4 Dividend Stocks To Consider And 2 To Avoid

Includes: AZN, ECA, LNT, PEP, SU, WBA
by: Mark Bern, CFA

By Mark Bern

I own two of these stocks and am considering the purchase of two others, although I may wait for another dip to occur before adding them. Of the other two, both may have long-term potential but short-term there are potential problems. The purpose of this article is to help dividend growth investors who look for rising dividends understand that the trend in dividend growth may change for the worse and that there are other traits that must be considered.

Rising dividends, in and of themselves, are a good trait, but if the fundamentals that have supported those increases are under attack the investor needs to reassess the future value of the underlying stock and its future earnings potential. In the case of the stocks highlighted here, four have sound, sustainable business models that are able to grow earnings faster than the rate of global economic growth and two are unable to sustain growth due either to forces outside of management's control or to management's inability to continue to execute the business model that led the company to its position of prominence.

The point is that if, as an investor, you are looking for good dividends you should first look at the quality of earnings to determine the sustainability of those dividends.

I differentiate these stocks based upon my expected average total return over the next five years. The first four have very favorable outlooks by my estimates while the other two could see the respective stock prices fall from current levels. I have written more detailed focus articles on most of the stocks over the last three months and links to those articles can be found here, should readers want to dig a little deeper into one or more of the companies on this list.

PepsiCo (NYSE:PEP) is the world's second largest food and beverage company. The company has 19 brands that contribute more than $1 billion in sales annually each. In 2000, that number stood at just 10 brands. The company derives more than 45 percent of its revenue from outside the U.S. and continues to grow that percentage, especially in emerging and developing markets from which it already originates 30 percent of company revenue. I don't know what the market will do in the short or even the intermediate term, but I do know that those companies that consistently post higher earnings, rising dividends and maintain strong financial positions will see their stock prices rise over the long term. PepsiCo is among that elite group that can lay claim to a bright and prosperous future, in my opinion. The company's dividend has risen for 39 consecutive years and still has room to grow. My estimated average annual total return over the next five years is 18%.

Alliant Energy (NYSE:LNT) supplies electricity, gas and other related services in Wisconsin, Iowa and Minnesota. Much of what I like about this company is the relative safety of the dividends which have increased for eight consecutive years. What makes this utility stand out from others for me is the potential earnings growth. At 6%, earnings should grow faster than the industry average of about 3.5%. That 2.5% may not seem like much, but in utilities it's huge. The non-regulated RMT has a healthy pipeline of wind and solar projects and should help this utility to outpace its peers in the next few years. The current dividend yield is 4%. I expect the total return for LNT to average about 9% annually over the next five years with about half of that coming from dividends.

Walgreens (WAG) is my third entry and is the largest drug retail chain in the U.S. The company has achieved the scale necessary to get better bargains from suppliers and has initiated improvements in its product mix to increase both sales and margins. Walgreens sales of generic drugs result in higher profit margins than from branded drugs. The coming disaster facing big pharmaceutical companies of having several multi-billion dollars branded drugs come off patent is a looming bonus for the company. Walgreens has paid a dividend every year since 1933 and has raised its dividend for 36 consecutive years. The current dividend yield is 2.7%. When we combine the potential for appreciation along with the rising dividend I believe we can expect an average annual total return in the area of about 15% per year from current levels.

Suncor Energy (NYSE:SU) is an integrated oil company focusing on Canada's oil sands. It is the leader in the oil sands play as the company was the first to begin a commercial oil sands operation in 1967. To quote a comment from one of my readers, rjj1960, "The key is that 90% of their reserves are on Canadian soil, not up in the North Sea or Nigeria. As technology advances, they should see the cost per barrel go down. This company, according to what I read, has 7 billion barrels of proven reserves and another 20 billion of probable reserves. What other oil company has those reserves?" The dividend is still a bit skimpy with a current yield of about 1.4%, but the payout ratio is low also at less than 15%. I expect the dividend to rise nearly 10% per year on average while earnings increase at a more robust rate of 15% on average for at least the next five years. I also believe that there is plenty of room in the current price for P/E expansion. My estimated average annual total return over the next five years is 20%.

AstraZeneca PLC (NYSE:AZN) is a global pharmaceutical company with 54% of sales from the U.S. and is headquartered in the U.K. The company has a nice portfolio of drugs currently, but is about to experience significant patent expirations over the next five years. Three of its largest drugs are among those about to come off patent. Also, over $3.5 billion of debt is coming due over the next five years. I expect earnings per share growth to go negative by an average of 5% per year. I also don't expect the company to be in a position to raise its dividend. This is not the type of story I consider appealing as a potential investment. The current dividend is 3.6%. I expect the shares to trade relatively flat over the next five years with an average total return of 5%. Let's avoid AZN for now and watch how management deals with the problems it faces.

EnCana (NYSE:ECA) is a pure play on Canadian natural gas. The company pays a nice dividend yielding 4.3%, but there is some risk as to whether the company can maintain the dividend level as earnings per share for 2011 are likely to drop below the declared $0.80 per year dividend level now in place. Unless this winter turns unseasonably cold, natural gas prices are more likely to drift lower that go up. That is not good news for EnCana shareholders. The long-term potential is much better for EnCana than the short term, but I would not purchase shares until we see what is going to happen with the dividend. After the dividend cut, if it occurs, there may be an opportunity for investors willing to hang on to shares for at least five years. But for now, I would avoid EnCana until I see some upward movement in natural gas prices due to a better balance between supply and demand. If investors already own EnCana, I would hold on for the long term. I just can't be certain what earnings will do until the picture for natural gas becomes more supportive of higher prices.

Disclosure: I am long PEP, WAG.