The Dividend Aristocrats: Increasing Leverage, Full Valuations, And Few Attractive Options

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Includes: ADP, BEN, CLX, GWW, HRL, JNJ, KMB, LOW, MCD, MDT, PNR, SWK, SYY, TGT, TROW, WBA
by: Investing Doc

Summary

Continuing an analysis of the Dividend Aristocrats, I find that in addition to slowing EPS growth and rising payout ratios, financial leverage has been increasing steadily.

Despite this increasing debt, capital investments have been curtailed in favor of share buybacks and other forms of financial engineering.

Full valuations and high expectations make the group as a whole unattractive at this point, though there are a few relatively attractive options.

In a previous article, I contended that the Dividend Aristocrats as a group exhibited several concerning characteristics that-it seems to me-would put their venerable record of dividend raises at risk. An analysis of recent financial data shows convincingly that the Dividend Aristocrats have continued to raise their dividends despite stagnant earnings-per-share growth, which has resulted in a peak in payout ratios. While there are still some companies that have managed to grow earnings at an impressive rate (and maintaining sustainable payout ratios), the group as a whole displays trends that are probably not sustainable in the long run.

Besides rising payout ratios and slowing earnings, though, the Dividend Aristocrats also exhibit other concerning features:

  1. As a whole, they have taken on increasing amounts of debt, leaving them with less room to raise debt later on;
  2. That despite this increasing leverage, capital investments have been curtailed, leaving existing cash flow ratios at risk should investment cycles have to resume again; and
  3. Despite these risks of increasing payout ratios (with their attendant risk of dividend cuts or freezes), increasing financial leverage, and risk of diminished future cash flows, investors now pay hefty premiums for the privilege of owning these companies.

In this article, besides reviewing the above points, I'll see if there are any of the Dividend Aristocrats that look particularly attractive at this point-ones with lower payout ratios, continued EPS growth, lower or reasonable amounts of leverage, and ones whose prices suggest a reasonable risk/reward ratio.

Point 1: Dividend Aristocrats have taken on increasing amounts of debt, leaving them with less room to raise debt later on.

It's not terribly surprising that companies with relatively predictable revenue streams would try to take advantage of an unprecedented low-rate environment to juice returns on investment. And lever up they did:

Source: 10-year financial data from Morningstar.

A review of 10-year financial data indicates that as a whole, Dividend Aristocrats have seen their median financial leverage steadily rise by nearly 50%, from 2.0x to 2.8x. While interest coverage ratios remain generally adequate and these companies don't appear to be in any danger of insolvency, the very fact that these companies have taken on these debt loads leaves them less room to maneuver in the future should things go south.

What's worse is that returns on equity don't appear to have budged very much despite this increasing debt load:

While some companies have been able to lever up their returns on equity to new heights, the vast bulk of Dividend Aristocrats have seen their returns on equity stay relatively stagnant over the past decade. Looking at changes in median net margin, asset turnover, and financial leverage makes clear that despite the additional leverage, companies' ROE have barely budged over the past 10 years, largely due to declines in asset turnover and stagnant net margins:

Source: 10-year financial data from Morningstar.

Of course, indebtedness isn't necessarily a bad thing. Debt allows companies to lower their cost of capital, and for companies with good revenue visibility-like Dividend Aristocrats-such leverage often makes sense. But the data make clear that the added returns from this increasing indebtedness have been minimal, at best.

It's perhaps worth noting some of the outliers in this group. Consumer goods companies like Clorox (NYSE:CLX) and Kimberly-Clark have levered themselves up to fairly significant levels, while medical companies like Johnson & Johnson (NYSE:JNJ) and Medtronic (NYSE:MDT) still have fairly reasonable relative debt levels. While ROEs for the former are off the charts, it's clear that these are due simply to financial leverage and not necessarily any improvement in the companies' underlying operations. In fact, when we break out returns on equity to isolate the highest performers in the Dividend Aristocrats, we find a disturbing trend:

Company Ticker

Trailing ROE

Leverage Ratio

KMB

991.95%

136.0

CLX

261.25%

16.5

MCD

127.96%

8.8

SHW

108.07%

6.0

CL

76.57%

7.1

PEP

46.90%

6.3

MMM

43.53%

2.8

ADP

39.82%

11.4

ITW

36.01%

3.0

GWW

35.13%

2.6

Of the companies with the top 10 returns on equity, 7 have leverage ratios over 6x, and 2 of the remaining 3 have leverage ratios greater than the median for the group. Only G.W. Grainger (NYSE:GWW) has managed to achieve a high return on equity while keeping debt at a reasonable level. But as for the Dividend Aristocrats in general, it is clear that the majority of them have been driving returns only through driving up tons of debt.

Point 2: Despite this increasing leverage, capital investments have been curtailed in favor of share buybacks and dividends.

So what have these companies been doing with the debt they've been raising? Well, if nothing else, they haven't been spending it on capital investments. A review of financial data shows how capital expenditures as a percent of operating revenues has declined significantly over the past decade:

Instead, these companies have been deploying capital raised on share repurchases and dividend payments, rather than reinvesting the funds into the business to drive better returns down the road.

Source: 10-year financial data from Morningstar.

This may be rewarding to shareholders in the short run, but ultimately this represents little more than financial engineering. (Furthermore, it's worth noting that share repurchases have continued apace despite stock prices having hit all-time highs, with most analysts and many on Seeking Alpha considering the market fairly- to fully-valued.)

The use of capital in this manner is not necessarily a bad thing. For one, companies may have seen few opportunities to safely invest in capital equipment and other items, or at least be assured of a reasonable return on investment. And it is probably true that as companies mature capital expenditures will probably shift more towards maintenance, and not necessarily purchases of new equipment.

But the divergence in capital allocation is striking nevertheless, and a reversion to previous norms would probably have a significant negative impact. Should the Dividend Aristocrats need to reinvest more money into their businesses, either secondary to new competitive threats or business opportunities, probability suggests that many of them would have to dip into existing cash flows, especially given their current state of indebtedness and the prospect of rising interest rates. This, in turn, would potentially put dividend growth and stock valuations at risk.

Point 3: Despite increasing payout ratios, slowing earnings growth, increasing indebtedness, and the possibility of diminished free cash flows, companies trade at remarkable premiums to historical norms, and are fully valued relative to analyst expectations.

Perhaps this point is not surprising. After all, the Dividend Aristocrats have indeed outperformed the wider S&P 500 by a significant margin over the past decade:

The premium investors now pay for the Dividend Aristocrats is about twice as high as it was a decade ago, with median trailing P/E's north of 22x. Keep in mind, we are talking about mature companies whose earnings have been demonstrated to be slowing, and whose debt ratios are climbing.

But even putting aside these concerns, the Dividend Aristocrats are priced for perfection. A review of their prices relative to historic ratios shows that they are trading well above where they would if things were to revert back to the mean. And even if things didn't revert back to the mean, and even if things didn't go wrong and earnings were to grow according to analyst expectations, and even if no companies were to experience any sort of solvency issues, the Dividend Aristocrats would still be expensive.

Company

Ticker

Price

Analyst Consensus Target

DCF Model

Historical Median

SYSCO CORP

SYY

$48.71

$47.90

$43.91

$29.11

C R BARD INC

BCR

$221.26

$224.29

$246.69

$124.03

CINCINNATI FINANCIAL CORP

CINF

$69.14

$63.50

$53.77

$38.58

CLOROX CO

CLX

$130.56

$124.67

$123.59

$83.47

LOWE'S COS INC

LOW

$79.72

$86.43

$125.81

$41.82

MCCORMICK & CO INC

MKC

$105.28

$94.78

$76.53

$53.39

BECTON DICKINSON AND CO

BDX

$166.06

$174.88

$137.17

$122.49

CINTAS CORP

CTAS

$143.88

$94.30

$81.08

$73.91

EXXON MOBIL CORP

XOM

$89.57

$85.02

$101.92

$63.78

LEGGETT & PLATT INC

LEG

$50.13

$50.25

$41.33

$27.12

PENTAIR PLC

PNR

$60.96

$59.06

$46.60

$31.02

MEDTRONIC INC

MDT

$80.92

$85.00

$88.44

$59.02

WAL-MART STORES INC

WMT

$70.38

$67.63

$72.12

$65.65

COLGATE-PALMOLIVE CO

CL

$70.98

$73.59

$84.54

$33.83

STANLEY BLACK & DECKER INC

SWK

$112.53

$120.31

$128.64

$71.88

AT&T INC

T

$38.47

$39.57

$55.34

$30.32

CONSOLIDATED EDISON INC

ED

$72.38

$70.04

$87.55

$43.29

ARCHER DANIELS MIDLAND CO

ADM

$48.28

$39.00

$44.73

$39.22

ECOLAB INC

ECL

$118.55

$118.56

$91.74

$89.79

JOHNSON & JOHNSON

JNJ

$112.89

$117.44

$149.67

$75.28

KIMBERLY-CLARK CORP

KMB

$126.65

$136.83

$111.35

$51.61

PROCTER & GAMBLE CO

PG

$81.31

$84.79

$93.77

$52.32

COCA-COLA CO/THE

KO

$44.49

$48.00

$43.52

$29.57

ILLINOIS TOOL WORKS INC

ITW

$104.72

$109.33

$94.32

$56.05

PEPSICO INC

PEP

$101.15

$111.80

$107.09

$61.94

3M CO

MMM

$168.26

$171.60

$107.09

$92.17

CHEVRON CORP

CVX

$99.98

$103.36

$82.58

$87.18

MCDONALD'S CORP

MCD

$124.28

$132.14

$82.58

$68.78

GENUINE PARTS CO

GPC

$95.38

$96.57

$76.81

$56.99

W W GRAINGER INC

GWW

$225.96

$227.00

$184.19

$165.69

SHERWIN-WILLIAMS CO

SHW

$292.47

$322.67

$199.84

$150.98

T. ROWE PRICE GROUP INC

TROW

$76.73

$78.79

$67.52

$77.58

WALGREENS BOOTS ALLIANCE INC

WBA

$77.36

$94.00

$79.17

$57.88

DOVER CORP

DOV

$86.46

$66.69

$73.89

$47.13

VF CORP

VFC

$61.94

$69.10

$46.48

$33.17

AIR PRODUCTS AND CHEMICALS INC

APD

$55.88

$156.27

$90.92

$73.34

AUTOMATIC DATA PROCESSING INC

ADP

$91.85

$89.79

$79.96

$46.26

NUCOR CORP

NUE

$47.35

$51.87

$26.19

$36.38

PPG INDUSTRIES INC

PPG

$107.59

$124.00

$64.85

$60.43

HORMEL FOODS CORP

HRL

$34.78

$40.50

$28.17

$18.70

EMERSON ELECTRIC CO

EMR

$51.16

$53.30

$54.86

$41.57

CARDINAL HEALTH INC

CAH

$77.70

$91.93

$133.69

$50.05

FRANKLIN RESOURCES INC

BEN

$36.43

$37.54

$42.08

$46.31

ABBOTT LABORATORIES

ABT

$43.52

$46.67

$50.85

$20.23

TARGET CORP

TGT

$69.56

$78.12

$88.37

$60.88

Source: DCF Models - 10-year financial data from Morningstar, analyst consensus forecasts from Zacks and Yahoo!Finance, and 10-year price data from Yahoo!Finance. Analyst consensus target data from Finviz. Historical models - 10-year financial data from Morningstar; pricing data from Yahoo!Finance.

What do I mean? Let's start with historical valuations. Here, the Dividend Aristocrats trade almost 50% higher than they would if the market were to snap back to historical medians. This is notably a wider margin than the companies of the Dow Jones are, where the premium is currently only a mere 25% or so from the historical norms. There is, perhaps, an explanation for this; stocks should trade at a premium in low rate environments, dividend-paying stocks perhaps more so (for income investors), and reliable dividend-paying stocks perhaps most of all. But if that is true, then the reverse should also apply-and should rates begin to climb, one might reasonably expect the premium currently being paid for the Dividend Aristocrats to quickly evaporate.

Furthermore, the stocks here all have analyst expectations fully baked into their prices at this point. To determine this, I utilized a Monte Carlo simulator to derive discounted cash flows for each company, utilizing analyst consensus estimates for revenue and earnings growth. In general, the prices generated by the DCF model matched the price targets issued by a consensus of analysts, suggesting that these price targets are dependent on the companies executing to these expectations-more on that in a second. In comparison to analyst expectations, stocks currently trade at about 0.95-1.0x target prices, on average. There is almost literally no room for error.

Source: 10-year financial data from Morningstar; Analyst Consensus data from Zacks and Finviz.

To make matters worse, analyst expectations seem to be built out of pure fantasy, as the consensus expected growth rates-which, again, are reflected in current price targets-far exceed those seen historically.

Source: 10-Y financial data from Morningstar; Analyst consensus data from Zacks.

This is not to say that these venerable companies are not capable of reaching such lofty goals-the past, as Shakespeare tells us, is merely prologue. It is to say, however, that analysts expect growth that is quite out of character for these companies, and that one might consider taking their expectations-and their price targets-with sizable quantities of salt. And considering that prices now basically bake in these outsized expectations, investors might be well advised to wait before jumping in wholesale, or at a minimum be choosy about which Dividend Aristocrats they purchase at these levels.

Conclusion:

So if you're really looking to invest in the Dividend Aristocrats, it bears mentioning once more that it would probably behoove you to be choosy. I would personally lean towards companies with reasonable debt loads, reasonable valuations, evidence of continued EPS growth, and low payout ratios. I ranked each Dividend Aristocrat and then equal-weighted them by payout ratio, financial leverage, EPS growth, and gave a double-weighting to valuation. Resulting scores are shown below.

Company Name

Ticker

Payout Ratio

Valuation

Leverage

EPS Growth

Overall Rank

SYSCO CORP

SYY

39

29

33

40

42

C R BARD INC

BCR

29

22

36

36

35

CINCINNATI FINANCIAL CORP

CINF

17

40

27

28

38

CLOROX CO

CLX

26

26

45

24

36

LOWE'S COS INC

LOW

10

6

38

7

3

MCCORMICK & CO INC

MKC

21

44

18

13

34

BECTON DICKINSON AND CO

BDX

32

23

34

20

30

CINTAS CORP

CTAS

2

45

11

10

18

EXXON MOBIL CORP

XOM

40

15

8

37

22

LEGGETT & PLATT INC

LEG

22

34

23

16

29

PENTAIR PLC

PNR

47

41

28

45

45

MEDTRONIC INC

MDT

37

12

10

18

13

WAL-MART STORES INC

WMT

15

10

17

17

5

COLGATE-PALMOLIVE CO

CL

41

21

42

30

39

STANLEY BLACK & DECKER INC

SWK

7

13

21

15

4

AT&T INC

T

35

5

31

43

25

CONSOLIDATED EDISON INC

ED

33

17

35

33

32

ARCHER DANIELS MIDLAND CO

ADM

16

25

13

41

26

ECOLAB INC

ECL

13

27

22

8

15

JOHNSON & JOHNSON

JNJ

25

7

5

35

9

KIMBERLY-CLARK CORP

KMB

42

35

46

39

44

PROCTER & GAMBLE CO

PG

38

14

12

38

24

COCA-COLA CO/THE

KO

36

19

37

22

31

ILLINOIS TOOL WORKS INC

ITW

14

30

29

12

21

PEPSICO INC

PEP

34

16

41

32

33

3M CO

MMM

23

42

25

19

37

CHEVRON CORP

CVX

45

18

4

26

17

MCDONALD'S CORP

MCD

31

39

43

21

43

GENUINE PARTS CO

GPC

24

32

19

14

28

W W GRAINGER INC

GWW

12

24

20

4

10

SHERWIN-WILLIAMS CO

SHW

4

38

40

1

27

T. ROWE PRICE GROUP INC

TROW

18

11

1

6

2

WALGREENS BOOTS ALLIANCE INC

WBA

19

8

14

29

8

DOVER CORP

DOV

6

43

15

9

23

VF CORP

VFC

20

33

9

2

14

AIR PRODUCTS AND CHEMICALS INC

APD

43

1

16

27

12

AUTOMATIC DATA PROCESSING INC

ADP

28

36

44

25

41

NUCOR CORP

NUE

44

31

7

44

40

PPG INDUSTRIES INC

PPG

5

37

32

3

19

HORMEL FOODS CORP

HRL

9

28

3

5

7

EMERSON ELECTRIC CO

EMR

30

9

26

31

16

CARDINAL HEALTH INC

CAH

8

2

39

34

11

FRANKLIN RESOURCES INC

BEN

3

3

2

11

1

ABBOTT LABORATORIES

ABT

27

20

6

42

20

TARGET CORP

TGT

11

4

30

23

6

The 5 worst-scoring firms, using these metrics, were Pentair (NYSE:PNR), Kimberly-Clark (NYSE:KMB), McDonald's (NYSE:MCD), Sysco (NYSE:SYY), and Automatic Data Processing (NASDAQ:ADP), generally due to valuation, though each has problems with EPS growth, leverage, or payout ratio. McDonald's, in particular, looks fully valued with regard to analyst targets, and its ROE in recent years has been largely secondary to an increasing amount of debt, though recent actions taken to revamp its menu may end up driving up excess returns down the road. Kimberly-Clark is a firm that I would personally love to buy, but which has never traded at a discount, and whose EPS growth has been slowing of late.

The top 5 best-scoring firms were Franklin Resources (NYSE:BEN), T. Rowe Price (NASDAQ:TROW), Lowe's (NYSE:LOW), Stanley Black & Decker (NYSE:SWK), and Wal-Mart. Target (NYSE:TGT), Hormel (NYSE:HRL), Walgreens Boots Alliance (NASDAQ:WBA), Johnson & Johnson , and G. W. Grainger rounded out the top 10. I had recently bought into Lowe's myself some time ago, and would be interested in adding to my position if the share drops. Wal-mart had been looking more attractive until the recent run-up in share price. Nevertheless, consider these names as a start for your research.

Disclosure: I am/we are long LOW, VFC, PG.

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.