By The Valuentum Team
Thomson Reuters' Dividend Cushion ratio is near parity.
--> Thomson Reuters Corp (NYSE:TRI) is a source of information (human intelligence, industry expertise and innovative technology) for businesses and professionals. It delivers insight to the financial and risk, legal, tax and accounting, IP and science and media markets. The company has a nice, balanced revenue stream.
--> The firm continues to sustain profitability in its core US legal business and capture global growth opportunities in its tax & accounting segment, while its IP & science group drives subscription expansion. Proprietary databases act as considerable barriers to entry for smaller rivals.
--> Thomson Reuters Corp has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 18.7% in coming years. Total debt-to-EBITDA was 2.4 last year, while debt-to-book capitalization stood at 36.4%. Roughly 90% of revenue is recurring.
--> The company is organized in four business units: 1) financial and risk -- news and analytics, 2) legal -- information to support legal and investigative purposes, 3) tax & accounting -- tax compliance and accounting information, and 4) intellectual property & science -- IP and science information.
--> We're big fans of the company's track record of returning cash to shareholders, with more than $14 billion dished out in share buybacks and dividends since 2004. Thomson Reuters boasts 20+ consecutive years of dividend increases.
Note: Thomson Reuters' dividend yield is above average, offering a ~3.5% yield at recent price levels. Thomson Reuters boasts a solid yield, but we think the company is one for the watch list, if only because its Dividend Cushion ratio could be better. Let's walk through several of its key investing merits.
Thomson Reuters may not have an elevated Dividend Cushion ratio like that of many of its peers, but it's more a function of the size of its dividend obligations than anything else. We're big fans of the company's track record of returning cash to shareholders, with more than $14 billion dished out in share buybacks and dividends since 2004. More recently, buybacks have taken a larger share of the capital returned, but a steadily-increasing dividend has become the norm at Thomson Reuters. Improving EBITDA and operating margins will help fuel free cash flow expansion, and with nearly 90% of its business recurring, there's so much to like. Thomson Reuters boasts 20+ consecutive years of dividend increases.
We're big fans of one of the world's leading sources of information for businesses and professionals, but we have to acknowledge the firm's Dividend Cushion ratio, which is near parity. The company does have a nice, balanced revenue stream, however, and its
predominantly subscription-based business offers significant visibility. Proprietary databases act as considerable barriers to entry for smaller rivals, and management's commitment to maintaining a strong and stable capital structure is quite encouraging. The company will look to build on its consistent free cash flow generation in 2016 and beyond, and we'd like to see more capital go to deleveraging initiatives than buybacks at the moment.
From the Comments Section: How to Interpret the Dividend Cushion Ratio -- A Ranking of Risk
As for how to interpret the Dividend Cushion ratio, itself, it is a measure of financial risk to the dividend, much like a credit rating is a measure of the default risk of the entity. Said differently, a poor Dividend Cushion ratio of below 1 or negative doesn't imply the company will cut the dividend tomorrow, no more than a junk credit rating implies a company will default tomorrow. That said, the Dividend Cushion ratio does punish companies for outsize debt loads because in times of adverse conditions, entities often need to shore up cash, and that means the dividend becomes increasingly more risky.
We think investors should look at a variety of different metrics in assessing the sustainability of the dividend. Because the Dividend Cushion ratio is systematically applied across our coverage, it can be used to compare entities on an apples-to-apples basis. Dividend payers with significant free cash flow generation and substantial net cash on the balance sheet often register the highest Dividend Cushion ratios, as they should. These companies have substantial financial flexibility to keep raising the dividend.
We think the safety of Thomson Reuters' dividend is good. Please let us explain.
First, we measure the safety of the dividend in a unique but very straightforward fashion. As many know, earnings can fluctuate, so using the payout ratio in any given year has some limitations. Plus, companies can often encounter unforeseen charges, which makes earnings an even less-than-predictable measure of the safety of the dividend. We know that companies won't cut the dividend just because earnings have declined or they had a restructuring charge that put them in the red for the quarter (year). As such, we think that assessing the cash flows of a business allows us to determine whether it has the capacity to continue paying dividends well into the future.
That has led us to develop the forward-looking Dividend Cushion™ ratio, which we make available on our website. The measure is a ratio that sums the existing net cash a company has on hand (on its balance sheet) plus its expected future free cash flows (cash flow from operations less capital expenditures) over the next five years and divides that sum by future expected cash dividends over the same time period. Basically, if the score is above 1, the company has the capacity to pay out its expected future dividends and the expected growth in them.
As income investors, however, we'd like to see a ratio much larger than 1 for a couple of reasons: 1) the higher the ratio, the more "cushion" the company has against unexpected earnings shortfalls, and 2) the higher the ratio, the greater capacity a dividend-payer has in boosting the dividend in the future. For Thomson Reuters, this ratio is 1, revealing that on its current path the firm should be able to cover its future dividends and growth in them with net cash on hand and future free cash flow.
Dividend Cushion Ratio Cash Flow Bridge
The Dividend Cushion Cash Flow Bridge, shown in the graph below, illustrates the components of the Dividend Cushion ratio and highlights in detail the many drivers behind it. Thomson Reuters' Dividend Cushion Cash Flow Bridge reveals that the sum of the company's 5-year cumulative free cash flow generation, as measured by cash flow from operations less all capital spending, plus its net cash/debt position on the balance sheet, as of the last fiscal year, is less than the sum of the next 5 years of expected cash dividends paid.
Because the Dividend Cushion ratio is forward-looking and captures the trajectory of the company's free cash flow generation and dividend growth, it reveals whether there will be a cash surplus or a cash shortfall at the end of the 5-year period, taking into consideration the leverage on the balance sheet, a key source of risk. On a fundamental basis, we believe companies that have a strong net cash position on the balance sheet and are generating a significant amount of free cash flow are better able to pay and grow their dividend over time.
Firms that are buried under a mountain of debt and do not sufficiently cover their dividend with free cash flow are more at risk of a dividend cut or a suspension of growth, all else equal, in our
opinion. Generally speaking, the greater the 'blue bar' to the right is in the positive, the more durable a company's dividend, and the greater the 'blue bar' to the right is in the negative, the less durable a company's dividend.
Dividend Cushion Ratio Deconstruction
The Dividend Cushion Ratio Deconstruction, shown in the graph below, reveals the numerator and denominator of the Dividend Cushion ratio. At the core, the larger the numerator, or the healthier a company's balance sheet and future free cash flow generation, relative to the denominator, or a company's cash dividend obligations, the more durable the dividend. In the context of the Dividend Cushion ratio, Thomson Reuters' numerator is smaller than its denominator suggesting weak dividend coverage in the future. The Dividend Cushion Ratio Deconstruction image puts sources of free cash in the context of financial obligations next to expected cash dividend payments over the next 5 years on a side-by-side comparison. Because the Dividend Cushion ratio and many of its components are forward-looking, our dividend evaluation may change upon subsequent updates as future forecasts are altered to reflect new information.
Please note that to arrive at the Dividend Cushion ratio, divide the numerator by the denominator in the graph below. The difference between the numerator and denominator is the firm's "total cumulative 5-year forecasted distributable excess cash after dividends paid, ex buybacks."
Now on to the potential growth of Thomson Reuters' dividend. As we mentioned above, we think the larger the "cushion" the larger capacity the company has to raise the dividend. However, such dividend growth analysis is not complete until after considering management's willingness to increase the dividend. To do so, we evaluate the company's historical dividend track record. If there have been no dividend cuts in the past 10 years, the company has a nice dividend growth rate, and a solid Dividend Cushion ratio, we characterize its future potential dividend growth as good, which is the case for Thomson Reuters.
Because capital preservation is also an important consideration to any income strategy, we use our estimate of the company's fair value range to assess the risk associated with the potential for capital loss. In Thomson Reuters' case, we currently think shares are fairly valued, meaning the share price falls within our estimate of the fair value range, so the risk of capital loss is medium (our valuation analysis can be found by downloading the 16-page report on our website). If we thought the shares were undervalued, the risk of capital loss would be low.
Wrapping Things Up
We're fans of Thomson Reuters' balanced revenue stream. The firm has sustainable profitability coming from its US legal business while it continues to capture global growth opportunities in its tax and accounting segment. The company has a strong track record of returning cash to shareholders, as evidenced by its strong dividend yield. This high yield has an impact on the firm's Dividend Cushion ratio, which could be stronger. Perhaps the largest threat to the pace of future dividend growth at the moment is the prospect for competing capital allocation options to take a larger share of cash used. We would like to see some deleveraging moving forward at Thomson Reuters, but we do not expect material pressure on the health of its dividend.
Breakpoints: Dividend Safety. We measure the safety of a firm's dividend by adding its net cash to our forecast of its future cash flows and divide that sum by our forecast of its future dividend payments. This process results in a ratio called the Dividend Cushion. Scale: Above 2.75 = EXCELLENT; Between 1.25 and 2.75 = GOOD; Between 0.5 and 1.25 = POOR; Below 0.5 = VERY POOR.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.