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Back to Part XVIII - The Fickle Apparel Industry

By Mark Bern, CPA CFA

If you are joining the series for the first time, you may find it informative to refer to the first article in the series, "The Dividend Investors' Guide to Successful Investing," where I provide more details about my process for selecting companies for my master list and details about why I use the metrics that I do.

I suspect that we may actually be at the bottom in the housing market unless something goes terribly wrong in the next year in Europe, which is entirely possible. Any rebound is not likely to be very robust, but the pent-up demand for housing will eventually put a floor under the market, in my opinion, and I think that we just might be there. Foreclosures will continue to weigh on the market for the next three years, which will hamper the rate of improvement. But if the bottom is in (as I suspect it may be), this becomes a good time to start looking for those companies that are most likely to benefit from the improvements that will eventually follow.

The long-term investor would be well advised to invest in the future of the housing market. This is not a place for short-term horizons. Eventually the housing market will return to a steady climb as new household formation trends improve along with the economy and jobs environment. The healing process may not yet be complete, but the worst may be behind us, and there is a lot of potential for this industry in the future when everything normalizes. We just need to be very selective.

When I first came across Tractor Supply Company (TSCO), I was surprised to see how well the company has done since the housing bubble popped. The company is a destination, carrying almost everything its customers need, and it continues to grow both in terms of new outlets and same-store sales. I expect that there is still a long way to go before the company has saturated its potential markets. TSCO operates in 44 states in the U.S. and has not yet expanded beyond U.S. borders. I expect that the company will begin opening foreign sites within the next five years. If it has as much success overseas as it enjoys in the U.S, the are no limits to its potential success. Let's look at the metrics for TSCO.

Metric

TSCO

Industry Average

Grade

Dividend Yield

1.0%

2.4%

Fail

Debt-to-Capital Ratio

0.0%

28.0%

Pass

Payout Ratio

19.0%

38.0%

Pass

5-Yr Average Annual Dividend Increase

20.8%

N/A

Pass

Free Cash Flow

$2.21

N/A

Pas

Net Profit Margin

5.3%

5.0%

Pass

5-Yr Average Annual Growth in EPS

22.1%

5.6%

Pass

Return on Total Capital

22.2%

12.5%

Pass

5-Yr Average Annual Growth in Revenue

15.1%

1.0%

Pass

S&P Credit Rating

NR

N/A

Neutral

This company has been sailing beneath my radar up until the last year. I can no longer ignore the evidence provided by the metrics. The one fail, one neutral and eight passes are an excellent showing for a company in this industry, especially since the measurement period covers the lackluster recovery in housing. The fail is because TSCO does not pay a dividend as high as we would like. Fortunately, management has been increasing the dividend at a pace similar to the growth in EPS, and with the low payout ratio, there remains room to expand the dividend in the future. I don't expect dividends to grow faster than EPS, as the company continues to open new stores at about an eight percent per year rate and will use its excess cash flow for additional growth. I do expect the dividend to increase every year by about 12 percent or more on average in the future, so I like that aspect enough to accept the lower dividend. I also expect the company to split its shares in the not-to-distant future; a price below $50 per share is more attractive to retail investors, and management wants to appeal to that market. My five-year price target for TSCO is $140, which works out to a compound average annual total return of about 12 percent.

Fastenal Company (FAST) is my second favorite company in this industry. It is amazing to me that a company can carve out a niche within an industry as well as FAST has done. I also like that the company is expanding internationally with outlets in the U.S., Canada, China, Mexico, Puerto Rico, Singapore and the Netherlands.The niche is much larger than I had first imagined years ago, based upon the name, including not just fasteners, but also tools, equipment, blades, abrasives, hydraulics components and accessories, pneumatics, plumbing and HVAC, and janitorial, welding, safety and electrical supplies. FAST does well against the metrics.

Metric

FAST

Industry Average

Grade

Dividend Yield

1.7%

2.4%

Fail

Debt-to-Capital Ratio

0.0%

28.0%

Pass

Payout Ratio

54.0%

38.0%

Fail

5-Yr Average Annual Dividend Increase

26.6%

N/A

Pass

Free Cash Flow

$0.60

N/A

Pass

Net Profit Margin

12.9%

5.0%

Pass

5-Yr Average Annual Growth in EPS

12.9%

5.6%

Pass

Return on Total Capital

24.5%

12.5%

Pass

5-Yr Average Annual Growth in Revenue

9.4%

1.0%

Pass

S&P Credit Rating

NR

N/A

Neutral

Two fails, one neutral ranking and seven passes compare favorably against many companies that have made the list. Of the two fails, the dividend yield concerns me the least. I like that the company is returning value to shareholders, but I also expect the future dividend growth will be slower than the growth in EPS to compensate for the high payout ratio and bring it down in the future. What impresses me about FAST is how well the company has done relative to the peak years in housing. EPS have nearly doubled, revenue is up over 50 percent, and the dividend has more than tripled. My five-year target price for FAST is only $64 per share, which works out to an average annual total return of about 11.5 percent. My expectations are more muted for FAST, because I believe that the stock price has gotten a little expensive and suggest that investors consider waiting for a better price before starting a new position or adding more. I think a correction of ten percent or a little more may be warranted for FAST before I would initiate a position.

Lowe's Companies (LOW) is one of the stocks that I purchased in 2009 when blood was running in the streets. The company is well-managed and has plenty of cash and free cash flow. I am currently selling calls against my position to collect extra income and will not be upset if the shares get called away so I can replace this holding with some shares of TSCO. LOW is a good company, but the recovery is taking longer than I had hoped, and LOW is just not recovering as well as I had hoped. It is a near miss and fell off of my list this year. I will continue to watch the company for further improvement and re-consider it based upon future results. Here are the metrics for LOW.

Metric

LOW

Industry Average

Grade

Dividend Yield

2.5%

2.4%

Pass

Debt-to-Capital Ratio

30.0%

28.0%

Neutral

Payout Ratio

31.0%

38.0%

Pass

5-Yr Average Annual Dividend Increase

28.5%

N/A

Pass

Free Cash Flow

$1.93

N/A

Pass

Net Profit Margin

4.3%

5.0%

Neutral

5-Yr Average Annual Growth in EPS

-3.2%

5.6%

Fail

Return on Total Capital

10.0%

12.5%

Neutral

5-Yr Average Annual Growth in Revenue

5.7%

1.0%

Pass

S&P Credit Rating

A-

N/A

Pass

Only one fail, but only six passes makes LOW a borderline company. I need to see a few more years of consistent increases in EPS to put LOW back on the list. I like that dividends have increased in each of the last nine years and that the pace of increases has been strong. However, a good portion of the increase in dividends came in the last year of the housing boom. Removing the first year (2006) from the analysis lowers the annual rate of increase to 16.4 percent. This is still a healthy rate, though, and the payout ratio still allows for additional room for dividend growth, as long as the company can continue to successfully increase EPS consistently in the future. My other concern is that we may not be quite out of the woods yet in housing, and LOW's EPS appear to be very sensitive to the health of housing. My five-year price target for LOW is $37, which would result in an average annual total return of about 11 percent.

The Home Depot (HD) was a favorite of mine for more than two decades before the housing bubble burst. Fortunately, I had my shares called away before the market peaked. I like the company, and believe that it is on the right track, but similar to LOW, the company needs to continue to show improvements before it will get back on my list for consideration. Let's take a look at the metrics.

Metric

HD

Industry Average

Grade

Dividend Yield

2.4%

2.4%

Pass

Debt-to-Capital Ratio

38.0%

28.0%

Fail

Payout Ratio

42.0%

38.0%

Neutral

5-Yr Average Annual Dividend Increase

8.9%

N/A

Pass

Free Cash Flow

$1.74

N/A

Pass

Net Profit Margin

5.5%

5.0%

Pass

5-Yr Average Annual Growth in EPS

-2.4%

5.6%

Fail

Return on Total Capital

14.5%

12.5%

Neutral

5-Yr Average Annual Growth in Revenue

0.0%

1.0%

Fail

S&P Credit Rating

A-

N/A

Pass

Three fails, two neutral rankings and only five passes. I had expected much better from HD. The one fail, for zero revenue growth over a five-year period, could be considered a neutral, since the miss was so small, but no top line growth at all over five years is not what we want to see from a company on our list. True, the past four years have been difficult, especially compared to the boom times that preceded them. The bottom line for me is that there are other companies in the industry that have thrived during the same period. I prefer to stick with the companies that perform better than average under all conditions. My five-year target price for HD is only $70, which would provide an average annual total return of about 9 percent.

One of the companies that is missing from my list is Sherwin-Williams (SHW). This is a very good company with a great record of increasing dividends every year. The primary reason SHW did not make the list is because EPS in 2011 were still slightly below the 2006 level. A company with zero earnings growth over a period during which others in the industry are growing is not acceptable. I do expect SHW to rebound, but we will continue to keep them on probation until the trend improves more. The other dividend-paying company in the industry is Watsco (WSO), which has the same problem exhibited by SHW. But WSO also has negative free cash flow.

Source: The Dividend Investors' Guide: Part XIX - Retail Building Supplies Near Bottom?