A New Dividend Growth Stock

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

Dividend growth investing is a slow and steady process taking place over a long period of time. The goal is to grow a stream of dividend income by buying stocks which not only pay a reasonable dividend today but are expected to raise that dividend consistently in the future. By reinvesting these dividends the income stream grows even faster. The Ultimate Dividend Growth Portfolio, which you can track here, is only a few months old but has now received its first serious dividend payments. I'll use these proceeds to open a new position and increase the dividend stream even further.

But before I talk about the new position, two of the existing positions in the portfolio recently announced earnings.

Good and bad for the cereal king

General Mills (NYSE: GIS), maker of popular cereals like Cheerios, as well as Progresso soup and other packaged foods, announced its Q4 earnings on June 26. The company beat analyst expectations for the quarter, with EPS rising to $0.55 from $0.49 a year earlier and revenue growing by 8.5% year-over year. The U.S. segment grew by 2%, while the international segment grew by 27% due to a few acquisitions.

What worried analysts and investors was the company's guidance. General Mills forecast sales for fiscal 2014 to grow at a low-single-digit rate and exceed $18 billion, compared to analyst expectations of $18.40 billion in sales. EPS was forecast to be between $2.87 and $2.90 in fiscal 2014, below the $2.93 analysts were expecting. The CEO had this to say:

The economic recovery continues to be very slow and we think the consumer is still quite cautious. And it's very competitive out there. It (the forecast) may be a little prudent for some, but we think that's probably appropriate given the economic conditions.

In terms of the dividend this earnings report doesn't change much. The company has already declared that its next dividend payment, which goes ex-div on July 8, will increase by 15% over the last payment. This puts the projected dividend yield at 3.13%

The payout ratio with respect to 2014 expected earnings is about 50%, which is nothing to worry about and may indicate that the company can afford to boost the dividend by a similar amount next year. I think you can count on at least high-single-digit or low-double-digit dividend growth in the near future from General Mills. And as the economy improves the company may very well beat its estimates for next year, possibly leading to a bigger dividend bump.

Less traffic, lower stock price

Walgreen (NYSE: WAG) is one of the lowest yielding stocks in the portfolio, balanced by its exceptional dividend growth prospects. Walgreen missed analyst estimates on all fronts when it announced its quarterly earnings on June 25, leading the stock to fall off a cliff. The stock is down about 13% from its recent high, with much of that decline due to the earnings miss.

Walgreen increased both revenue and earnings, with revenue rising by 3.4% compared to last quarter and 1.4% year-over-year, and EPS (adjusted for items) rising by a solid 18%. The company filled a total of 209 million prescriptions in the quarter, up 8.7% from last year. While same-store sales rose by 0.4%, customer traffic decreased by 3.9%, a point of worry for investors.

Analysts expected both higher revenue and higher earnings, but it seems to me that the sell off is quite a bit overdone. Even in a weak economy the company grew both revenue, albeit slowly, and earnings, and it may be that expectations were set a bit too high.

The dividend has now gone four payments without an increase, so I think that we can expect one to be announced in August. With a yield of only 2.5%, dividend growth needs to be robust to justify Walgreen's position in the portfolio, so I'll be looking for a mid-teens percent increase. The nice thing about Walgreen is that the payout ratio is so low that the dividend has plenty of room to expand. Just about a third of the free cash flow is used for the dividend, so even slow earnings growth can lead to substantial dividend increases.

A new position

The Ultimate Dividend Growth Portfolio received about $600 in dividend payments in the month of June, and I've used those proceeds to open a new position in Pfizer (NYSE: PFE). I recently wrote about Pfizer in an article entitled Big Things Are Happening At This Pharmaceutical Company, and my reason for adding Pfizer is two-fold.

Like many companies, Pfizer was forced to cut its dividend in 2009 due to the financial crisis. The dividend is still well below its peak even though the company is more profitable than it was five years ago, leading to a low payout ratio. In 2012 the dividend only accounted for about 42% of the free cash flow, leaving plenty of room for growth. The current yield is high at 3.42%, meaning that dividend growth can be in the mid-to-high single digits and still be sufficient.

The second reason I'm adding Pfizer is the company's renewed focus on its core business. Pfizer sold its infant nutrition business to Nestle last year and spun off its animal health business, Zoetis, in February. Cash generated from these deals are being used for aggressive share buybacks, which have the effect of lowering the payout ratio even further.

With cash from these deals in addition to a robust free cash flow Pfizer can drive the dividend higher while keeping the payout ratio in check through buybacks. Earnings growth can, and likely will, be slow, but I still expect the dividend to grow in the high-single-digits going forward. The last increase was about 9%, and I expect that type of increase to be the norm.

I'll add 21 shares of Pfizer to the portfolio. This is by far the smallest position, but I hope to add to it as more dividend payments come rolling in. The portfolio now has a yield on cost of 3.41%, and its value has increased by 5.37% since inception. Pfizer makes a great addition to the portfolio, and I expect to see exceptional dividend growth going forward.

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Timothy Green has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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