Overvalued New Dividend Aristocrat

By Chad Henage - August 14, 2012 | Tickers: GS, SEIC, STT, BK | 0 Comments

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When new dividend aristocrats are named, my first step is, to examine the company to determine if this is the beginning of a longer streak of dividend increases, or if the company represents the next dividend blowup. Looking at the business that SEI Investments (NASDAQ: SEIC) operates in, at first I was worried that this company would show a high payout ratio and challenging business fundamentals. However, I can say I was positively surprised at both the company's free cash flow and potential for growth. What I was not so happy about was the company's relative valuation to its peers.

SEI Investments operates in a highly competitive field of investment management, offering mutual funds and investment advice. Their competitors are much bigger companies that are much more well-known. However, some of these companies are more well known for all the wrong reasons. Investment managers have been under attack in the last several years, due to issues on Wall Street and Main Street. As a smaller company, SEI can comfortably stay out of the limelight and continue to conduct business in the way they always have. Before we get to how much investors can expect from this new dividend aristocrat, let's see how SEI compares to some of the larger competition.

One of my big problems with the SEI story is that the stock sells for a much higher multiple than any of their competitors. I also noticed that the company's dividend yield is the smallest of the four companies. The natural question that comes to mind is, why should investors choose SEI? Truthfully, investors shouldn't at current prices. We will get to some of the reasons in just a minute. Of the company's three competitors, Goldman Sachs arguably has the best name recognition. While Goldman does have some negative connotations connected to it from Wall Street issues during the Great Recession, it's hard to ignore the company's cheap P/E ratio relative to its higher growth rate. Where State Street is concerned, this company benefits primarily when the equity markets do better. While the company doesn't offer the same value as Goldman Sachs on a relative basis, State Street's yield and free cash flow payout ratio argue that this could be a better income producing investment. The Bank of New York Mellon sits somewhere in between, as it's neither as cheap as Goldman, and though the yield is similar, the company pays out a much higher percentage of their free cash flow compared to State Street. SEI, with a free cash flow payout ratio of just 22.25%, shows the company has room for further dividend increases. In addition, the payout ratio is close to what the company has paid out in the last three years. With the current dividend apparently safe, this allows us to turn our attention to potential dividend growth.

In the last several years, SEI has increased its dividend by a significant amount on average. Taking a look at a graph of these dividend increases gives you an idea of the type of dividend growth investors have experienced:

In the past six years, the average increase has been just under 17%. In addition, in the most recent three years, dividend growth has jumped to an average of over 21%. While initially this looks like a positive sign for investors in the future, analyst expectations and the company's performance argue against continued higher increases.

In the last three years, free cash flow growth has trailed net income growth. If this trend continues, analyst expectations of nearly 11% EPS growth will not likely turn into 11% growth in free cash flow. With this as a backdrop, though the companies free cash flow payout ratio is only 22%, longer-term free cash flow growth will determine dividend growth. Over the next few years, the dividend may grow at a rate north of 20%, but unless the company's cash flow generation rate speeds up, longer-term this growth rate is likely to fall below 10%. The fact  that multiple competitors have significantly cheaper stocks with better growth expectations is a reason to avoid the shares at current prices. Their competition paying higher yields is yet another negative. Even if you assume that SEI's competition is undervalued, this doesn't leave a lot of room for the argument that the company's stock should do tremendously well. At this point, I would recommend investors avoid the shares unless there's a pullback in the market that brings the company's valuation closer to their peers.

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