3 Picks For The Dividend Growth Index

Includes: ETE, NVS, WMT
by: Dividend Monk

This article covers my three selections for the Dividend Growth Index. The Dividend Growth Index is a fun project between eight dividend growth bloggers, where each person in the group has selected three stocks, for a total of 24 dividend paying companies. It’ll be an interesting index to follow.

My three selections are Wal-Mart Stores Inc (NYSE:WMT), Novartis (NYSE:NVS), and Energy Transfer Equity (NYSE:ETE). These are not recommendations to buy these companies, nor am I predicting that these will be the market’s best picks over the next few years. I’ve selected them for numerous reasons; primarily expectations of solid risk-adjusted returns, and diversification.

Picking only three stock choices brings is a lot of risk, but with 24 companies, it mitigates the risk somewhat. Still, my picks were chosen with the following in mind:
-I want to balance downside risk with upside potential for the three companies as a whole.
-I want the picks to represent different levels of risk and reward.
-I want at least a moderate average dividend yield between the three companies.
-I want diversification between business sectors, as well as geographic diversification.

For each pick, I’ll provide an overview of the company, a brief summary of my investment thesis for the business, my view of how it fits in with these three choices to meet the above goals, risks that may come up to make it a poor choice, and lastly I’ll present several metrics for each business.

Wal-Mart Stores Inc (WMT)

Walmart is an enormous general retailer of goods in the US and other areas. The company has revenue of over $430 billion and a market cap of nearly $180 billion.

Investment Thesis
Walmart has been growing EPS like clockwork. In addition to putting capital towards developing new stores or making acquisitions, they also buy back their own lowly valued shares, which reduces the total number of shares. In addition, they pay a growing dividend, and have done so for decades. The company has a large economic advantage in the form of scale- they can buy in such large quantities that they can secure prices that beat their competitors. The price to earnings is currently under 12, and forward P/E is projected to be even lower because EPS is expected to continue increasing.

Walmart is not the type of company at this stage in the business to make outsized returns. But it’s a fairly conservative pick, and is likely to result in decent risk-adjusted returns over the long term. If management can pay a 2-3% dividend yield, and grow EPS at just 6-8% per year, then that makes for decent returns for the level of risk that an investor is taking on.
Full Walmart Analysis

How it Fits
Walmart’s role of the three is to be the slow and steady workhorse. Due to a combination of organic growth, acquisitions, and share repurchases, WMT has grown EPS every year for at least the last ten years. Based on analyst expectations, and my own understanding of the scalability of the business along with things like share repurchases, I don’t expect Walmart to break this string of EPS growth any time soon. If there’s a significant bear move in the market, I’d expect Walmart to hold it’s ground better than the aggregate portfolio.

Walmart has had a flat stock price for the past decade, despite having excellent financial performance, because the valuation has been steadily reducing. While I believe Walmart has gotten to a fundamental point in valuation where expected risk-adjusted returns don’t make much sense for it to go any lower, there’s no immediate catalyst for stock price growth, so it wouldn’t surprise me for the flatness to continue for a bit. (A decreasing valuation gives reinvested dividends and share repurchases a better rate of return anyway, but a flat stock price is not too attractive to either impatient investors, or an index). So if there’s a bull stock market, Wal-mart might be left in the dust of the index.

In addition to that mostly technical note, Walmart has some fundamental risks. Online retailers may continue to grow in market share. Costco (NASDAQ:COST) may continue to pierce Walmart’s defense by accepting very low net profit margins in order to compete on price. Walmart is already highly saturated in the US, and their plan to use small stores in urban areas may not provide the same type of returns in the past. The company’s international expansion efforts or acquisitions may not provide great returns. If the US economy were to improve, Walmart may see a modestly negative shift as customers move to higher-end stores.

Five-Year Revenue Growth Rate: 6%
Five-Year EPS Growth Rate: 10.7%

Dividend Metrics
Dividend Yield: 2.81%
Payout Ratio: 33%
Five-Year Dividend Growth Rate: 15%
Most Recent Dividend Increase: 20.6%

Balance Sheet Strength
Total Debt/Equity: 0.68
Interest Coverage Ratio: 11
Goodwill/Equity: 0.25

Price-to-Earnings: 11.7
Price-to-FCF: 17
Price-to-Book: 2.65

Novartis (NVS)

Novartis is one of the world’s leading health care companies, with a large pharmaceutical segment, and also a growing generics segment. The company is based on Switzerland, and has large exposure to both the US and Europe, as well as other places around the world.

Investment Thesis
I picked Novartis because their diversification, valuation, and patent situation places them near the top of multinational drug makers at the current time. Although NVS does have upcoming patent expirations, they have Gilenya to replace some of that loss, and they also have a leading generics segment. The company has increased its annual dividend every year since it went public in the mid-90′s, has a solid balance sheet, and is at what I consider an appealing valuation.
Full Novartis Analysis

How it Fits:
Novartis has a modest valuation, offers a moderate dividend yield, and is in an industry I find appealing to the long term. I think the business has a lot going for it, and while I consider it riskier selection than Walmart, its very large-cap, diversified profile spreads risk out so that it’s not so risky of a pick. It’s also the only non-US based company out of the three, since it’s based in Switzerland rather than the US.

Novartis faces a 2012 patent expiration of a leading drug, Diovan. There’s also a lot of hope for the drug Tasigna to replace Glivec, and if it does not perform as expected, that could cause financial loss. Health care also faces ongoing regulation, and heavy litigation risks. The state of the European Union in general may affect even a strong business like Novartis in a negative way. There’s also currency risk.

Five-Year Revenue Growth Rate: 9%
Five-Year EPS Growth Rate: 10.2%

Dividend Metrics
Dividend Yield: 4.24%
Payout Ratio: 48%
Five-Year Dividend Growth Rate: 13.8%
Most Recent Dividend Increase: 4.8%

Balance Sheet Strength
Total Debt/Equity: 0.36
Interest Coverage Ratio: 15
Goodwill/Equity: 0.47

Price-to-Earnings: 13
Price-to-FCF: 12.5
Price-to-Book: 2

Energy Transfer Equity (ETE)

Energy Transfer Equity is a publicly traded master limited partnership that owns the General Partner interest in Energy Transfer Partners (NYSE:ETP) and Regency Energy Partners (RGNC), and has a deal to acquire Southern Union (NYSE:SUG). The partnership, therefore, owns interest in a vast natural gas pipeline and storage network, as well as a propane business and some other business segments.

Investment Thesis
Since ETE owns the General Partners (and more specifically, the Incentive Distribution Rights) of ETP and RGNC, ETE is entitled to a growing share of profits from ETP and RGNC, meaning that when those two partnerships grow their distributions to unitholders, ETE should grow its own distribution even more quickly. Holding a general partner as an investment adds an element of risk, but also offers potentially superior returns, as one can expect both a large distribution yield and significant distribution growth.
Full Energy Transfer Equity Analysis

How it Fits:
ETE’s place in the portfolio is to be the higher risk, hopefully higher reward selection. I expect ETE to have robust distribution growth over the next several years, along with their sizable distribution yield. However, the company is rather leveraged, and is acquiring more assets which may stretch the balance sheet, so this definitely isn’t a conservative pick.

In a word: leverage. ETE has more leverage than I am typically willing to take on with an investment. Asset-heavy businesses like MLPs typically need large amounts of leverage, but ETE is a bit more aggressively leveraged than the average based on its structure. Both ETP and RGNC have fair leverage, but ETE gets most of its income from these businesses, and also carries its own parent debt, so equity is basically nonexistent (despite the name). If ETP were to cut its distribution, it would affect ETE in an even more negative way, because their Incentive Distribution Rights would but cut even more.

The business also has some exposure to commodity costs, and is dependent on the general state of the economy.

As an MLP, and particularly a GP MLP, ETE should be described with a somewhat different set of metrics than the above corporations. Funds From Operations (FFO) is particularly important, and a certain degree of leverage is expected in an asset-heavy infrastructure business with low returns on assets and large depreciation amounts. Rather than present a large number of metrics here, I suggest readers take a look at my full article on ETE.

Combined Annual Distributions from ETP and RGNC to ETE: $628 million.

Dividend Metrics
Distribution Yield: 7.19%
Three-Year Distribution Growth Rate: 14%
Most Recent Distribution Growth: 11.6%

Balance Sheet Strength
LT Debt/Equity of ETP: 1.3
LT Debt/Equity of RGNC: 0.5
Additional Parent Debt of ETE: $1.8 billion

Disclosure: At the time of this writing, I own shares of NVS and ETE. WMT is on my watchlist for potential purchase.

You can see my portfolio here.