Dividend Increases Aren't Enough For This Company

By Chad Henage - July 5, 2012 | Tickers: MHFI, MORN, PSO, TRI | 0 Comments

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There might not be a more recognized name in the stock market than S&P. In fact, many thousands of mutual funds rate their performance based on the S&P 500. In addition, S&P ratings can either increase or decrease the borrowing costs of many companies by millions or even billions of dollars. The power of this brand is wielded by The McGraw-Hill Companies (NYSE: MHFI). I only mention the S&P division first, because when most people see McGraw-Hill they think what I first thought, which was textbooks. The other main claim to fame that McGraw-Hill has is over 25 straight years of dividend increases. If we have learned anything over the last few years, it's that dividend streaks are not set in stone. So there are two questions that naturally need to be answered. First, can the company afford their current dividend, and what type of dividend growth should investors expect in the future?

To understand if McGraw-Hill can afford their current dividend, we first need to understand a little bit of the competition that the company faces. On the textbook and education side of the business, one of the main competitors is Pearson (NYSE: PSO). When it comes to research and financial data, two of their bigger competitors are Morningstar (NASDAQ: MORN) and Thompson Reuters (NYSE: TRI). If you look at the news reported on many stocks you'll see S&P, Morningstar or Reuters listed as the source. To see how McGraw-Hill is positioned, let's see how the company stacks up to this competition:

You can see that McGraw-Hill has the best combination of free cash flow, dividend, and growth. While Morningstar has both better growth and better free cash flow, this stock sells for a much higher P/E ratio and a lower yield. It appears that McGraw-Hill is fairly valued based on a decent dividend, good free cash flow, and a reasonable P/E ratio. The next question about any dividend aristocrat is, can the company afford its current payout?

On this score, McGraw-Hill has its dividend well covered. Over the last three years, the company's free cash flow payout ratio has ranged from 23-25%. As a well established business, the company's capital expenditures don't change very much year to year. In addition, because of the type of business is not capital intensive, the company has only been spending $90 million to $120 million, versus over $1 billion in operating cash flow. With this low of a payout ratio, the company's dividend is very well covered. How about dividend growth?

While dividend growth has slowed down in the last several years, there doesn't seem to be a great reason why. You can see this slowdown over the last eleven years:

In a way it's strange to see this slowdown, looking at the last five years, the company only has increased its dividend by about 4.5% on average. In the prior four years, the company's dividend growth was never less than 10%. With a payout ratio of just 25%, there doesn't seem to be a great reason for this slowdown. So what should investors expect in the future?

Analysts are expecting EPS growth of nearly 12% in the next few years. Since free cash flow growth has trailed net income growth, normally I would suggest that growth in the dividend of 10-12% would make sense. However, my concern is the expectation for earnings growth, versus the company's willingness to raise the dividend. For 2012, the company is expected to grow EPS by 14%, yet the dividend increase for this year was only 2%. Given that the company only paid out 25% of their free cash flow last year, one would expect a greater increase. I would suggest that dividend growth of 6-8% seems more than reasonable in the next few years. This rate of increase would still leave the company's free cash flow payout ratio very low, and yet would improve on the company's dividend growth of the last few years. As long as McGraw-Hill continues to issue such low dividend growth, I would suggest investors consider Thompson-Reuters as an alternative. Since the company pays a dividend that is significantly higher, and the valuations are the same, this seems like a better buy.

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