Boring Business = Dangerous Dividend

By Chad Henage - July 10, 2012 | Tickers: GPC, JCI, LEG | 0 Comments

• Email
• Print

On the surface a company like Leggett & Platt (NYSE: LEG) should be perfect. The company operates in the boring business of springs, suspensions, shelving, garment racks, and many other sleeper industries. This is exactly the type of business that I imagine Peter Lynch would like. A boring business that is expected to grow, and a dividend aristocrat to boot. There are a few numbers to this company though that I think would make Lynch stay away. Let me show you what I've found, and why I'm skeptical of the company's ability to continue their dividend streak.

First and foremost, I'll tell you that I do expect the economy to continue its slow and steady recovery. I'm not one of these investors scared of the “next recession” because honestly this seems like trying to predict the future by looking in the rear-view mirror. With that as a backdrop, why am I so cautious about Leggett & Platt? To be blunt, the company's performance since the official end of the Great Recession has been downright scary. Look at how the company compares in a few areas versus two of their direct competitors:

One of the most important measures of a company's value creation is operating cash flow growth. A company's operating cash flow is usually what pays for capital expenditures, and thus for dividends, share buybacks, and expansion. With Leggett & Platt showing the worst measure of operating cash flow growth over the same time frame, investors should worry about what the company will be able to generate in the future. Of the three companies, only Johnson Controls showed growth in this category, but even Genuine Parts didn't show the amount of decrease that Leggett & Platt did.

It's true that Genuine Parts is more of a pure play on auto repair and Johnson Controls is involved in building systems and batteries as well as auto systems. The bottom line is Leggett & Platt is a diversified manufacturer and they underperformed two of their competitors by a wide margin in the last three years. In addition, the company has the highest level of relative debt compared to the other two companies. On just the above measures, it seems like Johnson Controls would be a better bet. That being said, Johnson Controls isn't a dividend aristocrat, so let's see what's going on with Leggett & Platt's dividend to see if this makes up for some of the above shortcomings.

Before we get to dividend growth, we need to know if the company can afford to pay their current dividend. This measure is one issue that I have with Leggett & Platt continuing their dividend streak. Over the last three years, the company's free cash flow payout ratio has increased from just over 32% to over 61% today. If this increase were primarily due to dividend increases, I would suggest the company slow the dividend growth. However most of this increase is directly related to the above mentioned decrease in operating cash flow. While a 61% payout ratio isn't trouble yet, the direction of this payout ratio is a problem. If the payout ratio increases much more, investors could call into question the company's ability to increase the dividend, or even worse the sustainability of the dividend itself. You would expect with a much higher payout ratio that dividend increases have slowed down. Aside from one outlier, that's exactly what's been happening.

In fact, I'm not really sure what the company was thinking in 2008 when the dividend was increased by over 38%. For six years from 2002 to 2007, the company's average increase was about 7%. Following this huge increase in 2008, the average dividend increase has been 4% or less. Clearly the higher payout ratio has hurt the company's ability to increase the dividend in the way they did before 2008. So what should investors expect in the future?

To be honest, until Leggett & Platt establishes a record of increasing operating free cash flow, I would suggest staying away from the shares. For the years 2009 to 2011, the company's net income increased 36%, while operating cash flow fell by over 41%. Even with analysts expecting 15% net income growth, this doesn't give me any confidence that this net income growth will generate significant free cash flow growth. In my estimation, if the company meets this 15% net income growth, operating cash flow might only grow by 5-7%. If that is the case, and the company wants to bring the payout ratio down, recent increases of less than 4% could be the norm. At nearly 16 times forward earnings and with 15% expected EPS growth, the stock would normally look like a good deal. As you can see from what we've found, these numbers don't begin to tell the story of what's really going on. This is a nice boring business that should benefit from an economic recovery, but recent developments make me believe the dividend could be in danger.

• Email
• Print
• Feedback