Published Wed, 02 Oct 2013 12:30 CET by DividendYields.orgCorporate balance sheets are flush with cash, as the share of cash holdings in total corporate assets sits at record-high levels. This is prompting shareholders to demand from companies a more shareholder-friendly capital deployment, including investor demands for higher dividends. Many companies are responding to these calls, returning increasing amounts of their cash flow to shareholders in the form of dividends and share buybacks. This is making dividend growth appealing, a reason many investors are chasing dividend growth stocks, which are trading at their biggest discount to dividend yield stocks in over two decades, according to Goldman Sachs’ citing Bank of America Merrill Lynch Global Research.
Indeed, the appeal of dividend growth stocks is supported by research (C. Thomas Howard, PhD. “The Power of Dividends”, Advisor Perspectives, January 25, 2011) that suggests dividend growth leading to increases in dividend yields may result in higher annual compound returns with lower risk, as measured by the stocks’ standard deviation. Certainly, dividend growth alone can lead to higher returns. For example, as the table below shows, a 15% compound annual rate of dividend growth would double to 6% (yield on cost) the initial 3% dividend yield over five years.
Among the companies increasing dividends at double-digit rates are a few that have solid financial standing and the enduring capacity to generate strong earnings and cash flow. The table below features the main profiles and dividend characteristics of four such stocks with dividend yields at least twice as large as the current yield on the 10-Year U.S. Treasury bond. All the following equities are credited with a capacity to sustain their dividend growth over the long term.
Among the featured stocks, Philip Morris (NYSE: PM), the international marketer of cigarette brands such as Marlboro and L&M, offers the highest dividend yield. Microsoft (Nasdaq: MSFT) trails the dividend yields of the other three companies, but its modest payout ratio and strong free cash flow generation suggest robust dividend growth is likely to extend into the future. Despite the budgetary austerity, the largest U.S. government contractor, Lockheed Martin (NYSE: LMT), has been able to continue its dividend growth this year as well, raising its payout by a robust 15.7%. Still, continued double-digit dividend growth is almost a promise for Williams Companies (NYSE: WMB), the owner and operator of midstream gathering and processing assets, and interstate natural gas pipelines. This company has committed to boosting its dividend by 20% each year through 2015.
Microsoft recently upped its dividend by nearly 22% and renewed its share repurchase program now worth $40 billion. Expectations are that the activist investment firm ValueAct Capital, which has an option to take a seat on MSFT’s board, will demand for investors a larger slice of the software giant’s $70 billion cash hoard in the form of dividends and share buybacks. Microsoft’s annual dividend payout now ranks fourth largest, behind Apple, Exxon Mobil, and AT&T. The company’s performance has been pressured by the secular decline in the PC market, which has weighed on its consumer software sales. However, Microsoft’s entry into the smartphone market as a device and services company, through the recent purchase of Nokia handset unit for $7.2 billion, represents a bold move that could transform the company in the future. In the meantime, counterweighing the weak consumer sales is the company’s enterprise business segment.
Lockheed Martin’s latest dividend increase is its 11th consecutive annual double-digit increase on record. An illustration of the robust dividend growth at this aerospace company, the largest U.S. government contractor, is the fact that over the past five years LMT’s dividends grew at an average rate of 22.3% per year. Despite such vigorous increases, the company’s payout ratio has remained manageable, demonstrating the company’s earnings power over the long-term periods. Indeed, Lockheed Martin has a wide moat, and is operating in a sustainable industry, which means it is able to withstand various adverse effects, such as the sequestration and budgetary austerity, better than most competitors. So far this year, the company has generated as much as $2.4 billion in free cash flow and has distributed some 69% of it in dividends and share buybacks. In fact, recently, the company expanded its share repurchase plan by $3 billion, thereby boosting shareholder value. Despite the budget instability, LMT, which has a strong cash flow generating capacity, represents an attractive income play with a rich dividend yield and robust dividend growth.
Philip Morris is the global marketer of popular cigarette brands, with seven of its brands making the top 15 global brands. The company has a wide geographic diversification, deriving the lion’s share of its revenues from emerging markets. The company is characterized by robust organic growth, high margins, good brand performance, and strong pricing power. It is also a major free cash flow generator. Earlier this year, the stock was selected as one of Morgan Stanley’s “20 for 2016,” the list of favorite high-quality stock to own for the next three years. Since 2008, PM has returned more than $59 billion to its shareholders, out of which nearly 41% was in dividends and the rest in share repurchases. The company has a large multi-billion share buyback program effective for the next two years. It is currently pursuing an international expansion in Africa vis-à-vis a purchase of a 49% stake in United Arab Emirates-based Arab Investors-TA (FZC) (“AITA”) for $625 million. This deal will give Philip Morris an almost 25% economic interest in the Algerian Société des Tabacs Algéro-Emiratie (“STAEM”), a joint venture which is 51% owned by AITA and 49% by the Algerian Société Nationale des Tabacs et Allumettes SpA, the market leader.
Williams Companies is a high-growth firm, whose good fortunes are a result of the shale gas boom that has lead to a surging demand for energy transportation infrastructure services. The company thus generates significant fee-based revenues from long-term contracts that depend on oil and gas transportation volumes and not necessarily on commodity price fluctuations. These fee-based revenues, which the company sees topping 74% of total revenues by 2015, give a dose of stability and security to the company’s cash distributions. Due to an expected surge in profitability within the next two years, WBM projects to boost its dividends (distributions) at a 34% CAGR between 2010 and 2015. In fact, WMB distributions are forecast to increase from $1.44 per unit in 2013, to $1.75 per unit next year and $2.11 per unit in 2015. Despite such a robust dividend growth, the company’s payout coverage will still be comfortable at 1.30x within two years.
In conclusion, there are many solid companies producing robust dividend growth. Some of the best among them have a proven earnings power over time and capacity to generate strong cash flow. Their double-digit dividend growth will prop up returns, and may be interesting for long-term income investors pursuing rising income flows from dividends with a potential for capital growth.