnings before interest, taxes, depreciation, amortization, and rent costs) in recent years:

Source: Omega Healthcare Investors

One of Omega’s four largest tenants, Genesis Healthcare (GEN), has also seen its stock price crumble nearly 90% since the start of 2015 as it faced charges for submitting false claims to Medicare and Medicaid for unnecessary therapy.

As a result of the industry’s challenges and reimbursement uncertainties, many healthcare REITs have decided to exit the SNF space in recent years. Some examples include Ventas (VTR), HCP (HCP), and Sabra Healthcare (SBRA), who are all seeking greater portfolio quality and cash flow predictability.

Even if Medicare and Medicaid policy doesn’t end up shifting too severely, the main growth catalyst for the SNF industry (an aging population) is still about a decade away, meaning that the next few years could remain trying for many of Omega’s customers.

So it’s no surprise that today’s news further rattled investors’ confidence in the SNF industry and Omega Healthcare’s ability to profitably manage its portfolio in an environment where more tenants could be challenged to meet their rent obligations.

What Today’s News Means for Omega Healthcare’s Dividend Safety

With that said, Omega’s report was not all doom and gloom, especially for its dividend.

Omega’s management stated they have built a “very significant cushion” and remain “confident” in the company’s ability to pay quarterly dividends, which seems to be supported by the firm’s fundamentals and Dividend Safety Score.

Omega Healthcare’s payout ratio remains reasonable at 82% of adjusted funds from operations (AFFO) and 89% of funds available for distribution (FAD), for example.

While management lowered Omega’s full-year adjusted FFO per share by 4.5% to $3.27 to $3.28 as a result of converting Orianna to cash basis accounting, the company’s full-year AFFO payout ratio would only be 79%.

This is a relatively low AFFO payout ratio for a REIT and indicates that Omega Healthcare retains a relatively high amount of cash flow from which to fund growth investments and its dividend, making it less dependent than some rivals on tapping debt and equity markets for capital.

These payout ratio percentages will further improve once the Orianna portfolio returns to paying rent over the next six months, restoring much of Omega Healthcare’s cushion to continue paying a safe dividend, which it has increased for 21 consecutive quarters (including a dividend increase announced earlier this month).

From a leverage perspective, Omega Healthcare’s balance sheet and dividend remain on solid ground as well. The company maintains an investment grade credit rating and has no material debt maturities until 2022 (assuming allowable credit facility extensions).

As of June 1, 2017, Omega also had approximately $1 billion of liquidity available through its revolving credit facility, which compares to the firm’s annualized dividend payments of approximately $540 million.

Simply put, Omega’s healthy payout ratio, conservative balance sheet, and committed management team are supportive of the dividend. The biggest question is whether or not Orianna, Signature, and Daybreak are canaries in a coal mine (i.a. an advanced warning of widespread danger in the SNF industry).

Management argues that the challenges faced by Orianna are specific to that operator rather than the broader industry. Orianna’s occupancy declined from 92% in 2014 to 89%, and management believes some of the Orianna facilities’ new operators may be able to improve performance.

Perhaps the strongest argument supporting overall industry stability (for now) is the overall trend in operator occupancy and EBITDAR coverage over the last year. You can see that both measures have been fairly steady the last five quarters.

Source: Omega Healthcare Earnings Release

Note that the Orianna portfolio is expected to increase its EBITDAR coverage to between 1.2x and 1.5x (from below 1x last quarter) once its properties are transferred, even after assuming a rent hit of $8 million to $14 million.

Based on today’s rent coverage, Omega’s tenants appear likely overall to be able to absorb moderate reimbursement rate reductions and still meet their monthly rent obligations. Management does not expect a big dropoff in occupancy rates going forward, which remains supportive of today’s EBITDAR coverage.

With approximately 90% of portfolio lease expirations occurring after 2021, Omega’s cash flow visibility to support the dividend is also solid so long as operators’ financial health does not deteriorate (combined EBITDAR coverage of leases expiring through 2021 was a reasonable 1.36x at the end of 2016, consistent with last quarter’s level).

Unfortunately, there is very little visibility into the real-time health of Omega’s operators since almost all of them are private companies. It’s also very challenging to predict what impact healthcare and tax reform could have on Medicare and Medicaid.

Management of course believes that today’s proposals are uncomparable to the challenges the industry faced in the late 1990s, when reimbursement rates were slashed dramatically to address a serious fiscal issue (more on that in the Dividend Safety discussion here).

Omega believes today’s proposals are more about fixing policies to prepare the healthcare system for the demographic wave that’s coming. Getting more efficient with patient lengths of stay and making sure people have access to care are larger priorities than the dollar amounts paid.

I tend to agree, but you never desire for an investment thesis to bank on neutral or favorable legislative outcomes.

This creates potential for a wider range of outcomes over the next several years before demographic tailwinds seem likely to start moving the occupancy needle more for the industry.

Overall, given what we know today, Omega Healthcare’s dividend appears to remain on stable ground, especially if the issues hurting the stock are truly operator-specific (i.e. short-term and fixable) rather than indicative of overall industry conditions deteriorating.

With that said, legislative and regulatory changes, especially surrounding reimbursement amounts, can significantly impact the profitability of Omega’s somewhat-fragile tenants going forward.

While Omega Healthcare’s operational and financial conservatism positioned it well to continue paying safe and growing dividends throughout unexpected headwinds such as Orianna, income investors still need to watch how these potential long-term headwinds play out over the coming years (stable occupancy and EBITDAR coverage are key).

Closing Thoughts on Omega Healthcare

Omega Healthcare’s earnings report highlighted challenges that several important operators are facing as the SNF industry works through a number of murky changes.

While the company’s overall property portfolio and financial health continue to look reasonable and supportive of the dividend, it’s fair to say that Omega investors now face even greater uncertainty about the industry’s realities (i.e. are today’s issues isolated to a few underperforming operators, or is the tide starting to go out on all SNF players?).

I have been taking a “wait and see” approach with most healthcare stocks in light of ongoing reform efforts, and I think the jury is still out with how the SNF industry will evolve. Monitoring occupancy and rent coverage metrics closely over the coming quarters will help determine how isolated the cases of Orianna, Signature, and Daybreak really are.

There is certainly risk that Omega Healthcare turns into a value trap (I wouldn’t be interested in adding to an existing position), so maintaining appropriate position sizes and healthy portfolio diversification is important to acknowledge the wide range of outcomes that Omega faces.

Despite the stock’s rising yield, which still looks safe for now thanks to Omega’s conservatism (although industry conditions could change quickly), I would not be opposed to replacing shares of the company with another high dividend stock given the growing uncertainties.

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The post Omega Healthcare (OHI) Reports Disappointing Earnings: What Dividend Investors Need to Know appeared first on Simply Safe Dividends.

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Blue chip drug makers such as Merck (MRK) have historically been very popular with income investors because of their defensive nature, meaning that drug demand isn’t really affected by economic downturns.

However, what many investors fail to realize is that, while the pharmaceutical industry as a whole may be recession resistant, successful long-term dividend growth investing is far harder to achieve at the company level.

This is why just two drug makers are part of the venerable dividend aristocrats list, meaning they are S&P 500 companies that have managed to raise their payouts for at least 25 consecutive years.

Let’s take a look at Merck to see if this high-yield favorite is a reasonable choice for a diversified dividend portfolio, especially in light of recent challenges that have sent MRK’s stock on its largest two-day decline in more than eight years, according to Reuters.

Business Overview

Merck has deep roots, going back to 17th century Germany, but in the U.S. it was founded in 1891 in Kenilworth, New Jersey. Today Merck is one of the largest pharmaceutical giants in the world, with 69,000 global employees selling drugs in over 140 countries through two main divisions.

Pharmaceutical (88.7% of Q3 2017 revenue) makes patented drugs to treat all manner of diseases and conditions, such as cardiovascular disease, type 2 diabetes, asthma, chronic hepatitis C virus, HIV-1 infection, fungal infections, hypertension, arthritis, osteoporosis, and fertility diseases.

It also offers anti-bacterial products, cholesterol modifying medicines, and vaginal contraceptive products, as well as vaccines for measles, mumps, rubella, varicella, chickenpox, shingles, rotavirus gastroenteritis, and pneumococcal diseases.

The company’s bread and butter sales, earnings, and free cash flow stem from just nine main large drugs, including blockbusters Januvia (type 2 diabetes) and Keytruda (antibody based cancer drug).

Source: Merck Earnings Release

Animal Health (9.7% of Q3 2017 sales) sells antibiotic and anti-inflammatory drugs to treat infectious and respiratory diseases, fertility disorders, and pneumonia in cattle, horses, and swine; vaccines for poultry, parasiticide for sea lice in salmon, and antibiotics and vaccines for fish

Merck’s remaining sales come from two smaller divisions (1.6% of Q3 2017 revenue), Healthcare Services (serves drug wholesalers and retailers, hospitals, government agencies and entities, physicians, physician distributors, veterinarians, distributors, animal producers, and managed health care providers) and Alliances segments (collaborations with Aduro Biotech, Inc, Premier Inc, Cancer Research Technology, Corning, Pfizer Inc, AstraZeneca PLC,  and SELLAS Life Sciences Group Ltd).

Merck’s 2016 sales were geographically diversified, with the U.S. responsible for 46.5% of revenue, with international markets representing 53.5%.

Business Analysis

Like most major drug makers, Merck struggles to maintain consistent top and bottom line growth.

Source: Simply Safe Dividends

This is inherent in the business model, which relies on patented medications, whose patents eventually roll off, resulting in strong generic competition. In addition, rival medications, even for patented drugs, are constantly hitting the market, meaning that its top products face a boom and bust cycle.

Combined with high fixed costs, primarily in R&D spending on developing its large drug pipeline ($9.9 billion or 24.8% of last 12 month’s revenue), Merck’s margins and returns on capital can be volatile, as are its overall earnings and free cash flow.

Another problem Merck faces is that because of the drug development hamster wheel (even new blockbusters merely replace revenue lost to patent expirations and rival products), its growth is largely dependent on large-scale acquisitions, such as its $41 billion purchase of Schering-Plough in 2009 to help diversify the busienss.

Such large purchases are incredibly tough to pull off successfully because they require careful integration of differing corporate cultures, R&D pipelines, and administrative organization to deliver on expected synergistic cost savings (i.e. elimination of overlapping business costs).

Another challenge for Merck is that in this industry there are three primary factors that determine success: drug pipeline, manufacturing efficiency, and distribution. In other words, economies of scale.

However, while Merck is a large player, it’s management is not nearly as high-quality as those of larger and better run rivals such as Pfizer (PFE), and Johnson & Johnson (JNJ), which is arguably the gold standard of drug makers.

This can be seen in Merck’s inferior profitability, including lower returns on invested capital and a lower free cash flow margin.

Trailing 12-Month Profitability

Sources: Morningstar, Gurufocus, CSImarketing

Now that’s not to say that Merck is a terrible company. After all, it does have a solid track record of bringing numerous successful drugs to market, including its current rock star, cancer drug Keytruda.

Source: Merck Investor Presentation

Thanks to receiving numerous approvals for a growing number of cancer indications, plus greater rollout to over 50 countries in the past year, Keytruda sales increased to $1.05 billion last quarter, up from $356 million a year ago.

Better yet? Analysts expect this drug to eventually generate peak sales of $10 billion per year, according to Morningstar.

Unfortunately, global sales may not be as robust as analysts currently hope. Merck provided an update last Friday that it was withdrawing an application to sell Keytruda as a first-line treatment for lung cancer in combination with chemotherapy in European markets.

The company also said it experienced a delay in another Keytruda study. A decision to make overall survival a main goal for a pivotal lunch cancer trial of Keytruda plus chemotherapy will push back those results until February 2019, according to Reuters.

With lung cancer representing the most lucrative oncology market and first-line approval giving access to most patients, this news was unsurprisingly received poorly by investors.

While this news is certainly not lethal for the company or its dividend, it potentially disrupts a very important growth driver that investors had been banking on.

Outside of Keytruda, Merck has a large pipeline of 36 drugs in development, including several potential blockbuster drugs including biosimilar (i.e. biological generics) versions of other companies’ blockbuster medications, such as Humira, Remicade, Enbrel, Lantus, and Herceptin, which combined sold $40 billion last year.

This strong pipeline should at least keep its sales, earnings, and free cash flow relatively stable in the coming years. For example, Merck currently expects 2017 sales to be essentially flat compared to 2016 ($39.6 billion vs $39.8 billion, respectively).

Despite stagnant revenue, due to the high margins on Keytruda, which still has patent protection, and cost cutting actions over the past year, EPS is expected to rise about 18% in 2017.

This impressive operational leverage (earnings growing faster than sales) is a hallmark of the drug industry; while a drug has patent protection and is growing quickly, profits can surge.

However, this patented drug hamster wheel is also a double-edged sword because unlike Johnson & Johnson, which also markets stable over-the-counter consumer products, as well as medical devices, Merk is essentially a pure play biotech company, whose earnings and free cash flow can be highly volatile.

So while short-term focused Wall Street might cheer at brief periods of explosive earnings growth, ultimately long-term dividend growth investors have a lot less to like about the highly complex, and cyclical nature of big drugmakers such as Merck.

That’s because the company faces numerous challenging headwinds that could make it a rather underwhelming long-term dividend growth investment.

Key Risks

While the worst of its patent cliff is behind it, Merck will lose patent protection on several key drugs in the coming years, including cholesterol drugs Zetia and Vytorin (generic competition likely in 2017 and 2018), as well as its steroid and decongestant Nasonex. These drugs combine for around 5% of company-wide revenue.

In fact, Merck’s selloff this past Friday was driven in part by disappointing sales of off-patent pharma products. Here’s what the company stated in its press release:

“The pharmaceutical sales decline was largely driven by the loss of U.S. market exclusivity for ZETIA (ezetimibe) in late 2016 and VYTORIN (ezetimibe/simvastatin) in April 2017, medicines for lowering LDL cholesterol, and the ongoing impacts of generic competition for CUBICIN (daptomycin for injection), an I.V. antibiotic, and biosimilar competition for REMICADE (infliximab), a treatment for inflammatory diseases, in the company’s marketing territories in Europe. In the aggregate, sales of these products declined approximately $800 million during the third quarter of 2017 compared to the third quarter of 2016.”

Management is wisely focusing on oncology, where it has a first mover advantage in revolutionary new therapies based on antibody treatments (very high margin), specifically in treating non-small-cell lung cancer, but this space is going to be increasingly competitive, with major drug trial results for rival products expected in 2017 and 2018.

In addition, Merck is forced to spend a fortune on R&D to bring its drug pipeline to market, up to $2.7 billion per drug (and climbing over time), and there is no guarantee that potential blockbusters will actually receive approval.

Source: Tufts Center For The Study Of Drug Development, Scientific American

For example, in the past Merck has faced numerous failures in drug development, including:

  • Cardiovascular disease drugs Tredaptive, Rolofylline, and TRA
  • Telcagepant for migraines
  • Osteoporosis drug odanacatib

In addition, late-stage drug anacetrapib (for heart disease), is chemically similar to rival drugs (torcetrapib and dalcetrapib) which failed to receive approval.

In other words, there is a lot of uncertainty around just how valuable Merck’s drug development pipeline will truly be to the bottom line, especially in light of its recent update on Keytruda, the company’s biggest earnings driver over the short-term.

Next, it’s worth mentioning that all drug makers (as well as all companies in the medical space) face constant uncertainty regarding healthcare regulations.

For example, Merck does most of its overseas business with national health systems that sometimes have strict regulations limiting drug prices, which forces Merck to turn to U.S. sales to cover its expensive and time consuming (up to 12 to 13 years to bring a drug market) development process.

However, U.S. healthcare policy is also in flux, not only because an eventual repeal of the Affordable Care Act could remove over 20 million Americans from the healthcare system (lowering access to and demand for drugs), but also because current regulations forbid Medicare and Medicaid from negotiating bulk drug purchases with pharmaceutical companies.

If this changes in the future, then all drug makers could see significant margin compression. Merck, already recording from below average profitability, could suffer more than most, especially when it comes to its future dividend growth.

Finally, be aware that all drug makers face significant legal risk, specifically from lawsuits of approved drugs that end up harming consumers.

For example, in 2004 Merck pulled its pain killer Vioxx from the market after subsequent studies showed it increased the risk of heart attack and stroke.

Over the next 12 years the company faced numerous class action lawsuits from consumers, the Department of Justice, and various states Attorney’s General. All told, the long legal battles resulted in almost $6 billion in fines and settlements.

The bottom is that Merk isn’t as low risk of a stock as many investors may believe, and its overall payout profile is a bit lacking, both when it comes to safety and long-term growth potential.

Merck’s Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

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One of Warren Buffett’s best pieces of investment advice is that “it’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

This is why each quarter, when Berkshire Hathaway reveals its portfolio via regulatory filings, investors eagerly look to see what companies have the Oracle of Omaha’s quality and valuation stamp of approval.

Investors can read analysis of all of Warren Buffett’s dividend-paying stocks here.

Starting in 2016, Berkshire began making big acquisitions of refining giant Phillips 66 (PSX) and has continued to add shares over the past year. Today, Buffett’s company owns 80.7 million shares of Phillips, worth $7.5 billion and representing 15.9% of the company.

Of course, it’s never a good idea to just blindly follow along with any large institutional investor no matter how amazing his or her historical performance has been.

So let’s take a closer look at Phillips 66 so see why Buffett is such a fan, and more importantly, whether or not this industry leader deserves a spot in a diversified dividend growth portfolio.

Business Description

Phillips 66’s roots go back all the way to 1875, though as a company it was spun off from ConocoPhillips in 2012. It’s the nation’s second largest independent refiner with 13 refineries in the U.S. and in Europe. However, Phillips 66 is also a highly diversified petrochemical company with a total of four business segments:

Marketing & Specialties (44% of 2016 segment income): sells refined products through its 7,850 Phillips 66, Conoco, and 76 branded gas stations in the U.S., and 1,306 JET and COOP  stations in Europe.

Chemicals (29% of 2016 segment income): a 50% stake in Chevron Phillips Chemical Company LLC (CPChem), whose 32 global facilities and two R&D centers produce specialty petrochemicals that serve the solvents, catalysts, drilling chemicals, and mining chemicals industries.

Refining (19% of 2016 segment income): refines crude oil into gasoline, diesel, and jet fuel.

Midstream (8% of 2016’s segment income): gathers, processes, transports, and markets natural gas, and transports, fractionates and markets natural gas liquids in the U.S. This segment has a 50% stake in general partnership of DCP Midstream Partners (DCP), and a 59% stake in Phillips 66 Midstream Partners (PSXP), whose infrastructure services parent company’s oil transportation and storage needs.

Business Analysis

Management says that “Phillips 66 is committed to paying a regular dividend that is secure, has a competitive yield and increases annually.”  Now that may come as a surprise since refining is hardly an ideal industry for safe and consistent dividend growth.

That’s because it’s highly capital intensive and very cyclical, with sales, earnings, and cash flow at the mercy of volatile commodity prices.

Source: Simply Safe Dividends

In addition, the high fixed costs of maintaining its assets (about $1 billion in projected 2017 maintenance costs) mean that profitability and returns on shareholder capital are equally volatile.

The industry is also famous for its low margins, and even with Phillips 66’s great economies of scale, which allows for better-than-average profitability, the company is hardly swimming in profits.

Phillips 66 Trailing 12-Month Profitability

Sources: Morningstar, Gururfocus

So what exactly about this company has attracted Buffett’s attention and caused him to take such a large position? Well, despite the challenges of the industry, there is actually a lot to like about Phillips 66.

For one, thing the company’s vast nationwide infrastructure is tapped into all of the U.S.’s largest shale oil formations, resulting in an ability to source discounted crude for its refineries and achieve higher profitability than many of its smaller, more regional peers.

Source: Phillips 66 Investor Presentation

Another benefit Phillips 66 has, courtesy of its significant geographic diversity, is the ability to tap into America’s fast-growing oil and petrochemical export market.

The prolific production growth of U.S. oil over the years, thanks to the shale fracking revolution, has resulted in much lower input costs for U.S. refiners, giving American petrochemical companies a big competitive advantage over rivals in other countries.

This means that cheaper U.S. refined products are finding huge demand overseas, which bodes well for the industry since America’s export capacity is only 66% utilized at the moment.

And because the global economy continues to grow at around 3% to 4% per year, demand for gasoline, diesel, and jet fuel continues to increase, especially from fast-growing emerging markets such as India and China.

Since U.S.-sourced refined products are cheaper, they are steadily winning market share and helping Phillips 66 keep its refining utilization rate high (96% in 2016). That’s in contrast to global refining utilization rates in the low 80% range, which means that large U.S. refiners such as PSX are able to better offset their high fixed costs with steadily rising sales, resulting in far better profitability.

Another positive factor for Phillips 66 is that cheap U.S. natural gas is resulting in an abundance of low cost ethane, a key input into its various chemical products. This too results in strong export demand for low cost U.S. petrochemicals such a propylenes, which are the base constituent into all manner of plastics and other global products.

These increased sales from its far more stable chemical and midstream segments have helped to turn things around for Phillips 66 in recent quarters, with both its top and bottom line returning to strong growth.

Importantly, Phillips 66 is working hard to diversify itself away from more volatile refining and towards higher margin chemical and midstream operations.

For example, since 2014 the company’s single largest investment has been a $6 billion joint venture with Chevron (CVX) to construct a massive new ethane cracker that is slated to be completed by the end of the year.

That cracker will increase PSX’s ethylene and polyethylene capacity by 33%, boosting sales and margins for the company.

Phillips 66 is also investing the majority of its  growth capex budget into midstream projects, such as the $3 billion Sweeny Fractionator One and Freeport LPG Export Terminal in Texas.

The company also partnered with Energy Transfer Partners (ETP) to invest $4.8 billion into two pipelines linking North Dakota’s Bakken shale formation with export terminals on the Gulf Coast.

To help fund all these billions of new assets, Phillips 66 has set up a midstream MLP called Phillips 66 Partners, of which is owns a 59% stake and the lucrative incentive distribution rights (IDRs).

PSX also has a joint venture with Spectra Energy, now owned by Enbridge (ENB), to be the general partners of DCP Midstream Partners, and there too it enjoys a large limited partnership stake and 50% of all IDR fees.

The way it works is that midstream MLPs raise debt and equity capital from investors to buy transportation, storage, and processing infrastructure from their general partners (PSX in this case).

Their infrastructure comes with long-term, fixed-fee, volume insensitive contracts (i.e. take or pay), helping ensure many years of consistent and recurring cash flows.

These are used to fund their generous and fast-growing distributions (a form of tax advantaged dividends).

Phillips 66 Partners Payout Growth Over Time

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Even blue chip dividend stocks can fall on hard times, especially when they operate in highly cyclical industries that depend on volatile commodity prices.

Such was the case with Caterpillar (CAT), which despite an impressive track record of growing its dividend at an average rate of 11% over the past 20 years, was forced to freeze its pay increases for eight consecutive quarters during the worst industry downturn in decades.

However, now it appears as if the worst is over, so let’s take another look at Caterpillar to see how its fundamentals have held up during this most recent industrial recession and if today could be a reasonable time to consider adding the stock to a diversified dividend growth portfolio.

Business Overview

Founded in 1925 in Peoria, Illinois, Caterpillar is the world’s largest industrial machine maker, with its hands in all major infrastructure industries.

The company manufactures and sells construction and mining equipment, diesel and natural gas engines, industrial gas turbines, and diesel-electric locomotives.

A meaningful amount of Caterpillar’s revenue is also tied to higher-margin, less volatile aftermarket parts and components; however, the company does not disclose the size of its aftermarket business.

Source: Caterpillar Investor Presentation

The company operates through four main business segments.

Construction Industries (40% of 2016 sales, 47% of 2016 segment profits): makes backhoes, site prep tractors; excavators; and motor graders, pipelayers, telehandlers, cold planers, asphalt pavers, compactors, road reclaimers, and wheel and track skidders and feller bunchers.

Resource Industries (15% of 2016 sales, -30% of 2016 segment profits): produces electric rope and hydraulic shovel, landfill and soil compactors, dragline, large wheel loader, track and rotary drills, electronics and control systems, work tool, hard rock vehicle and continuous mining systems, scoops and haulers, wheel tractor scrapers, wheel dozers products;continuous miners; and mining, off-highway, and articulated trucks.

Energy & Transportation (37% of 2016 sales, 63% of 2016 segment profits): offers reciprocating engine powered generators set, centrifugal gas compressors, diesel-electric locomotives and components, and other rail-related products and services.

Financial Products (8% of 2016 sales, 20% of 2016 segment profits): primarily offers financing for Caterpillar equipment, machinery, and engines, as well as dealers; property.

In general, Caterpillar makes most of its money from the road construction and heavy construction industries, with about 50% of sales from North America.

Business Analysis

You typically don’t find companies with lengthy dividend growth track records in capital intensive and highly cyclical industries.

That’s because high fixed costs and volatile revenues, which are heavily influenced by global commodity markets, make for extremely unpredictable earnings, cash flows, margins, and returns on capital over time.

Source: Simply Safe Dividends

However, just because an industry is volatile doesn’t mean that select, best-in-breed industry leaders can’t make great dividend growth stocks. That’s because the capital intensive nature of the industry also makes Caterpillar’s moat very wide.

Specifically, the company has numerous competitive advantages that allow it to maintain strong pricing power for those products that are ordered (even if the volume decreases during an industrial recession).

This is because the products Caterpillar manufactures are typically very complex and increasingly high-tech, and the end consumer is most concerned with highly reliable and rugged products (that can operate in extreme climates where temperatures vary from -40F to 120F) from a brand they know and trust.

The company’s large global distributor network (Caterpillar sells its products to dealers who sell them to end users across different markets) is also a major competitive advantage.

Caterpillar’s network consists of about 150,000 global independent contractors who have strong local relationships with end users. To put this in perspective, Caterpillar’s largest rival, Japan’s Komatsu, is about half the size.

Why is a large dealer network so important for Caterpillar in the heavy equipment market?

A machine that breaks can stop an entire job – restarting work in a few hours compared to a few days can make or break a project’s financial and operational objectives.

Therefore, large dealers with plenty of parts and technicians are a big selling point influencing a customer’s purchase decision – a rapid response rate to machine breakdowns is essential.

Efficient dealer networks also enable more aftermarket business for Caterpillar, which helps the company survive during trough years as it continuously expands its base of machines that require servicing.

With machines lasting for decades in many instances, partnering with a financially healthy and proven dealer is just as important. Local dealers are also more knowledge about their communities and customers’ needs than a giant like Caterpillar could ever be.

As such, they are more effective at selling locally and provide a better customer experience. Lower-priced Asian competitors lack a global dealer support network and, therefore, struggle to take share from Caterpillar.

Overall, the company’s large dealer network is a critical advantage that helps Caterpillar more easily win new orders, resupply old sales, and maintain global market share.

Even during long industry downturns, including the slump from 2013 to 2016 when global commodities crashed (which hurt miners and energy producers), Caterpillar’s giant scale and access to vast resources allowed it to not only survive but make vital changes that ensure its long-term market dominance will continue.

For example, Caterpillar has undergone major restructuring in the past four years that includes vast cost cutting, non-core asset sales, and maximizing low cost global sourcing for inputs, while actually improving the quality and reliability of its products.

While those restructuring costs have resulted in substantial decreases in reported earnings, the company’s free cash flow has risen nicely to $4.3 billion, good for a healthy double-digit margin.

Caterpillar Trailing 12-Month Profitability

Sources: Morningstar, Gurufocus

And that’s after spending $2 billion in 2016 on R&D, including cutting edge Internet of Things (IoT) and automation integration into its products that will help its customers achieve greater cost efficiency in the future.

In other words, while Caterpillar has spent the industry downturn cutting costs to the bone, it’s also been planning for the future by focusing on improving quality and making its machines’ capabilities aligned with the market’s emerging trends.

Better yet, because Caterpillar is an industry leader in automated mining technology, the company is appears to be well positioned to maintain and gain market share in an industry where maximizing productivity and thus lowering production costs per ton is the primary concern.

Meanwhile, Caterpillar’s integration into the Internet of Things, via fast developing 5G technology, will allow end users to maximize the utility of their machines and thus reduce cost overruns to help maximize profits.

Caterpillar has more than 3 million machines in the field, most packed with sensors and diagnostic technology throwing off data that is used to gauge the health of its equipment.

Advancements in data collection and availability, coupled with improving data analytics capabilities, have made machine information increasingly valuable to solve real customer problems.

For example, what if Caterpillar’s dealers could better identify a repair need before a customer’s machine actually fails, scheduling preventative maintenance and improving the efficiency of customers’ fleets?

Accessing and intelligently using more real-time machine data can ensure that customers make more money using Caterpillar’s equipment than competitors’ gear over the equipment’s lifetime, factoring in initial purchase price, uptime, life expectancy, maintenance costs, operating costs, and resale value.

Maintenance and uptime are critical value propositions in the large equipment market, and data analytics investments should help Caterpillar deliver even better on these metrics – by becoming smarter about internal operations, dealers can services dozens more customers per day.

With faster, more relevant service, Caterpillar’s equipment and brand value will likely increase in customers’ eyes, supporting the premium pricing its brand enjoys.

Simply put, technology has the potential to transform the supplier/customer relationship over the next 5 to 10 years, and Caterpillar is investing to take advantage of this emerging opportunity.

Best of all, Caterpillar is set to benefit in the coming decades from growth in infrastructure needs as the world’s population increases and the world urbanizes, requiring trillions of dollars in new infrastructure and construction spending.

 

In addition, because so much of this population growth will be in fast-developing emerging markets, energy use, including from traditional fossil fuels, is still expected to grow strongly despite the rise of renewable alternatives, supporting demand for much of Caterpillar’s product portfolio.

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