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Even in soft economic environment, there are companies out there that are continuing to increase dividends for their shareholders. While dividend increase is good, it is more critical to make sure we understand that companies can sustain their dividends. Following are four companies that recently announced their quarterly results and increased dividends.

Brady Corp (BRC): It is a dividend achiever and has paid increasing dividends for last 24 years. Most recent dividend increase of 2.9% was in September 2009.

The 4Q09 earning per share was $0.37 (vs. $0.64 in 4Q08).

I had presented stock analysis for CBY and observed that it is good dividend growth company. CBY is an international dividend achiever has been raising its dividends for last 11 years. The most recent dividend increase was in February 2009. Investors holding CBY shares are hedged against international growth, dollar fluctuations, and emerging markets. In addition, it continues to maintain its leadership position in segments of confectionery business with its unparalleled reach across the global, multiple brands, and diversified revenue streams. Therefore, CBY knows its market positioning and brand potential.

In my view, overall KFT’s offer was a good for CBY shareholders and they should take the money and run. But the inclusion of KFT stocks in the bid offer is what I think makes CBY as undervalued. CBY is much bigger global brand than KFT, for which KFT needs to dole out cash (and not its shares). Accordingly, CBY rejected the first bid offer hoping to stoke competitive bidding from Nestle and Hershey. This is a good scenario for CBY and its shareholders.

This leaves KFT in a very intriguing position. KFT acquisition seems to be driven by its quest to become more competitive to Mars, inorganically get into higher profitability business, and expand into emerging markets. KFT made an offer worth USD 16.7 billion which includes cash and stock component. It will have to increase proportion of cash in its bid offering or raise the offer all together. KFT shareholders are being motivated by the statistics that their revenue growth will increase to 5%+ (instead of 4%+) and earnings per share will grow 9% to 11% (instead of 7% to 9%). If I were KFT shareholder, I would question these projections and its implications. Do I really want to spent USD 16.7 billion, probably more, to get this 2% additional growth in EPS? In a nutshell, management is saying, we cannot increase shareholder value organically, or give us USD 16 billion for inorganic growth of 2%?

Furthermore, KFT already has close of USD 25 billion of debt on the books. The acquisition of CBY will add financing debt and CBY’s existing debt. I would tend to assume that the total combined debt will easily go beyond USD 30 billion. Therefore, two or three years down the road  the value preposition or growth projection that KFT management is showing is likely to be out of whack.

I do not think KFT’s existing management which made this offer knows what is growth or value to shareholders. We investors need to understand that real growth or values means increased return on capital. Putting the company under huge debt for 2% top line growth is not a wise decision. What this does is (1) it generates enormous fees for investment bankers; and (2) C-suite officers get brownie points for building large global companies. These managers and investment bankers will not structure a deal which includes a clause for scheduled payments depending upon how the deal works out over a period of time. They take their fees and run. KFT shareholders are getting a raw deal.

To me, it is immaterial whether KFT increases its dividends or not, it is immaterial whether this acquisition goes through or not. KFT management has shown lack of vision by going after and overpaying (or over offering) for 2% revenue growth.

Full Disclosure: No position in any of stocks discussed in this post.

In general, I have always tried to compare dividend stocks yields to S&P500. But I have not had a minimum dividend yield floor value, below which I have not invested. Another aspect is, it is likely that the low dividend yield is perhaps due to the higher stock price which in turn could mean good quality stock. As an example, I have been holding on to LOW stock for a while now. I tend to look for quality of the dividends, risk to dividends, and core competency of the company. Let us take two examples.

• John Wiley & Sons (JW.A) is in publishing industry where there is a general concern about industry’s continued decrease in profitability. Contrary to this trend, JW.A continues to have stable gross and operating margins, generates stable operating and free cash flows. Its core competency is digital publishing that focuses on the subscriber based products. It does not have to depend upon advertising revenue alone. Notwithstanding, the low payout and low dividend yields, the company will last longer than 10 years. Therefore, I believe low dividends yield alone should not be a show stopper.

• Becton, Dickinson and Company (BDX) is another example of low dividend yield stock. The company does not have excessively high debt levels and hence, is not affected by financial turmoil. It does not depend upon the credit markets. BDX generated more than half of its sales from outside of US which seems to be recovering faster than US economy. Yes, it does have challenges such as regulatory driven change in spending patterns, health care reforms, or recession driven slow down. But these issues will affect the whole industry and not BDX alone.  Contrary to general belief, BDK operates in an industry with high barriers to entry. The quality and reliability requirements for end products in this industry are among the stringent ones. It has build business around its core competency which makes me think and believe that it will last for more than 10 years.

I am still in my early thirties and have a long way to go before I stop investing. So if I think the company has some core competency, competitive advantage, low risk to dividends, and will survive beyond ten years, then I am open to invest in such low yield dividend stocks. I believe the slow steady earnings will provide capital gains and help me moderate out total returns.

Trend Analysis
Here I am looking at trends for past 10 years of corporation’s revenue and profitability. These parameters should show consistently growth trends. The trend charts and data summary are shown in images below.

• Revenue: In general, a growing trend since 1999. The reduction in 2008 is due to divestiture of business unit. The average revenue growth for last 10 years has been approximately 9%.
• Cash Flows: Operational and free cash flow has been more or less stable until 2005. Although year 2008 cash flow issues can be arrtibuted to divestiture of business unit, it is difficult to understand what happened in year 2006 and 2007. Not a good observation.
• EPS from continuing operation: In general, it is range bound, but there is no consistency in earnings.
• Dividends per share: Dividends in local currency (i.e. GBP) has been growing consistently since 1997. Minor differences or reductions are reflection of currency fluctuations.

CBY - Summary of Trends

CBY: Data Summary

Risk Parameter Calculation
Here I use the corporation’s financial health to assign a risk number for measuring risk-to-dividends. The risk number for risk-to-dividends is 2.00. This is a medium risk category as per my 3-point risk scale.

Quality of Dividends
This section measures the dividend growth rate, duration of growth, consistency over a period of past five years.

• Dividend growth rate: The average dividend growth of 8.7% (stdev. 10%) is higher than average EPS growth rate of 6.8% (stdev. 29.1%). Dividends have grown faster than earnings per share.
• Duration of dividend growth: 11 years.
• 4 year rolling dividend growth rate for past ten years: Less than 10%
• Payout factor: In the past 10 years, the average has been 75%. Presently it is at 63%. Historically, the company has maintained high payout ratio.
• Dividend cash flow vs. income from MMA: Here, I analyze how the dividend cash flow stacks up against the income from FDIC insured money market account. The baseline assumption is (a) stock is yielding 2.9%; and (b) MMA yield is 3.4%. Last 10 years average dividend growth rate has been 8.7%, however, my projected dividend growth rate is 6.8%. With my projected dividend growth of 6.8%, the dividend cash flow is equal to MMA income in 10 years time period. For dividend cash flow to be twice the MMA income, the pricing has to be $21.12 (i.e. yield 4.9%)

Fair Value Calculation
This section determines what price I should pay to buy a given stock

• Net present value (NPV) price based on 15 year DCF: $19.3
• Average high yield price calculated based on past 10 years: $24.1
• Pricing based on past 10 year relative price-to-earnings ratio. $35.6
• Pricing based on price-to-earnings ratio of 12: $20.4
• Graham number: $20.3

The range of fair value is calculated as $21.9 to $23.6.

Qualitative Analysis
CBYs history can be traced back to 1824. It has survived all the significant ups and downs in the global economy. This demonstrates that it keeps adapting to changes in the market place.

• CDY continues to maintain its leadership position in confectionery business, with its unparalleled reach across the global, multiple brands, and diversified revenue streams.
• It is operates in a consumer staples industry, which historically does not get affected by recessions. However, history apart, CDY has shown signs of slowing growth.
• Year 2007 and 2008 results may show erratic cash flow. However, I believe those are due most likely due to divestiture of business unit.
• One significant concern that I have is the reduced operating margins and high payout factor. Both on these metric may affect the near future dividend growth. Management has acknowledged this as an issue and has been focusing on profitability. Most of which is centered around cost cutting.

Conclusion
I like CBY’s global presence. Overall, it is a company that will provide international exposure, hedge against dollar fluctuation, and proxy for emerging markets. It has been raising dividends for last 11 years. The stock’s current risk-to-dividend rating is 2.00 (medium risk). However, the current pricing of $37.87 is much higher than my fair value range. I would buy a long position, when it falls into my buy price.

Full Disclosure: No position at the time of writing.

During these economic challenging times, one of the key aspect that helps us understand the financial strength of the company (and stocks) is its ability to pay growing dividends. It is also critical to make sure we understand whether companies can sustain their dividends. Following are eight companies that recently announced their quarterly results.

McDonalds Corporation (MCD): The 2Q09 earning per share was $0.98 (vs. $0.87 in 1Q09).

• The key highlight was reduced overall profits on y-o-y basis (vs. $1.04 in 1Q08) due to fluctuations of exchange rates.
• Quarterly dividend of $0.50/share is well covered with earnings. The quarterly payout ratio is 51%.

 3M Company (MMM): The 2Q09 earning per share was $1.12 (vs. $0.74 in 1Q09).

• The key highlights were increased EPS, reduced overall income, and reduced revenue.
• Increased EPS seems to be due to controlled operating expenses.
• In near term, it seems that quarterly dividend of $0.51/share is well covered with earnings. The quarterly payout ratio is 45%.

 Procter & Gamble Company (PG): The 4Q09 earning per share was $0.80 (vs. $0.84 in 3Q09).

• The key highlight was reduced earnings on q-o-q and y-o-y basis (vs. $0.92 in 4Q08) and reduced revenue.
• For year 2009, EPS increased by 17% to $3.64 (from $4.26). This increase is due to sale of Folger’s business unit.
• Yearly dividend of $1.76/share is well covered with earnings. Payout ratio is at 41%.

Clorox Corporation (CLX): The 4Q09 earning per share was $1.20 (vs. $1.08 in 3Q09).

• The highlight was 8% increase in EPS (vs. $1.13 in 4Q08) on y-o-y basis.
• For year 2009, EPS increased 16% to $3.81 (from $3.24)
• Increased EPS came from combination of increased revenue and cost control.
• Annual dividend of $2.00/share is well covered with earnings. Payout ratio is 52%.

 The Chubb Corporation (CB): The year 2Q09 earnings per share was $1.54 (vs. $0.95 in 1Q09).

• This is increase in earnings on y-o-y (vs. $1.27 in 2Q08)
• The highlights were increase in operating income (6%) and reduced revenue from premium collections.
• Quarterly dividend of $0.35/share is well covered with earnings. The annual payout ratio is 23%.

 PepsiCo (PEP): The year 2Q09 earnings per share was $1.02 (vs. $1.05 in 1Q09).

• The key highlights were reduced y-o-y EPS (vs. $1.05 in 2Q08).
• Y-o-Y revenue reduced by 3%. The reduction in EPS was due reduced sales of Pepsi’s beverage products.
• Quarterly dividend of $0.45/share is very well covered. Quarterly payout ratio is 44%.

 AT&T Inc. (T): The 2Q09 earning per share was $0.54 (vs. $0.53 in 1Q09).

• The key highlights were reduced overall profits on y-o-y basis (vs. 0.63 in 1Q08) and reduced revenue.
• Quarterly dividend of $0.41/share is barely covered with these earnings. This quarter’s payout ratio is close to 76%.
• The last few quarters shows that payout ratios have increasing trends. Is this a warning sign?

 United Parcel Service Inc. (UPS): The 2Q09 earning per share was $0.44 (vs. $0.40 in 1Q09).

• The key highlights were reduced overall profits on y-o-y basis (vs. 0.85 in 1Q08) and reduced revenue.
• Quarterly dividend of $0.45/share is not covered with these earnings. The quarterly payout ratio is more than 100%.
• The quarterly payout ratios have been above 100% for two quarter in a row now.
• Expect dividend cuts for UPS.

 Based on these results, we can observe that earnings from MCD, MMM, PG, CLX, CB, and PEP cover the dividends paid to the shareholders. These can be sustained. However, T and UPS are at the point where dividends are either close to earnings or already exceed the earnings. As the payout ratio start increasing beyond 70% it is perhaps a warning sign that dividends will be under strain unless earnings improve.

 
Full Disclosure: Long on PG, MCD, and PEP.

ADM is a dividend aristocrat and has been raising its dividends for last 34 years. The most dividend increase was in February 2009. I view ADM in dividend portfolio as a proxy for commodity asset class. Considering the recent turmoil in commodities sectors, my objective here is to analyze if ADM still continues to be a good dividend growth stock and how does it rate on my scale of risk-to-dividends.

Trend Analysis
Here I am looking at trends for past 8 years of corporation’s revenue and profitability. These parameters should show consistently growth trends. The trend charts and data summary are shown in images below.

• Revenue: In general, a growing trend since 2001. The average revenue growth for last 9 years is 21%.
• Cash Flows: Very erratic operating cash flow with significant reductions since 2005. Negative in 2007 and 2008. Same trends fro free cash flow. Not a good observation.
• EPS from continuing operation: In general, increased trend, with exponential growth between 2004 and 2007.
• Dividends per share: Consistently growing dividends since 2000 (and before than since last 34 years).

ADM: Trend Analysis

ADM: Data Summary

Risk Parameter Calculation
Here I use the corporation’s financial health to assign a risk number for measuring risk-to-dividends. The risk number for risk-to-dividends is 2.14. This is a medium risk category as per my 3-point risk scale. The reduced gross margin and negative EPS growth rate in 2008 makes it a medium risk to dividends.

Quality of Dividends
This section measures the dividend growth rate, duration of growth, consistency over a period of past five years.

• Dividend growth rate: The average dividend growth of 17.2% (stdev. 8.7%) is less than average EPS growth rate of 28.6% (stdev. 39.1%). Dividends have grown slower than earnings per share.
• Duration of dividend growth: 34 years.
• 4 year rolling dividend growth rate for past ten years: More than 10% for past 8 years. 14% for last five years.
• Payout factor: In the past 8 years, it has always been less than 35%. Presently it is at 18%.
• Dividend cash flow vs. income from MMA: Here, I analyze how the dividend cash flow stacks up against the income from FDIC insured money market account. The baseline assumption is (a) stock is yielding 2.1%; and (b) MMA yield is 3.4%. Last 8 years average dividend growth rate has been 17.2%, however, my expected dividend growth rate is 8.5%. With my projected dividend growth of 8.5%, the dividend cash flow is equal to MMA income in 10 years time period.

Fair Value Calculation
This section determines what price I should pay to buy a given stock

• Net present value (NPV) price based on 15 year DCF: $15.5
• Average high yield price calculated based on past 10 years: $20.5
• Pricing based on past 10 year relative price-to-earnings ratio. $43.1
• Pricing based on price-to-earnings ratio of 12: $33.2
• Graham number: $35.4

The range of fair value is calculated as $23.9 to $29.6.

Qualitative Analysis
ADM’s history can be traced back to 1902. It has survived all the significant ups and downs in the economic growth of United States. This demonstrates that it keeps adapting to changes in the market place.

• ADM is continues to maintain its leadership position in agriculture business, with its unparalleled global asset base, flexible processing capabilities, and financial strength. Unlike its business competitors, ADM focuses on long term profitability and building core competency.
• It is operates in a cyclical commodity industry. While current recession seems to have had an impact on its year-over-year financial results, it continues its asset expansion through acquisitions and capacity expansion. To me any corporations that still can go down that path in recession is something that shows positivity and management’s confidence.
• It’s year-over-year may show cash flow concern or reduced EPS. However, I believe those are due to capacity expansions and acquisitions.
• In addition, a lot has been said about ADM’s push into ethanol business and its long term viability and sustainability. I believe ADM has positioned itself (and still continues to do so) as an undisputed leader of ethanol producer. The market for alternative fuel is bound to grow in future.
• One thing that came as a surprise to me was the gross margins and operating margins are in single digits. Perhaps, it is the operational capability that allows it to maintain continued profitability at such low margins. At such low margins, there is no room for error.

Conclusion
I like ADM’s global asset base, focus on long term profitability, and diversified product strategy. I also like ADM as a proxy for agriculture commodity asset class. It has been raising dividends for last 34 years. The stock’s current risk-to-dividend rating is 2.14 (medium risk). I recently initated a long position in ADM for (1) agriculture commodity exposure; (2) slow dividend growth company with potential capital long term appreciation; and (3) relatively low volatile stock in my portfolio.

Full Disclosure: Long at the time of this writing.