When contemplating a new dividend growth investment, there are three things that may principally play a role in your decision to make an investment: the current valuation, the likelihood that the company will grow earnings per share, and the potential ability of the company to raise its payout ratio. Kohl's (NYSE:KSS), a family department store, is a company that looks favorable on each of those three metrics.
First, there is the question of valuation. At a current price of $59, compared to trailing earnings of $4.15, Kohl's trades at a P/E multiple of 14.21. That's a pretty good deal, considering that Kohl's has grown sales per share by 12.5% annually over the past decade and grown cash flow per share by 13.5%, and seems especially favorable compared to the typical valuation range of 18-22x profits that was typical at Kohl's before the financial crisis (and even during the financial crisis, Kohl's valuation only came down to a 15x earnings valuation). Also, as a matter of common sense, things tend to work out well when you can get a non-cyclical company for under 15x earnings that has earnings per share growth in the 10% range.
Secondly, despite the lower valuation, the company's growth hasn't declined commensurately with its changing growth profile (in other words, Kohl's is not growing at the 15% clip it enjoyed in the 1990s when it traded at over 40x profits, but the shift in valuation down to 14.2x profits has overshot on the downside). For instance, Kohl's is still growing sales at 6.5% and growing earnings per share at 8.5%.
This continued earnings growth is largely driven by a significant stock buyback program -- Kohl's is one of those companies that has been serious about reducing its share count, taking it from 345 million shares in 2005 to 207 million shares now (meaning that 40% of the share count has been reduced since 2005). The company's net profits have grown from $842 million in 2005 to $889 million by the end of last year, yet earnings per share increased from $2.43 to $4.05 during the 2005-2013 period. As you can see, a lot of this growth has been the result of a dwindling share count.
From a dividend growth perspective, the appeal of Kohl's lies in the fact that shareholders are currently riding the dual combination of earnings growth plus a rising dividend payout ratio. Kohl's instituted a dividend policy in 2011, taking the annual dividend from $1.00 (2011) to $1.28 (2012) to $1.40 (2013) to $1.56 (2014). The payout ratio has gone from 23% in 2011 to 30% in 2012 to 34% in 2013 to somewhere in the 32%-37% range in 2014 (depending on what the end-of-year profit numbers look like). Someone buying Kohl's today can participate in a dividend growth rate that is greater than the earnings per share growth rate as the company moves its dividend payout ratio towards the retail average of 50%-60% net profits.
On the monitoring side, the risk to watch out for in the coming years is the interplay between the dividend and the stock buyback program. Over the past nine years, much of the company's growth has been the result of using free cash flow to buy back stock, retire it, and then boost earnings per share. As the dividend payout continues to grow larger, the company will have less money available to conduct share buybacks, meaning that the company will have to rely on actually increasing the profits from its business operations rather than merely buying back stock, and the company has struggled to do this over the past nine years.
Right now, the price of Kohl's stock gives you a fair shake -- before the financial crisis, you could never buy shares in this company at under 15x profits (the closest was 2006 when you could buy the stock at 18x profits). Earnings per share growth seems likely to continue to grow in the 8%-9% range, fueled largely by a significant buyback program that has seen 40% of outstanding shares get taken off the market since 2005. Given that Kohl's dividend is relatively young and the payout ratio increasing, investors that own the stock now can receive outsized dividend growth that outstrips the rate of earnings per share growth for the next five years or so.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.