2 Of My Favorite Stocks That Could Fit Your Dividend Income Portfolio

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Includes: LEG, RAI, SPY, XLP
by: Robinson Roacho

Summary

The economy is recovering slowly but surely.

Defensive stocks are always a good idea for portfolio diversification.

DuPont ROE analysis tells us these stocks are buys.

The economy seems to continue recovering from the financial crisis in 2008-09 and the euro crisis in 2011. The consumer confidence index is in the upper range on a multi-year basis according to the latest U. Michigan report. This suggests that cyclical stocks will have a nice performance in the interim. Personally, I believe that we are in the early stages of the bull market because although consumers are confident in the economy, the retail investor is still not confident in the stock market. There are barely bullish headlines in the financial media and there is no evidence of greed or delusion, Figure 1. However, this is a debatable topic and it is best to leave it for another article.

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Figure 1

Although cyclical stocks will produce juicy returns in coming years, diversification is important if one wants to sleep well. Over the last two years, the Consumer Staples ETF (NYSE:XLP) has outperformed the S&P 500 (NYSE:SPY), Figure 2. Therefore, it is a good idea to have defensive stocks in our portfolios. Most of the defensive stocks also pay dividend distributions which are appealing for income investors. Two ideas that I will discuss are Leggett & Platt (NYSE:LEG) and Reynolds American (NYSE:RAI) for you to continue researching upon.

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Figure 2

The return on equity analysis is a powerful analysis that tells us the efficiency of the company of producing income per unit of stockholder's equity. However, the 5-step extended DuPont ROE analysis is far more meaningful because we can see with better clarity the reason for a change in the ROE. For simplification purposes, the assets and equity are taken at the end of the period as opposed to the average. However, this simplification does not affect the results meaningfully.

Leggett & Platt

LEG deserves your attention because its ROE improved by 170 basis points mainly due to improving profit margin. It is important to notice that the financial leverage remained unchanged. Usually, if the ROE increases resulting from the financial leverage, it makes things riskier for the company. However, this is not the case.

In terms of dividend distribution, I like that LEG is confident in finding profitable investments as observed by the plowback ratio. Even though the dividend distribution rose by $0.01 per share, the plowback ratio increased from 39% in Q1 2015 to 50% in Q1 2016. A higher plowback ratio means that the company is using a larger percentage of the earnings to finance new projects. The increase in ROE and plowback ratio resulted in a growth of 4.18% for Q1 2016 compared to 2.56% for Q1 2015.

Q1

Tax Burden

Interest Burden

Profit Margin

Asset Turnover

Financial Leverage

ROE

2016

0.77

0.93

13.6%

0.31

2.77

8.35%

2015

0.71

0.91

11.6%

0.31

2.78

6.52%

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Q1

EPS

Dividend

Plowback

ROE

Growth

2016

0.64

0.32

50%

8.35%

4.18%

2015

0.51

0.31

39%

6.52%

2.56%

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Looking at debt, LEG's long-term debt expanded by $90 million to $1.03 billion from December 2015 to March 2016. It is good that LEG is taking advantage of the multi-year low interest rate environment to issue debt. You should not be concerned at this point because LEG's net income covers easily the interest expense. In fact, the interest coverage ratio increased from 10.15 in Q1 2015 to 13.81 in Q1 2016.

The interest coverage ratio = EBIT / Interest Expense

Q1

2016

2015

EBIT

127.1

111.7

Interest Expense

9.2

11

Interest Coverage Ratio

13.81

10.15

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Overall, Leggett is on the growth track.

Reynolds American

The tobacco company's profit margin improved to 44% in Q2 2016 from 36% in Q2 2015. Also, asset turnover improved from 0.04 to 0.06 over the same period. The return on equity increased from 2.20% to 3.72% despite a significant decrease in financial leverage. Personally, I would have liked to see a similar financial leverage. RAI must take advantage of the low interest rates environment now by issuing long-term debt and finance new projects.

RAI grew by 0.93% for Q2 2016 compared to a contraction of -0.43% for Q2 2016. The reason for the contraction is that RAI posted a significant gain on divestitures in Q2 2016 which resulted in an EPS of $1.70. However, only $0.28 came from recurring operations. Therefore, the plowback ratio was negative and the company experienced a slight contraction. I would not expect dramatic growth going forward since the company is in a mature industry, but at least we must see growth.

Q2

Tax Burden

Interest Burden

Profit Margin

Asset Turnover

Financial Leverage

ROE

2016

0.63

0.89

44%

0.06

2.42

3.72%

2015

0.54

0.86

36%

0.04

2.98

2.20%

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Q2

EPS

Dividend

Plowback Ratio

ROE

Growth

2016

0.56

0.42

25.0%

3.72%

0.93%

2015

0.28

0.335

-19.6%

2.20%

-0.43%

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In terms of debt, RAI's interest coverage ratio also improved on Q2 2016 on a YOY basis from 9.30 to 8.23. There is no reason to believe that RAI will have any issues meeting its financial obligations in the near future.

Q2

2016

2015

EBIT

$ 1,415

$ 865

Interest Expense

$ 152

$ 105

Interest Coverage Ratio

9.30

8.23

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The take home message

The DuPont ROE analysis of LEG and RAI shows that these companies are on the right track in terms of growth. The increase in plowback ratios for both companies is appealing because the managements are sending the signal that they are confident in their projects. I encourage you to consider these companies for your dividend-income portfolio.

Disclosure: I am/we are long LEG, RAI.

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.