One of the key factors that is relevant to most dividend investors is the capacity of dividend-paying companies to sustain and, if possible, to increase their dividend payouts. We are always very cautious about stocks that yield 8% or more. We also pay special attention when a stock's yield is around 5-8% and the stock doesn't have a lot of moat or it is in a challenging business environment. Dividend sustainability and future growth generally depend on a continuous growth in earnings per share (EPS) and free cash flow. A limited number of high-quality companies face transitory obstacles that restrict or undermine their medium-term EPS growth potential.
Here is a look at three companies that face contraction in their EPS over the next five years. These stocks could be out of favor with investors for some time, which could drive their prices to lower levels. However, all three pay generous dividends that are sustainable despite the expected shrinking of their EPS. Their long-term growth prospects remain generally favorable. As such, undervalued relative to their peers and paying high yields, these stocks may represent value and income plays for the long run. Lower price levels would boost their dividend yields and would represent good entry points for investors with faith in the capacity of these companies to stage a rebound in earnings growth in the future.
Eli Lilly & Company (LLY), a multinational pharmaceutical company, pays a dividend yield of 4.7% on a payout ratio of 51%. The company's competitors Merck & Co. (MRK), Pfizer (PFE), and GlaxoSmithKline PLC (GSK) pay yields of 4.2%, 3.9%, and 4.8%, respectively. The company has seen its EPS grow, on average, almost 10% per year over the past five years. Analysts forecast that the company's EPS will contract at an average rate of 8% per year for the next five years. The reasons for the contraction primarily include patent expirations that will hurt revenues, and the slow introduction of new breakthrough drugs.
Late last year, the company lost its U.S. patent on Zyprexa, a blockbuster antipsychotic drug. This year, its patent on Evista will expire, while next year its patents on both Cymbalta and Humalog will end. Growth in several existing drugs, including Cialis, Humalog, Humulin, and Forteo, will partly make up for the loss of Zyprexa revenues. The company has a dozen of pipeline drugs in Phase III clinical trials and looks to "return to sustainable growth after 2014." Eli Lilly's stock is currently trading at $41.57 a share, almost flat year-to-date and close to its 52-week high. The stock has stable cash flows and attractive dividend yield for income investors. The stock boasts a P/E based on the trailing-twelve-month earnings that is well below the industry's average ratio. Fund manager Joel Greenblatt is a major investor in the company (check out his Gotham Asset Management's portfolio).
Vale SA (VALE) is a $98 billion Brazilian mining giant, engaged in the exploration and production of ferrous/base metals. It is the world's largest iron ore miner and the second biggest miner by volume. The company pays a dividend yield of 6.0%, about 4.4 percentage points above its industry on average and as much above the 10-year Treasury yield. Vale SA's payout ratio is 37%. The company's peers BHP Billiton (BHP) and Rio Tinto (RIO) pay dividend yields of 3.5% and 3.9%, respectively. The company's EPS grew, on average, 26% per year over the past five years, aided by the robust iron ore and steel demand in China. In recent years, margin expansion has also contributed to higher EPS growth rates. Still, analysts now forecast that the company's EPS will contract at a 0.9% rate per year for the next five years.
Vale considers that the global market for minerals and metals will remain tight in the long run, helping sustain commodity prices. This remark contradicts the statements from its competitor BHP Billiton which sees a softening outlook for commodities in the medium term. In fact, slumping iron ore prices amid a slowdown in China have already contributed to Vale's first-quarter 2012 earnings plunge. Going forward, a moderating steel demand in China, one of Vale's key export markets, will adversely affect the demand for Vale's products. The stock is trading at $19.13 a share, down 17.5% year-to-date and close to its 52-week low. Based on its forward P/E, the company's stock is undervalued relative to its peers on average and the company's historical ratios. Vale could be viewed as both a value and income play, given it is relatively undervalued and has a high current yield, supported by high net income and a low payout ratio. Billionaire Ken Fisher is upbeat about the company's future prospects.
Exelon (EXC) is a $31 billion utility holding company, supplying electricity to 6.6 million customers in Maryland, Illinois and Pennsylvania and natural gas to some 494,000 customers in Philadelphia. It is the largest U.S. nuclear-power utility and the second-largest regulated distributor of electricity and gas in the United States. Exelon pays a dividend yield of 5.7%, the second-highest yield among the electric utilities, on a payout ratio of 70%. Its main competitors, including Ameren Corporation (AEE) and PPL Corporation (PPL), pay yields of 4.8% and 5.2%, respectively. Exelon's EPS has grown at nearly 10% a year over the past five years. However, analysts forecast that the firm's EPS will contract at an average rate of 0.6% per year for the next half decade.
Given low natural gas prices and the increased hedging of future natural gas volumes through 2014 at low rates, Exelon's electricity prices will remain low in the near future. The company sees next year as the trough in natural gas and electricity prices. It expects that, when natural gas prices rebound in 2014, so will Exelon profits. The company has come under pressure by the electricity regulator in Illinois to reduce its electricity rates. All these factors could significantly undermine the company's revenues and income in the next several years. Still, Exelon has an aggressive plan to increase sales of power generation to retail customers in those states that allow electricity competition (e.g. Texas, Pennsylvania, Ohio, etc.). The company has seen its stock price drop to a new 52-week low of $36.34 a share, down 13% in a year. As regards the forward valuation, the stock is undervalued relative to its industry. The stock is thus both value and income play, supported by low valuation and attractive dividend yield. Fund manager D.E. Shaw (D.E. Shaw-check out its top holdings) purchased a stake in the company last quarter.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.