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As soon as one hears the phrase “income stocks,” certain things come to mind: REITs, Pipeline Limited Partnerships, Electric Utilities, Banks, etc. Some such associations (REITs and Banks, for example) are not as solid as they once were given the financial crisis, but even here, many income investors feel it’s just a matter of time before the world goes back to normal and dividends once again flow well from entities like those.

Two examples of stocks that definitely do not come to mind are Best Buy (BBY) and Casey’s General Stores (CASY), which had yields of 1.39% and 1.30% respectively when they made the Triple-Play Income Model I presented on Seeking Alpha last week.

If I wanted to get rigid and preachy, I could point out that those yields are a lot better than what investors are seeing nowadays from CDs and, perhaps, some short-term Treasury fixed-income funds. But that sort of explanation, accurate as it is, probably won’t satisfy anybody. Accepting these stocks as bona fide income plays requires one to recognize the yield-versus-dividend growth tradeoff (this is easy; we’ve all heard it a gazillion times) and really and truly buy into it (this is the hard part).

Let’s focus on each stock and see if we can find a way to genuinely appreciate buy into the income angle. At the end, I’ll explain why it may be important to open our portfolios to names like these.

Best Buy (BBY)

We usually think of BBY as a play, perhaps the premier play, on consumer-electronics retailing. The stores offer some other product lines, but realistically, if consumer electronics fizzles, so, too, will the company’s financials not to mention the willingness of many investors to consider the stock.

Let’s start by considering some basic year-over-year sales and EPS growth rates.

Table 1

EPS % Growth

Sales % Growth

2003

7.4

18.2

2004

27.1

17.2

2005

15.8

11.8

2006

21.9

12.4

2007

22.8

16.5

2008

11.9

11.4

2009

-23.5

12.5

2010

29.7

10.4

TTM

49.7

7.1

Fiscal Years begin in February
TTM = Trailing 12 Months

Notwithstanding the fiscal 2009 pothole, the EPS column definitely does not look like anything except a growth company, but the sales column is worth some closer attention. Although it’s bounced around a bit, notice how lesser numbers are dominating the more recent years, more so than might be explained by macroeconomic trends. We can pretty much recognize what’s happening here. For much of the 2000s, BBY was benefitting from strong demand for all kinds of new electronic products, whether variations on older products (laptops or netbooks or better printers) or things that were completely new (mp3 players, GPS products, etc.), or products that can be classified either way depending on one’s point of view (e.g., flat screen TVs, smart phones).

Looking ahead, we’re still going to be seeing all three categories (with tablets probably dominating the new-product headlines for a while), but it does seem that, as the newer or very much better products achieve wider penetration, and as consumers settle into the realization that credit-card limits really are limited, an increasing portion of BBY’s business is likely to come from less-revolutionary offerings. This is not by any means a bad business. But it may cause BBY to be a bit less hot than what we remember from, say, the mid-2000s. The market is already on to this. Table 2 shows the trend of some important valuation metrics, which seem to be edging lower, and to a greater and more lasting degree than might be explained by the late-decade market trauma.

Table 2

TTM PE

TTM Price/Sales

Price/Book

2003

16.97

0.51

3.80

2004

19.18

0.63

4.39

2005

19.13

0.66

3.95

2006

19.34

0.72

4.05

2007

18.56

0.71

4.01

2008

15.14

0.53

4.33

2009

14.78

0.33

3.14

2010

12.19

0.32

2.50

Latest

12.97

0.34

2.88

Fiscal Years begin in February
TTM = Trailing 12 Months

Now, let’s look at Table 3, which shows some important dividend-related trends.

Table 3

Div. % Growth

Div. Capacity**

Yield %

2003

- -

- -

- -

2004

- -

16.46

0.86

2005

5.00

9.26

0.79

2006

10.71

13.83

0.71

2007

16.13

16.91

0.70

2008

27.78

16.61

0.97

2009

17.39

38.85

1.53

2010

3.70

14.71

1.48

TTM

0.00

16.73

1.39

Fiscal Years begin in February
TTM = Trailing 12 Months
* Dividend initiated in fiscal 2004
** Dividend as % of Cash From Operations minus Capital Spending

The third column, the one showing yield, is consistent with what we saw in Table 2, the market being increasingly less inclined to see BBY as a growth stock. The middle column shows that BBY can easily afford to pay a much greater dividend than is now the case. The first column is the wild card. How quickly will management choose to grow the dividend?

We see that the brass was quite willing to be generous with dividend during the heady years of the mid-2000s. Then, when the economy hit a wall, management got cautious about the payout, a stance that still hasn’t changed.

Looking to the future, I think we face three scenarios which, although quite different, both favor the income angle in BBY stock.

One scenario, the theoretical ideal for an income investor, would be for the company to recognize that growth in the future may be less zippy than in the past and that the company generates far more cash than it could continue to profitably reinvest in the business (especially since there’s probably less room for new-store openings than was once the case), and that it follows up by gradually and significantly increasing the portion of available cash it pays to shareholders. I think a lot of investors and U.S. business in general would be a lot better off if BBY and many other companies were to adopt this approach, but I’m not going to hold my breath waiting for it to happen. The current generation of corporate executives is just as much afflicted with the growth-stock-macho syndrome as the current generation of investors and as such, is unlikely to boost payouts much absent some sort of external inducement (see below). But who knows. We can always hope. Perhaps long-term changes in the post-financial-crisis economy will serve as the external inducement.

Another scenario would be for consumer electronics to continue to evolve and for consumer capacity to buy to increase at enough of a rate to allow BBY to continue to be a bona fide growth company. This would make for a pretty straightforward income-investing case, as management would likely shrug off its current gun-shy attitude toward dividend growth and go back to increasing the payout at a nice rate, as was done in the pre-crisis 2000s. We wouldn’t need BBY itself to grow quite as quickly. Given that BBY’s dividend-paying capacity is so huge, there’s ample room for management to allow the payout ratio to creep upward a bit without the need for them to give up the growth-company self-image.

The third scenario is the special situation. This would occur if BBY were to stubbornly fail to embrace reality and resist boosting the dividend even though they could well afford to do it. That would likely open the door to “SA” (no, not “Seeking Alpha;” I’m referring to “Shareholder Activism”). For an example of this, consider the discussion below of our other oddball income stock.

Casey’s General Stores (CASY)

CASY operates the kind of business most readers probably see every day and patronize pretty often, and possibly every day: small convenience stores usually anchored by self-service gasoline pumps. The probabilities are, however, that most readers use convenience stores operated by companies other than CASY. That’s not a statement about CASY’s operation. It’s a matter of numerical probability: 61% of CASY stores are located in areas populated by fewer than 5,000 people mainly in Iowa, Missouri, Illinois and surrounding states.

A rural emphasis like this can make for a great business model. The areas where CASY operates tend to be of little interest to national chains. That said, CASY, with more than 1,500 stores, has enough scale to offer competitive prices and broader selection compared to other convenience stores to which its customers have access.

Tables 4, 5 and 6 present the key numbers for CASY.

Table 4

EPS % Growth

Sales % Growth

2003

41.7

4.1

2004

-8.3

9.7

2005

11.6

19.9

2006

47.9

25.3

2007

0.3

15.3

2008

33.2

20.3

2009

0.8

-3.2

2010

36.1

-1.1

TTM

8.5

11.6

Fiscal Years begin in April
TTM = Trailing 12 Months

Table 5

TTM PE

TTM Price/Sales

Price/Book

2003

14.24

0.28

1.44

2004

20.95

0.34

1.80

2005

20.92

0.32

1.89

2006

17.80

0.32

2.14

2007

19.35

0.31

2.14

2008

15.84

0.28

2.07

2009

14.93

0.27

1.77

2010

13.30

0.34

1.88

Latest

19.26

0.33

1.83

Fiscal Years begin in April
TTM = Trailing 12 Months

Table 6

Div. % Growth

Div. Capacity*

Yield %

2003

17.65

12.46

0.85

2004

20.00

25.50

0.86

2005

62.50

26.60

1.10

2006

-7.69

18.71

0.81

2007

11.11

42.97

0.82

2008

22.50

13.88

0.93

2009

18.37

44.48

1.15

2010

18.97

20.40

1.13

TTM

35.00

17.14

1.30

Fiscal Years begin in April
TTM = Trailing 12 Months
* Dividend as % of Cash From Operations minus Capital Spending

Like many firms in the real world, this company has hit some potholes. But by and large, we see that it experienced pretty good growth. Looking ahead, demand for what the company sells should stay healthy, but like BBY, we do have to wonder about growth: how much further can the company go before it’s forced to move into new regions (and, possibly, stretch its logistics) or into more heavily populated areas (presently, only 14% of stores are in locales with populations above 20,000) and, thereby, expose itself to more and stronger competition. Also like BBY, we see that CASY has the ability to maintain a far larger dividend than it’s been paying.

Again, like BBY, income-oriented CASY shareholders could benefit from a management decision to boost the payout, or surprisingly good growth in the business, and presumably, the dividend. Here, however, the SA scenario has turned real. Earlier this year, Alimentation Couche-Tard (ATD-A.TO) made a tender offer for CASY. Neither the initial bid nor the subsequent increase were all that far above the market price, so CASY management was able to persuade its shareholders to let it pass, which is what happened.

Depending on one’s point of view (i.e. one who is a high-level CASY executive), that might be considered a “win,” but, possibly, a Pyrrhic victory. Once the SA cat gets out of the bag, it’s hard to put it back in. One possibility is another buyout opportunity. Indeed, CASY had acknowledged talks with 7-Eleven. Clearly, though, there is pressure here to do something about the status quo. Buyout might be one answer. So, too, might expansion (beyond the small in-region deals CASY has been doing from time to time). So, too, might big share buybacks. So, too, might the scenario of direct interest to income investors; bigger increases in the dividend. Indeed, we may start to see enough SA activity to suggest to corporate executives that adjusting unduly low payout ratios might be a way to keep the next generation of Gordon Gekkos away from the front door. And even if you really want income, if you get a to sell into a nice pop that results from buyout activity or speculation, will that be the end of the world?

The Income Investing Cases for BBY and CASY

I can easily imagine you wondering why any income investor should bother with any of these issues. It’s easy to find plenty of stocks yielding 7%-9%, and even assuming we don’t want to cope with the risks often associated with yields so far above average, there are plenty more yielding say, 3%-5%.

I don’t argue with that. A well-constructed income portfolio should be well-stocked with selections that yield a heck of a lot more than what we’re seeing here. Unfortunately, though, this is late-2010 and interest rates are very close to zero. That means declining interest rates, a major underpinning of much of the strong fixed-income- and equity-market performance numbers you might have seen for a generation is not now part of the investment landscape.

This is important, perhaps even critical. A vital driver of performance that an entire generation of investors has come to take for granted is over, done and gone, at least until market prices have an opportunity to readjust. That’s why commentators talk of a bond bubble. It’s not certain that bond prices will collapse, but when the best one can hope for is sideways, it’s hard to get up in arms at use of the word “bubble.”

The higher a stock’s yield, the more bond-like its performance is likely to be. That is likely to pose huge problems for traditional income stocks, problems unlike any of those the typical income investor has ever seen. It’s unfortunate that the phrase “past performance is no guarantee of future results” has been so badly over-used as to cause many investors to tune it out. Now is the time when it needs to be taken seriously!

In last week’s article, particularly the Appendix, I showed that an income strategy that sacrifices day-one yield has the potential to outperform more conventional income strategies at times when interest rates are not plummeting. While I certainly understand investors will want to try as best they can to get as decent a day-one yield as they can (and discussed two such strategies last week), I believe it would be fruitful for income seekers to leave at least some respectable portion of their portfolios open to the possibility of benefiting from the kinds of scenarios discussed here for BBY and CASY (in my income portfolio, the lower-yielding-better-growth allocation is 25%).


Author's Disclosure: Long BBY, CASY

Source: Oddball Income Stocks: Best Buy and Casey’s General Stores