2 Dogs Of The Dow To Buy, 1 To Avoid

Includes: GE, MRK, PFE, T, VZ
by: Bidness Etc

In this article, we will look at the 2012 "Dogs of the Dow," and analyze them from the perspective of dividend sustainability. We are bullish on few Dogs of the Dow, with the exception of AT&T Inc (NYSE:T), which has an unsustainable payout ratio of 250%. This high payout does not seem to be backed by its operating cash flows, which have declined, and an unimpressive free cash flow yield compared to its dividend yield of 5%. General Electric (NYSE:GE) and Merck Co and Inc. (NYSE:MRK) have high payout ratios as well, but they are well backed by their respective operating cash flows and high free cash flow yields.

General Electric

General Electric is a multinational conglomerate that produces various industrial products, as well as consumer appliances. Its operations also span healthcare, energy and financial services.

GE is a high dividend stock, currently yielding 3.50%. Not only is that significantly higher than its peers, but it also provides value. GE's gross and operating margins are impressive at 36% and 10% respectively, higher than its peer Siemens AG 's (SI) figures at 29% and 9% respectively. The company's margins have also expanded over the last three years, with Energy Infrastructure revenues growing by 18% in the first quarter of 2012, mainly due to increased equipment sales. GE's earnings have grown at a CAGR of almost 11% over the last two years. A consistent earnings growth may lead to a high price-to-earnings multiple for the company, which is currently at a discount (16X) to its industry average (18X). The company has a dividend payout ratio of 52% and has paid dividends every quarter for over a hundred years. It is currently paying an annualized dividend per share of $0.68 for the current fiscal year, growing by almost 17% from the previous $0.58 per share. GE has an impressive free cash flow yield of almost 21% with cash of around $84 billion as of the most recent quarter. However, the company's cash flows from operations have declined by almost 30% in the first quarter of the year compared to 4Q2011. We believe that the company is a good dividend stock to hold based on its dividend history, and even though it has a healthy payout ratio of 50%, it will be able to sustain it with its cash flows and a high free cash flow yield of 21%.

GE's dividend history

(Click to enlarge)

AT&T Inc

AT&T Inc. , together with its subsidiaries, provides telecommunications services to consumers, businesses, and other providers worldwide. The company's wireless segment offers wireless voice and data communication services, such as local wireless communications services, long-distance services, and roaming services. This segment also sells various handsets, wirelessly-enabled computers, and personal computer wireless data cards; and accessories.

T is a high dividend stock, currently yielding 5%, higher than its peer Verizon Communications Inc. (NYSE:VZ). T has posted impressive gross margins of 55%, however, they are on the decline YoY, largely due to rising selling, general and administrative expenses. The company had impressive earnings of almost $20 billion in FY2010, but has ever since been on the decline, with the company reporting a loss in the quarter ending December, 2011. The company's P/E of 51x is at a premium to the industry average, indicating that the stock is overvalued. The company has a very high dividend payout ratio of 250%, which is not well supported by its free cash flow yield of 3%. It has a cash balance of almost $3 billion as of the most recent quarter. Yearly cash flows from operations have remained steady at around $34 billion, but with a decline of almost 28% visible in the latest quarterly results. We believe that the company's high dividend payout ratio is not sustainable based on its contracting earnings and margins, as well as a levered free cash flow yield of only 3%.

Merck & Co Inc.

Merck & Co. Inc provides various health solutions through its prescription medicines, vaccines, biologic therapies, animal health, and consumer care products. The company provides human health pharmaceutical products, such as therapeutic and preventive agents for the treatment of human disorders in the areas of cardiovascular, diabetes and obesity, oncology, vaccines, and women's health and endocrine. MRK has a dividend yield of 4.2%, higher than its peer Pfizer Inc (NYSE:PFE)'s yield of 3.90%. MRK posted an impressive gross margin of 66% in the year ending 2011, however, the margin contracted from the previous year. MRK's earnings grew in excess of 600% in FY2011, and this growth has carried forward in the company's quarterly results as well. This earning growth may lead to a high price-to-earnings multiple for the company, which is currently at a discount of 56% to the industry average. MRK has a dividend payout of 71% and is currently paying an annualized dividend of $1.68, up 4 cents from the previous quarterly dividend of $0.38. MRK's payout is well supported by its free cash flow yield of 10% and healthy operating cash flows, as of the most recent quarter end, of $13 billion, showing a two year CAGR of almost 90%. Its cash balances have grown over the years as well, and it has a reasonable amount of debt with no serious threats to its profitability. We believe that the stock provides good value to its investors in terms of dividends, and will be able to maintain its payout of 71% going forward.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.