By Serkan Unal
In aggregate, corporations have amassed record cash on their balance sheets and have near-record net cash flows, which has prompted many to return large chunks of their cash to shareholders in the forms of dividends and share repurchases. Larger dividend payouts have been driving dividend growth in the last year, with the S&P 500 constituents boosting their dividends, in aggregate, at a rate of 15.5% year-over-year for the twelve months ending September 30, 2012, according to FactSet. Still, the record aggregate cash hoard does not mean that all companies have accumulated substantial cash and can raise their dividends robustly.
In order to identify companies that may have the capacity to grow their dividends robustly, we ran a screen on fundamentally sound and profitable companies based on our criteria that include market caps above $2 billion, dividend yields exceeding 2%, past and forward long-term EPS growth above 5%, return on equity above 15%, long-term debt to equity below 30%, payout ratios below 40% of earnings or free cash flow, and trailing and forward P/Es at or below 15x. The screen returned 10 non-financial stocks, but our focus is on five that stand out based on their combination of high percentage of total assets in cash and consistently high conversion rates of net income into free cash flow (signifying their ability to generate cash without external financing).
CA Technologies (CA), an IT management software company, has about 20% of total assets in cash and a ratio of free cash flow to net income of 1.29. The company has been reporting positive free cash flow growth since 2007. Over the past five years, CA boosted its EPS and dividends, on average, by 53.8% and 25.0% per year, respectively. Its long-term annualized EPS CAGR is forecasted at 9.0%. Given the company's dividend yield of 4.3% and payout ratio of 50% of trailing earnings and 39% of trailing free cash flow, CA could afford to continue increasing its dividend robustly, but not necessarily at the same average rate as over the past five years. The stock has a ROE of nearly 17% and a high free cash flow yield of 7.8%. CA's main cash cow has been its low-growth, wide-margin mainframe business. Currently, however, most of the company's growth comes from a low-margin enterprise business. The fierce competition in that segment and slow growth in the mature mainframe business is a reason why CA trades at below-industry 9.4x forward earnings, with a PEG ratio of 0.9. Billionaire Jim Simons holds a stake in CA, which he trimmed by 13% last quarter.
KLA-Tencor Corporation (KLAC), a leader in process diagnostics and control, serving semiconductor and nanoelectronics industries, has 52% of total assets in cash as well as the ratio of free cash flow to net income of 1.29. The company has been generating consistently positive free cash flow. Over the past five years, KLA-Tencor increased its EPS and dividends, on average, by 11.2% and 21.3% per year, respectively. Its five-year annualized EPS CAGR is forecasted at 10.0%. KLAC pays a dividend yield of 3.3% on a payout ratio of 39% of trailing earnings and 30% of trailing free cash flow. KLA-Tencor is in a cyclical industry, characterized by a currently weak demand for wafer fab equipment. According to IT research firm Gartner, wafer fab equipment spending will not return to positive growth until 2014. In the meantime, the company is benefiting from a stronger demand for logic memory chips and chip foundries, which is expected to remain robust in 2013. KLAC is trading at 11.3x trailing and 15.1x forward earnings, with a near 20% discount to its peer group on a forward earnings-basis. Last quarter, Jim Simons boosted his stake in KLAC by 265% to almost $92 million.
Intel Corporation (INTC), the world's largest semiconductor maker, has 14% of its total assets in cash and equivalents and a ratio of free cash flow to net income of 0.68. The company generates consistently positive free cash flows. Over the past half-decade, its EPS and dividends grew, on average, by 22.8% and 12.9% per year, respectively. The company's long-term annualized EPS CAGR is forecasted at 9.2%. The secular decline of the PC market has weighed on Intel's performance, and the company looks inclined to boost its growth in the mobile device chip business gravitating toward smartphones and PC tablets. This year, Gartner expects weak PC sales, recovering semiconductor sales, and surging smartphone unit production growth and media tablet production. Intel yields a high 4.1% on a payout ratio of 39% of trailing earnings and 58% of trailing free cash flow. We like the company's wide moat, low debt, high dividend, and relative valuation well below the company's historical metrics. Its forward P/E of 12.2x is a large discount to its peers on average. Fund managers Ken Fisher and Jim Simons, and Jean Marie Eveillard's First Eagle Management hold hundreds of millions invested in this stock.
Guess Inc. (GES), a fashion retailer, has some 16.9% of total assets in cash and a ratio of free cash flow to net income of 1.00. The company's free cash flow has been positive since 2008. We recently wrote about GES as a defensive value stock. Its dividend yields 3.1% on a payout ratio of 35% of both trailing earnings and free cash flow. With almost no long-term debt, 11% long-term EPS CAGR, and strong free cash flow generation and conversion rates, the stock has plenty of room to expand its payout ratio. GES has attractive valuation, trading at a near 20% discount on a forward-earnings basis. The stock could see accelerated growth in the future on Asia and emerging markets. Based on last quarter 13Fs, fund managers Chuck Royce, Cliff Asness, D. E. Shaw, and Steven Cohen reported owning stakes in this stock.
General Dynamics Corp. (GD), an aerospace and defense company, has 8.1% of its assets in cash and a ratio of free cash flow to net income of 1.44. The stock also has a high free cash flow yield of 11%. Its free cash flow has consistently grown each year since at least 2002, with the exception of 2008. Over the past five years, the company's EPS and dividends grew, on average, by 10.6% and 12.0% per year, respectively. GD's long-term annualized EPS CAGR is forecasted at 6.4%. The company has fared well despite the defense cuts. Recently, it received several large contracts, including three U.S. Navy contracts worth $4.6 billion, $133 million for Saudi tank production, and $65 million for Columbian light armored vehicles production. Yielding 2.9%, below main peers, with a low payout ratio of 30% of trailing earnings and 22% of trailing free cash flow, GD's dividend has plenty of room to grow. We like the firm's free cash flow position, attractive valuation based on both its free cash flow and earnings, below-industry price-to-book of 1.8, and the potential for dividend growth. Fund manager James A. Star (Longview Asset Management) owned more than $2.2 billion in GD last quarter. Investing legend Warren Buffett is also an investor (see Warren Buffett's top stock picks).