Sysco Corporation (NYSE:SYY), the food wholesaler and distributor, was one of my early income stocks. I added it to my income portfolio in the early 2000s for diversity and the near 4% yield it then provided. Since that time, the dividend has grown slowly but steadily... almost like a regulated utility... at the following rates (growth rates shown are over the previous year's dividend):
Past 10 year dividend CAGR: 7.3%
SYY has raised its dividend every year since 1970 and is carried on David Fish's spreadsheets as a Dividend Champion. A long term and very reliable dividend payer and grower, SYY is one of those income stocks the income investor can almost buy-and-forget. But notice I said "ALMOST"....
A Funny Thing Happened Today...
From my ongoing notifications I regularly receive in my e-mail inbox on significant changes to stocks I hold in my income portfolio, I noticed SYY on this list, and out of curiosity I took a quick peek at whatever was getting SYY into the spotlight. Well, as many may be aware, a better-than-expected earnings report sent SYY up 8.5% in price, but more importantly, its current yield has dropped to about 2.86%. Is the market telling us that it feels SYY has growth potential and so is trying to get out in front of future earnings jumps... or is this some sort of market 'anomaly', or transient inefficiency? Frankly, I have no idea and I really don't care why. I have always preached to anyone bold enough to listen to my tirades that price rarely matters to an income investor, only the dividend and the company's proven willingness and recent trends in their ability to pay the dividend, along with any near-term projections on significant changes to their revenues, really matters. Downward trends in the company's ability to sustain its dividend, to include a failure to grow it as expected, is usually cause for ejection. Absent this, my strategy is to hold the income stock indefinitely and rarely ever sell it.
Again, I use the adverb 'rarely', which means there are going to be exceptions to this general rule, and I think SYY may be providing us with an exception.
The two exceptions I have to never selling an otherwise financially healthy income stock that I will plan to buy and hold forever are tax loss selling (in a taxable account) and a "sell/replace" for an income stock that is doing what SYY is currently doing.
Tax loss selling simply involves an income stock whose market value in my income portfolio has fallen below my basis in the stock by a wide enough margin to justify selling it, waiting 31 days and repurchasing it and doing this between dividends, or if a monthly dividend payer, including the negative value of one month's lost dividend. The risk here is the price of the stock will rise high enough during the 31 days so as to negate the financial benefit of the tax loss and the friction of two trading commissions. One added potential problem with tax loss selling is that my year's long-term capital gains may all be in my 15% tax bracket and the net tax loss is less than my existing realized capital gains, which means I would derive no financial value in tax loss selling (see my article on this topic).
Sell/Replace is possible if the income stock is sharply rising in price at a rate much faster than its dividend is growing. As previously mentioned, this may be a short-term market inefficiency of some sort, or it may be the market reclassifying the stock from Income and Growth to Growth and Income. Whichever the case, can the stock be sold and replaced with a stock of similar income risk, such that household income is improved without increasing portfolio income risk?
SYY: Sell and Replace?
The first step in this analysis is to find a replacement income stock providing a higher current yield and of similar income risk, which is to say similar dividend growth rate and similar cash flow analysis of the company's dividend paying ability. A quick look for an SYY replacement shows nothing in the food services industry of a higher yield. In fact, to make a long search short, there are no comparable yielding in the 4%... or even 3% range for food services of any type. So let's try this... SYY's dividend history has been extremely stable with slow but constant growth, and as I said earlier, almost like a regulated utility. So how about replacing SYY with a long dividend paying regulated utility such as Consolidated Edison (NYSE:ED). Let's compare them on some important dividend growth and cash flow metrics:
Although SYY shows a stronger historic dividend growth rate than ED, this rate of dividend growth has merged between the two to be almost identical in 2015 over 2014. How will dividend growth evolve in the years ahead? This is not known, but SYY seems to have an advantage based on its historic dividend growth record.
Interest as a fixed expense is important to a company's financial health. Interest cannot be electively reduced by management during economic recession and so is an important metric in measuring a company's financial health and its ability to sustain its dividend during an economic recession.
SYY has taken on additional debt (interest expense) that have recently exceeded ED, although both are moderate as compared with peers. I don't see a significant difference in interest rate risk between them.
ED shows a distinct advantage in the dividend-to-CFFO (cash flow from operations) payout ratio. Although PORs tend to vary by industry, generally the lower this ratio, the more of the remaining CFFO will be available to pay for necessary investing expenses, which leads to this important metric....
Here, SYY has the clear advantage in that it is able to pay for all of its Cash Flow required for Investing activities (or CFFI) from operational cash, thus not requiring it to raise capital through the sale of additional company debt or issuance of company stock. ED's ability to fund 73% to 84% of CFFI consistently speaks well to this utility's ability to fund investing activities from operational cash over the previous 10 quarters... an advantage ED has over most of its peers. I do not see a sharp distinction between SYY and ED on their ability to fund investments from operations.
Reviewing these metrics suggests that although a slower dividend grower, ED would be a comparable replacement for SYY, although it would be useful to run these comparisons with other long-term dividend paying and moderate dividend growth utilities such as SO or DUK, as two examples.
Using ED as an example, a sale/replace of SYY with ED would provide the following change to income from SYY: (all prices are as of market close, 1 Feb 2016)
Number of SYY shares held: 500
Current annual dividend: 500 X $.31/qtr X 4 = $620
Total value of SYY sold: ($43.15 X 500) - $8 = $21,567
Total number of shares of ED purchased: (21,576 - 8)/70.42 = 306.15
Total ED annual dividend: 306.15 X $.67/qtr X 4 = $820
Increase in portfolio income/yr: $820 - $620 = $200
Looks pretty good. But wait.....
If this is a tax deferred account (such as an IRA), then stop at the above calculation. But if this is a taxable account, the amount of tax that will be generated by this transaction must be subtracted from the amount available to be reinvested. In short, each transaction must pay for itself. Of course, the tax expense generated will depend on two important variables: 1) how much of the realized capital gains will be below the 25% tax bracket. If all of it will, then tax will not be an issue. 2) If some or all of the capital gain will be at or above the 25% bracket, then the tax generated by the sale must be subtracted from the amount available after the sale of SYY to reinvest. So let's assume in this example that the individual/couple are making the sell/replace transaction in a taxable account and they are in the 25% bracket:
Basis in SYY: $15,000 (original purchase price + trading commission)
Capital gain: $21,567 - $15,000 = $6,567
Federal tax on transaction: $6,567 X .15 = $985
Available to purchase ED: $21,567 - $985 = $20,582
Shares of ED purchased: ($20,582 - 8)/$70.42 = 292.2 Shares
ED dividend: 292.2 X $.67 X 4 = $783
Increase in portfolio income/yr: $783 - $620 = $163
In addition to Federal Tax, there may also be a state tax that will have to be computed and added to the Federal Tax as the total tax generated by the sale of SYY.
My purpose here is not to recommend current holders of SYY replace these shares with ED or any other income stock. Rather, my purpose is to point out the process by which an income investor may be able to sell/replace an income stock with an income risk-equivalent stock if the market elects to run its price up much faster than the company management grows the dividend. These conditions do not happen very often, as the market tends to reward/punish stock prices of all stocks of a given industry in unison. But these conditions do periodically present themselves to those who are attentive.
Disclosure: I am/we are long SYY, ED.
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.