Originally published October 11th, 2016.
By Ben Reynolds
This is the part 1 in the 50-part Dividend Aristocrats in Focus series on The Dividend Aristocrats. What is a Dividend Aristocrat?
Dividend Aristocrats are businesses that meet the following criteria:
Members of the S&P 500
25+ Years of consecutive dividend increases
Certain minimum size and liquidity requirements
For a business to pay increasing dividends for 25+ consecutive years, it must possess a strong and durable competitive advantage and a shareholder friendly management that emphasizes dividend payments.
"When we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever."
- Warren Buffett
As you might expect, the Dividend Aristocrats Index has outperformed the market by 3.1 percentage points a year over the last decade.
Source: S&P Fact Sheet
Intuitively, it makes sense that businesses with competitive advantages and shareholder-friendly managements would outperform the market over long periods of time.
Selecting from Dividend Aristocrats is a 'shortcut' to investing in high-quality dividend growth businesses. Analyzing every Dividend Aristocrat helps investors know what to look for. Certain patterns emerge when analyzing the best businesses in the world. There's much to learn from the Dividend Aristocrats in Focus series.
This year's Dividend Aristocrats in Focus series takes a slightly different approach from prior years. Dividend Aristocrats will be examined in order based on GICS sector. This way, patterns between Consumer Staples stocks will become apparent as investors read the analysis of all of them in order as opposed to switching from sector to sector.
The number of Dividend Aristocrats in each of the 11 GICS sector is below:
Consumer Staples - 13
Industrials - 8
Health Care - 7
Consumer Discretionary - 6
Financials - 5
Materials - 5
Energy - 2
Information Technology - 1
Real Estate - 1
Telecommunication Services - 1
Utilities - 1
The Dividend Aristocrats Index is dominated by the Consumer Staples sector. The Consumer Staples sector is the best sector for long-term sustainable competitive advantages. On the other end of the spectrum are the Information Technology, Real Estate, Telecommunication, and Utilities Sectors. Each has only one constituent in the Dividend Aristocrats Index.
The first sector we will cover is the Utilities Sector. The sole utility sector Dividend Aristocrat is Consolidated Edison (NYSE:ED). This article takes a look at the investment prospects of Consolidated Edison.
Consolidated Edison Business Overview
Consolidated Edison is a regulated utility holding company. The company owns Consolidated Edison Company of New York (Abbreviated: CECONY) and Orange and Rockland Utilities (abbreviated: O&R).
CECONY sells electricity, gas, and steam in New York City and Westchester County. O&R sells electricity and gas in New York and New Jersey.
In addition, the company has ownership in midstream gas businesses and competitive energy businesses.
The image below gives an overview of the company's operating structure:
Source: Consolidated Edison September 2016 Update, slide 4
Make no mistake; Consolidated Edison is by and large an electric, gas, and steam utility. CECONY & O&R generated 95% of 2015 earnings per share. The company's base rate composition is shown in the image below:
Consolidated Edison has a long operating history. The company can trace its history back to 1823 - when it was known as New York Gas Light Company.
61 years into the company's history (1884), several gas light utilities in New York consolidated their businesses. The combined company was known as the Consolidated Gas Company of New York. The consolidated business continued to grow, acquiring gas, electric and steam companies along the way. In 1936, the company changed its name to Consolidated Edison.
A business with such a long-operating history certainly qualified as a blue chip stock. Consolidated Edison has a long dividend history as well…
Consolidated Edison's Dividend History
Consolidated Edison has paid increasing dividends for 42 consecutive years. The company's dividend history since 1982 is shown in the image below:
Source: Data from Yahoo Finance
The stock currently has a dividend yield of 3.7%. The S&P 500 has a dividend yield of 2.1% for comparison.
Two things stand out about Consolidated Edison's dividends:
Long history of slow growth
Relatively high yield versus the market average
Consolidated Edison's last dividend increase was 3.1%. The company has grown its dividends at a compound rate of just 1.5% a year over the last decade. For comparison, inflation has averaged around 1.9% a year over the same time period.
The company's dividend growth over the last decade leaves much to be desired. Keep reading for the company's expected growth going forward.
Growth Prospects & Expected Returns
While dividends have grown at just 1.5% a year over the last decade, the company's earnings per share have grown slightly faster - at 3.1% a year.
Earnings (not earnings per share) actually grew faster. Unfortunately, Consolidated Edison funds part of its growth with share issuances. These issuances have caused a drag on earnings per share growth of 1.6 percentage points a year on average over the last decade.
With 95% of earnings coming from the company's regulated utilities, growth is determined in large part by its rate base growth.
I expect the company to grow its earnings at around 4% to 5% a year going forward. Continued share issuances will hurt growth. In total, I expect earnings per share growth of 2.5% to 3.5% for Consolidated Edison.
This growth, combined with the company's 3.7% dividend yield, gives investors expected total returns of around 6% to 7% a year.
The company's management is targeting a payout ratio of between 60% and 70%. The company's expected 2016 payout ratio is around 65%. Dividend payments should grow in line with earnings per share growth (2.5% to 3.5%) going forward.
Consolidated Edison's growth prospects may not cause excitement, but the company does offer slow (emphasis on slow) and steady growth. The company's 42 years of consecutive dividend increases is a sign of a strong and durable competitive advantage.
Competitive Advantage & Recession Performance
There isn't much guessing about Consolidated Edison's competitive advantage. Utilities naturally lend themselves to natural monopolies.
Consolidated Edison's natural monopoly happens to service New York City. New York City is the world's 7th largest city (depending on how you define the size of a city) based on its metropolitan population of around 20 million.
The utility industry is highly regulated in the United States. This provides further barriers to entry into the market.
Growth will be slow for Consolidated Edison - but growth is very likely to continue due to the company's strong and durable competitive advantage. As long as New York's population grows and people need electricity, gas, and steam, Consolidated Edison will likely pay increasing dividends.
The company sells energy. Its product is vital regardless of the overall economy. As a result, Consolidated Edison tends to perform well during recessions.
The company's earnings per share from 2007 through 2011 are shown below.
2007 Earnings per share of $3.48 (high at the time)
2008 Earnings per share of $3.36 (3.4% decline from high)
2009 Earnings per share of $3.14 (9.8% decline from high)
2010 Earnings per share of $3.47 (recovery, 0.3% off all time high)
2011 Earnings per share of $3.57 (new all-time high at the time)
As you can see, the Great Recession modestly reduced earnings per share in 2008 and 2009. Still, Consolidated Edison's earnings covered its dividend payments - even through the worst of the Great Recession.
The company's stability gives it an exceptionally low stock price standard deviation. Consolidated Edison has the 2nd lowest stock price standard deviation of any Dividend Aristocrat over the last decade… Only Johnson & Johnson's (NYSE:JNJ) is lower.
The company's low stock price standard deviation is a result of its low-risk operations.
Consolidated Edison is trading for 17.8 times expected 2016 adjusted earnings per share.
The company has traded for a price-to-earnings ratio of around 14.5 over the last decade. For comparison, the S&P 500's median price-to-earnings ratio over the same time period is 18.2.
The reason the company's price-to-earnings ratio is elevated is due to historically low interest rates. Low interest rates raise the value of bonds - and bond-like securities. With its slow growth and stable dividends, Consolidated Edison is similar to a bond. Its share price tends to rise when interest rates fall - and fall when interest rates rise.
A 'fair' multiple for Consolidated Edison is around 80% of the S&P 500's price-to-earnings multiple, based on data from the last decade.
With the S&P 500 currently trading for a price-to-earnings multiple of 24.8, this implies a fair price-to-earnings ratio for Consolidated Edison of just under 20.
There is uncharacteristically high risk with investing in Consolidated Edison today. If ultra-low interest rates continue to rise (as the Fed has suggested), Consolidated Edison will very likely see its price-to-earnings multiple revert downward - causing the share price to fall.
Consolidated Edison is a stable, slow-growing utility with a long history of dividend increases. The company's above-average 3.7% dividend yield may be appealing to yield-starved investors.
What bothers me about Consolidated Edison today is the company's sensitivity to interest rates. If interest rates rise, the share price could drop significantly. Consolidated Edison's expected total returns of 6% to 7% a year would take years to 'catch up' if the stock price drops by 20%.
The company makes a potential long-term hold for investors who need above average income with very little risk of a dividend reduction. As a total return play, Consolidated Edison is unattractive.
The company has a mediocre rank using The 8 Rules of Dividend Investing. It scores well for yield and low stock price volatility, but its sluggish growth holds the company back from ranking higher.