Income Now, Income Later, Part 2

Robert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

In the first part of this two part series, I reviewed three companies that a current retiree might use as sources of immediate income.  If you have some time before retirement, there are alternative investments that, in the long run, could provide more income than companies currently paying higher initial yields.  The key metric: dividend growth.

Consider Exelon (NYSE: EXC), a utility company currently paying a 7% dividend.  We’ll ignore the current payout ratio of 112% for the moment and look instead at its dividend growth rate of zero over the past five years ($2.03 in 2008, $2.12 in 2009-2011, $1.97 in 2012).  If its dividend growth rate stayed zero for the next 15 years, and the dividends reinvested, a $1000 investment today would yield $193 a year.  If you invested that money instead in Enterprise Products Partners (NYSE: EPD), with a lower initial yield of 5.2%, but a higher dividend growth rate of 5.4%, in 15 years a $1000 investment will yield $348 a year.  

Exelon illustrates another important consideration in a long term income investment: sustainability of dividend payout and dividend growth.  While Enterprise has been steadily paying an increasing dividend for years, Exelon hasn’t.  Given an earnings projection of a 2% decline, the dividend may not increase in 2013.  If anything, it will likely decline again.  Clearly, one would look elsewhere than Exelon for retirement income.

So what should you invest in?

Perhaps one big granddaddy of blue chip stocks with steadily rising dividends is ExxonMobil (NYSE: XOM).  This integrated petrochemical powerhouse pays a modest 2.6% dividend and has a five year dividend growth rate of 7.7%.  Assuming continued dividend growth and re-invested dividends for 15 years, Exxon will pay $155 a year for every $1000 invested today.  What I like about Exxon is its low payout ratio and financial strength.  The payout ratio comes in at the low 20’s%.  This gives Exxon flexibility to raise dividends even in the face of declining earnings.  For example, in 2009, earnings went from $8.64 to $4.36 per share.  The dividend?  Rose from $1.55 to $1.66 per share, a 7% gain.  Standard and Poor’s gives Exxon a AAA credit rating and a A+ quality rating.  No surprise, the company has $13 billion in cash and generates an average free cash flow of around $5 billion each fiscal quarter.  Current debt to equity comes in at 0.07.  Bringing this cash home is a return on equity of 26.6%.  Continuing to bring the cash home are over 120 upstream exploration projects, including a joint venture with the Russians to explore the Bazhenov oil shale in western Siberia.

Another favorite dividend stock is Clorox (NYSE: CLX).  Its core business is consumer products and food, hardly electrifying enterprises.  Its dividend and particularly its dividend growth rate should light you up.  Specifically, Clorox pays 3.5% dividend and has increased its dividend by 11.44% on average over the past five years.  Which means $1000 invested today, with the usual assumptions, will yield $549 a year 15 years from now.  While earnings have seesawed over the past few years, the company’s launch of its Centennial Strategy, with its focus on improving financial performance, should bolster corporate earnings.  Two notes of concern.  First, corporate debt to capital, while reduced over the past year, remains high.  Second, the payout ratio is 59%, great for shareholders sharing in the company’s profits, but giving Clorox less leeway in raising its dividend in a down year.

Lastly, and perhaps most appetizing, comes McDonald’s (NYSE: MCD).   While the current dividend yield comes in at 3.5% like Clorox, and has a payout ratio of 53% similar to Clorox, McDonald’s dividend growth rate beats Clorox at 15.6%.  So what’s in it for you over the long haul?  $1000 now, reinvested, will yield $1348 in 15 years.  Can McDonald’s pull off a sustained dividend growth rate like that?  The Affordable Care Act will likely hurt margins.  However, as fellow Motley Fool blogger Matt DiLallo points out, margins are already high, with operating margins coming in at 80% at franchised stores.  With 90% of its stores franchised and many of the buildings owned by McDonald’s, the impact of Obamacare may not be as dire as some might think.  Further, growth in China has years to go before market penetration approaches that of the United States.  So, in a word, yes, McDonald’s could very well sustain its current five year dividend growth rate.

Final Foolish Thoughts

As a rule, diversity protects investment portfolios.  So if you invested $1000 each in Exxon, Clorox and McDonald’s, in 15 years your annual dividend income would be about $648, or effectively, 23%.  As always, past performance does not guarantee future results.  However, investing in financially strong companies will likely provide income in your retirement years.  Start investing early, reinvest the dividends and and pick a firm with a strong dividend growth track record.  It may not be as fun as watching an IPO triple in price, but then again, a secure income stream lets you sleep at night. 

dylan588 owns McDonald's Corporation. The Motley Fool recommends Enterprise Products Partners L.P., Exelon Corp, and McDonald's Corp. The Motley Fool owns shares of ExxonMobil Corp, McDonald's Corp, and The Clorox Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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