Can Anything Save This Yield?

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

It should be no secret that I love stocks that pay a good dividend. In fact, over the last year or so I've shifted most of my personal portfolio into what I would call growth and income stocks. This isn't because I'm afraid of the economy melting down, or because I don't have enough guts to stick with a stock that pays no yield. Instead, I've chosen to go with dividend payers because they offer an attractive combination of traits. Many of these companies pay yields that are much higher than investors can get with fixed income, and several are expected to grow their earnings by double-digits over the next few years. With dividend reinvestment, I hope to beat the market averages. There is one company I've had my eye on for over a year, and yet I can't bring myself to buy despite its huge yield, that is Pitney Bowes (NYSE: PBI).

The problem with Pitney Bowes business should be no secret, the company makes a lot of money on selling services and equipment that help individuals and businesses with their postage needs. The issue is, “snail mail” as it has been dubbed is slowly but surely fading. Between the advent of online banking, direct deposit, check cards, digital versions of books, movies, games, and music, there isn't as much to be shipped as there once was. This same issue is hitting two other companies that compete with Pitney Bowes for document management solutions. If you are looking for two more troublesome stocks, how about Xerox (NYSE: XRX) and Hewlett-Packard (NYSE: HPQ). Both of these companies offer printing and document solutions, as well as software solutions that compete directly with Pitney Bowes' enterprise businesses. The problem across the board is the move to digital documents is vast and if you sell something that relies on paper, you immediately have a problem.

There are some who have openly questioned if Pitney Bowes and its competitors are going the way of the buggy whip. On the opposite side of the coin, there are investors that see a 13.8% yield and can't stay away. Someone is right and someone is wrong, but which group wins in the end? I'm not ashamed to say that I've written positively about Pitney Bowes in the past, and seriously considered buying shares. When I wrote about the company in July, I noted that Pitney Bowes was targeting different enterprise businesses like database management, printing solutions, and software to try and combat the slowdown in their postage business. In addition, at the time the company was targeting $700 million to $800 million in free cash flow and today this target has been raised to $750 million to $850 million. So why have I had a change of heart?

To be honest, the company's last earnings report was horrific and I can't get past the massive drop in profits at nearly every division and sub-division. In fact, if you look at their financials, nearly every division saw a year-over-year decline in revenue. If this were a one-time issue I could look past it, but this was the fourth consecutive quarter of declining revenue. The fact that these declines come on the back of multiple years of declines in revenue, makes me wonder when does the drop in revenue subside? What's worse if that's possible, is Pitney Bowes is trying to move towards more enterprise offerings and things could go from bad to worse.

Just to make the point, CFO Michael Monahan said the company's changing, “...mix of business continues to shift toward more enterprise-related revenues..., we anticipate these new revenue streams will have lower margins.” While it's true that the company is also cutting costs further to meet this change, lower margins are something Pitney Bowes really can't afford. Consider this, three years ago Pitney Bowes' gross margin was 50.84%, last year 50.44%, two quarters ago 50.04%, and in the current quarter the margin dropped to 49.27%. Compare these margins to competitors Xerox at 30.98% and Hewlett-Packard at 23.08% and you can see, if Pitney Bowes margin dropped to anything close to these companies, free cash flow and earnings would nosedive.

Speaking of cash flow, Pitney Bowes has high hopes for its free cash flow in the future. However, recent results seem to argue that investors could be disappointed. If you look at how much free cash flow the company generates for each dollar of sales, Pitney Bowes generated about $0.11 in the last quarter. By comparison, Xerox produced about $0.09 of free cash flow, and Hewlett-Packard generated about $0.07 of free cash flow for each dollar of sales. Again, if Pitney Bowes enterprise offerings are lower margin, it makes sense that free cash flow generation could drop as well. In my last article about the company, I expected their free cash flow payout ratio to stay below 50%. In the current quarter, this ratio came in at 77.29%. If margins take a hit, and free cash flow drops, this situation could get very ugly, very fast.

The bottom line is, Pitney Bowes has a huge dividend and if they are able to manufacture a turnaround, investors could be greatly rewarded. However, multiple years of revenue declines and the movement toward less paper and less physical mail argues that this turnaround will be very difficult. Since about half of Pitney Bowes's revenue and the majority of their profit comes from mail processing, only turnaround in mail processing would change the fortunes of this company. Since analysts are calling for negative EPS growth, it sounds like they are not convinced that the company can make real growth happen at least in the short-term. I like the dividend yield a lot, and the stock sells for just 5.6 times next year's projected earnings, but if the future is anything like the current quarter, investors need to watch out below.

MHenage has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. 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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