High Dividend Yield Stocks with High Free Cash Flow Yields

Published Tue, 06 Aug 2013 12:15 CET by DividendYields.org

Free cash flow represents cash from operations available to shareholders after capital expenditures have been subtracted. This measure of a company's profitability has been referred to as owner earnings. In fact, free cash flow is a more precise measure of a company's operating success than earnings (net income), given that standard earnings may be distorted through the use of accruals, depreciation, and by capitalizing expenditures. In this sense, a free cash flow yield, representing a company's free cash flow per share divided by its stock price per share, may be viewed as a fundamental indicator of the company's valuation. Asset manager Manning & Napier says that “as free cash flow yield is a measure of price relative to a fundamental indication of value, it may help identify attractive companies for investment”. In fact, research suggests that, over the long term, companies with the highest free cash flow yields have historically outperformed their peers with lower yields and the large-cap market indices. Manning & Napier's study (read more about it here) finds an even more appealing investment combination: pairing high free cash flow yields and high dividend yields. The asset manager concludes: “Alone, dividend yield and free cash flow yield have each shown to be effective factors when screening for attractive long-term investments. High free cash flow yield tends to identify companies that have experienced higher rates of total return, while dividend yield has identified companies with higher levels of downside protection and income generation. However, the data demonstrates that, when paired together, these factors have achieved results beyond what either factor has achieved alone”. The chart below illustrates the investment performance of this potent combination.

Free Cash Flow Yield and Dividend Yield Quartiles Graph
Based on a quick screen of stocks boasting high free cash flow yields and high dividend yields, below is a quick glance at three stocks with the noted combination. The following table features their main profiles and dividend characteristics.

Dividend Stocks with High Free Cash Flow Yields
Among the three featured stocks, both Seagate Technology (NYSE: STX) and Ennis Inc. (NYSE: EBF) pay the highest dividend yields. They have also realized the highest total return since the beginning of the year. However, Domtar (NYSE: UFS) has the highest levered free cash flow yield, based on the trailing-twelve-months data provided by Yahoo! Finance. Its free cash flow yield is 19.3%. Ennis Inc.'s levered free cash flow yield is the second highest at 11.5%, followed by Seagate Technology's free cash flow yield of 10.5%. Both Seagate and Domtar Corporation have been very generous with their capital allocation policy, implementing significant dividend increases over the past 12 months. What's more, Seagate has much more room to boost dividends in the future.

Ennis Inc. is a global producer of printed business products and apparel – in fact, it is “one of the largest wholesale manufacturers of these products in the world”. The company is an avid dividend payer, boasting some 20 years of consecutive dividend payments. While Ennis Inc.'s strong financial position has enabled it to pay dividends for such a long period of time, its earnings have been under pressure from elevated cotton prices, which have adversely affected Ennis's apparel business. While the company's total revenues have increased, margins have declined. However, the outlook is improving, as lower priced cotton is helping boost margins. The company has been reducing debt, and its ratio of long-term debt to equity now stands at only 12%.

Domtar is the largest integrated manufacturer and marketer of uncoated freesheet paper in North America and the third largest in the world. It derives 80% of its revenues from the pulp and paper sales, while some 88% of its total revenues comes from North America. The company has been paying a regular quarterly cash dividend since the second quarter of 2010. Since 2010, the company has increased its dividend 120% and has repurchased 22% of its shares outstanding. Moreover, Domtar has achieved a total return to shareholders as a percentage of free cash flow of 78% since inception. The company's objective is “to return a majority of free cash flow to shareholders” in the forms of dividends and share repurchases. Domtar, like other paper producers, is seeing stronger paper pricing trends; however, its operational performance has been stifled by operational issues/planned outages that have reduced productivity. Nevertheless, the company is optimistic about its outlook, suggesting that the pulp segment will benefit from lower planned maintenance costs, higher productivity and higher sales volumes. Moreover, higher productivity should boost paper earnings. Domtar stock is trading at a 20% discount to its book value.

Seagate Technology is one of the two dominant market players in the global hard disc drive (HDD) market. The company has increased its quarterly dividend twice in the past twelve months. It is committed to increasing shareholder value by allocating at least 70% of its operating cash flow to dividends and stock buybacks. Still, the company has faced strains on its financial performance resulting from a secular decline in PC sales. As a result, IHS iSuppli projects that PC HDD shipments will fall 8% in 2013 to 436.9 million units. From 2012 to 2017, the PC HDD shipments will be falling at a CAGR of -2.9%. To offset the losses in the PC HDD segment, Seagate is diversifying its product offering, tapping into the lucrative and a fast-growing market for tablets. Strong enterprise demand and cloud computing trends have also been a boon for Seagate. Some view this stock as a value play.

In conclusion, dividend investing focused on fundamentally-sound, high-yielding stocks with high free cash flow yields may be an alternative investment approach to boost returns. However, it requires significant due diligence to identify appropriate stocks with a high dividend yield and high free cash flow yield pairing that can achieve above-average returns. The three stocks above are featured as stocks that exhibit the characteristics of high dividend and high free cash flow yields, serving as a basis for further research about the investment strategy described by asset manager Manning & Napier.