Not All Dividends Are Created Equal
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
It's interesting when people notice a trend, but then immediately assume that there is some sort of problem. I recently saw this in an article by Morgan Housel of The Motley Fool. While generally I like Morgan's writing, this article seems to draw a conclusion that might not be there. In summary, he suggested that because certain companies have seen an increase in stock price, that their dividend might be “dangerous.” There are two problems with this thinking. First, it assumes that the stock was not undervalued to begin with. Second, this assumes an increase in the stock price means that the lower dividend makes the company less attractive. However, each of the companies in question regularly raises its dividend. These lower dividend yields are not set amounts that don't change. This pokes a hole in the "less attractive future returns" theory. Let me walk you through the few examples he gave, and explain which ones I think are a problem, and which ones don't appear to be so.
The first company he picked on is Consolidated Edison (NYSE: ED). His primary comment about this company was, the dividend yield is the lowest it has been in 14 years. While I agree that the lower yield represents a challenge for investors going forward, I'm not sure that this is necessarily a “problem.” In fact, in a prior post I looked at consolidated Edison's dividend history. I came to the conclusion that while the stock won't win an award for the best dividend, it appears sustainable and the company should be able to continue increasing the dividend each year.
The second company Morgan mentioned was Southern Company (NYSE: SO). Ironically, I've also examined Southern Company in a prior post, and Morgan's comment about the dividend yield being near the lowest on record, is not the biggest problem surprisingly. The biggest problem is on an ongoing basis, the company spends more on dividends than it brings in free cash flow. In fact, in the first quarter alone, the company's operating cash flow was about $568 million versus over $1.2 billion in capital expenditures. When your free cash flow is negative by multiple millions of dollars, it does not bode well for future dividend payments. This one could be a problem in more than one way for investors.
Verizon (NYSE: VZ) is next on the list, and Morgan suggested that the stock's increase of 80% in the last two years was an issue, as it makes the current dividend less attractive. This is one that honestly Morgan and I have to disagree on. Verizon operates one of the largest wireless carriers, and the companies new Share Anything plans actually seem like a decent deal. In addition, Verizon's yield is currently about 4.5%, looking back at the stock several years ago, it was not unusual to find the stock yielding around 4%. Only during the time of 2008 to 2009 did the stock decrease enough to drive the yield up to the 6% to 7% range. In addition, the huge growth in smartphone, tablet, and other device usage is driving future earnings growth at the company. With analysts expecting growth of over 11% in EPS, this stock just doesn't look too dangerous to me.
Another company Morgan took issue with was Altria (NYSE: MO), and in this case I have to agree. The company faces significant legal risks in the future, and while it generates a tremendous amount of free cash flow, most of this free cash flow is already being used on the current dividend. Just to make the point, last year the company brought in about $3.5 billion in free cash flow, and then paid out about $3.2 billion in dividend payments. With such a slim difference between the two categories, it appears that the company will reach a point soon where dividend increases will no longer be possible. With net income and operating cash flow growth both basically flat in the last three years, the companies 4.6% yield does not look particularly attractive.
A completely different story, is Phillip Morris international (NYSE: PM). I've actually profiled this company before, and the difference between this company and Altria is readily apparent. The two big differences between the two companies, are their free cash flow payout ratios and their future expected growth. When you consider that the free cash flow payout ratio for Phillip Morris International has dropped from about 60% down to less than 50% in the last three years, you can see there's plenty of room for the company to continue increasing its dividend. By comparison, in the last three years Altria's payout ratio has been over 90% in the same timeframe. In the last few years, Philip Morris International has been increasing its dividend by over 9% per year. Analysts are calling for earnings growth of well over 10%, and the company committed to repurchasing over $4 billion worth of shares during 2012. If this company is a “dangerous” company, then this is the type of danger I want.
As you can see, picking out companies that have increased in value does not necessarily mean that they represent a problem, or that their dividends are not attractive. Morgan even went as far as admitting this fact, when he said that if you reinvested dividends and share prices fell, you would buy more shares at cheaper prices. This speaks to the effective yield of each company. For those who don't know, effective yield simply means your yield is not the same as what you see quoted today. As you own the stock longer, reinvest dividends, and the company increases the payout, your “effective yield” is different than the dividend yield of someone buying the stock today. Warren Buffett has been such a great investor in part because he understands this concept. Selling shares might allow you to capture a capital gain on the increase in share price. However, there's no guarantee that by the time you can buy the shares again, your effective yield will be the same. Buying and holding great companies, while reinvesting dividends is a great way to build wealth over time. As long as the company doesn't have financial problems, trying to buy and sell as prices increase or decrease doesn't seem like a good strategy to me.
MHenage owns shares of Verizon Communications. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Philip Morris International and Southern 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.If you have questions about this post or the Fool’s blog network, click here for information.