So far, since I published my first Seeking Alpha article nearly two months ago, modest progress has been made in realigning the portfolio to more closely resemble a well-diversified Dividend Growth portfolio. There is one final stock we haven’t addressed yet that to my way of thinking does not fit my guidelines. If I would not purchase a stock that is currently in my portfolio, the question is why would I keep the stock? I shouldn't, right? So we will look at that position in detail and also a potential replacement in the same sector.
In June the Sand in Shoes portfolio generated $121.73 in dividends, which puts dividends collected in the second quarter at $230.38, well above the $147.94 from Q1. This purchase of Omega Healthcare Investors, Inc (NYSE:OHI) was the primary driver of the increase, and a few dividend increases from International Business Machines (IBM), Southern Company (NYSE:SO), and Southern Copper Corporation (NYSE:SCCO) helped as well.
With the $121.73 in dividends and a strong performances from Amgen (AMGN) and the banks, the portfolio saw a 4.07% increase for the month!
I am obviously thrilled with the performance for the month, but even with the excellent price appreciation I am more excited with the growing dividend stream. If you read my article on the banking stocks I own, you may remember I was fairly interested in finding out the results of the Comprehensive Capital Analysis and Review (or CCAR), which were released the afternoon of June 28. For the first time since they started this stress test, the Fed had no objections to any of the capital plans submitted. As a result, both Citigroup (C) and Bank of America (BAC) substantially increased both their dividend and their stock buyback plans. BAC raised their dividend 60%, from $0.30/share to $0.48/share (annually), and Citi doubled their dividend, from $0.64/share to $1.28/share (again, annually). This brings the yield on both stocks up to approximately 2%. Every one of my positions with one exception is now right at or above 2%. We’ll give C a pass at 1.9%, but SCCO is on notice (see my article here about that).
Below is the projected dividend income if nothing else changes. Total of $237.12, an increase quarter over quarter of almost $7. There may be a dividend increase for OHI as well, but I haven’t seen an announcement to that effect yet.
The sector weightings have changed very little since May 31 so we won’t worry too much about that. The sector weightings may change a great deal next quarter, but that depends on the results of my call option on Southern Copper.
We've discussed most of the stocks and my reason for purchasing them and keeping or selling them. There are a few I have not gotten to yet, so let’s look at a possible change to the portfolio by analyzing one of these stocks that might not fit in to my plans in the long run.
Discussion of COH
I was introduced to the Coach (COH) brand by the fetching Mrs. Soule, and through various birthday or Christmas gifts I came to own a wonderful briefcase, a braided belt, and a portfolio, all of which are still in use and still look great after 10+ years. I have nothing but praise for their products, and this became something of a Peter Lynch type investment.
Invest in what you know.
I have long been invested in Coach making my first purchase in May of 2007. I sold that position about four months later after the stock had run up and I had a few-hundred-dollar gain (about 5.3% including transaction fees). So that was nice. I later purchased these 60 shares back in February of 2013 for $48.25/share and have had a bumpy ride ever since, to now where I am almost back to even money.
When I first purchased the shares to own, not just trade like my first purchase, the company had a history of raising their dividend. The graph from 2009 when they first instituted the dividend policy right up until the quarter I bought the stock looks great. Look at the left half of the chart below. Who wouldn't like that kind of dividend policy? When I purchased the stock in 2013, my first dividend was $0.30 per share and right on cue, they raised the dividend the next quarter to $0.3375/share. And, no, that is not an error in the charting software. That is where the dividend has stayed ever since. So the "dividend growth" portion of this dividend growth stock is broken. Let's see what else we need to consider.
I don't want to delve too deeply into the following numbers since there is an elephant in the room, or 800 lb gorilla, depending on which metaphor you prefer - namely, Coach's recently announced acquisition of Kate Spade & Company (KATE).
|Free Cash Flow||1,040.0M||1,170.0M||765.8M||738.1M||362.2M|
When looking at the above table, the two scariest rows for the dividend investor have to be the declining Free Cash Flow and the payout ratio that last fiscal year reached over 100% of FCF. Looking at the most recent quarter we have numbers for, Net Operating Cash Flow was $200M, Capital Expenditures was $70M, leaving $130M for everything else (this $130M is the definition of Free Cash Flow). Coach pays about $95M in dividends per quarter, so you can see that the business is really not generating enough FCF to boost their dividend. In fiscal year 2016, their cash reserves took a $400M hit, from $1.3B at the end of 2015 down to $859M in June 2016.
One of the things I liked about COH when I first bought it was their total lack of long term debt on the balance sheet. They of course always carried short term liabilities (Accounts Payable, Accrued Payroll, and that kind of thing), but they had, until the last few years, $0 in long term debt. That has changed, and at the end of June last year they had nearly a billion dollars in LT debt ($861.2M), mostly due to their 2015 purchase of the luxury shoe brand Stuart Weitzman. Recently a line item that was previously zeroes is now making a presence in their income statement, namely "Interest Expense" - almost $33M in FY16.
They have worked the $860M down to just under $600M at the end of last quarter, but what is going to happen when they acquire KATE for $2.4B "cash". They don't have $2.4B cash. They have a lot of cash, but not $2.4B. Well, they have set up a $2B credit facility. So one might ask: What will happen to their cash flow when the acquisition is completed? That is the question, and of course it is impossible to answer with any precision.
I can see a long term benefit in Coach's new strategy, which is making acquisitions to turn the company into a luxury brand powerhouse. Kate Spade products, which are far more popular with millennials than Coach products, will have a much larger and more efficient distribution system. There is an estimated $50M in "synergies" to be realized over the next three years. So potentially the cash flow situation could improve, perhaps improve dramatically, but that might take a while.
However, I do not anticipate that the first thing on the board's mind will be hiking the dividend, especially since the company will now be leveraging itself somewhat substantially. The combined equity of COH and KATE as of March 31 stood at about $3.4B, and they have just lined up a credit facility that, combined with KATE's debt and COH's debt, would put their total liabilities above that. So I would expect any excess cash flow would be used to at least partially reduce their leverage (pay down their credit facility).
In short, I do not believe a dividend increase is coming soon and probably not before KATE has been successfully integrated into Coach which will likely take years. In fact, I would put the odds of a dividend cut higher than a dividend hike in the short term. But my best guess is they leave the current dividend policy in place until this acquisition shakes itself out.
Is there a better stock out there, hopefully in the same sector, that we could possibly replace COH with? I'm glad you asked.
Another "Buy What You Know" Company
Every month, especially this time of year, I make a handful of trips to my neighborhood Home Depot (HD) and I seem to have trouble getting out of the store for less than $100. And apparently I'm not alone because in fiscal year 2016 Home Depot had $94.6 billion in retail sales. If you own a home like 63.6% of Americans do, you have probably been to the Home Depot. A lot. Home Depot does a marvelous job of separating home owners from their dollars, and if your family is like mine there is a long list of projects just waiting to be started, nearly all of which will require multiple trips to the big orange box store. So let's take a look at some numbers.
Revenue Per Share Increasing
Home Depot is knocking the cover off the ball in this metric. This is due to a combination of the revenues increasing (of course) and HD's aggressive stock repurchase plan. More on this later. Either way, while COH's revenue per share has remained stagnant, HD is killing it.
Book Value Per Share Increasing
Well this is disappointing. However, we need to dive into the numbers to see what is happening.
- Book Value/Share is defined as Total Shareholders' Equity divided by the Share Count.
- Shareholders' Equity is defined as Assets minus Liabilities.
Home Depot's assets have remained fairly flat of late, from a touch over $41B in 2013 to just under $43B in 2017. Their Liabilities, however, have increased steadily from $23B in 2013 to almost $39B in 2017.
Whoa. What are they doing? Why are they sinking themselves into so much debt? Quite simply, they are repurchasing billions and billions of dollars of their own stock. In 2014 they repurchased $8.55 billion in stock and for the past three years they have purchased roughly $7 billion in stock. They have issued $2-4 billion in Long Term debt (net) each of the past four years. So the liabilities side of the balance sheet has grown quite a bit, which has lowered their book value.
Is this a smart strategy? Let's keep going, and we'll find out.
Well despite taking on ever increasing amounts of debt, Value Line still gives them their highest ratings for both Safety and Financial Strength. That is good news.
We knew this wasn't going to look good, but even though they are taking on more debt, their cash hoard has been growing since 2015 as well. This is good news.
Free Cash Flow & Dividend Payout Ratio
Wow. Turns out that $22B in long term debt is no longer as concerning to me looking at the mountains of cash Home Depot generates while operating their business. In FY2017, Home Depot's Net Operating Cash flow was nearly $10 billion. They historically spend approximately $1.5 billion on Capital Expenditures, call it $3.5 on Dividends Paid, and $7B on repurchasing common stock. That is $2B more than their operating Cash Flow, resulting in HD taking on some long term debt. But this is nothing new, Home Depot has been spending approximately this same amount on these same large categories for four years. There is other noise on the Cash Flow Statement, but notice how these three expenditures are the bulk of what their Cash Flow is spent on: They issued slightly more debt in 2016 than either the year before or after due to their acquisition of Interline ($1.7B). You can argue whether or not borrowing money to repurchase stock or pay dividends is a good idea, but one thing is clear, their cash flow is impressive and if they just toned down the amount of shares they repurchase they would not need to borrow any money, and indeed could start paying the debt down, easily.
Common Shares Outstanding
|1.50 B||1.43 B||1.34 B||1.28 B||1.23 B||-3.9%|
Pretty impressive. In five years Home Depot has reduced their share count by a quarter of a billion shares. This has a large effect on their EPS (Earnings Per Share). While they earned $7.96B in 2017, had their share count remained at 1.50B, the Earnings Per Share figure would have been $5.31 instead of the $6.47 they reported. Of course they would have a lot less debt than they do now, so there are two sides to the story. You have to decide if you're comfortable with the current strategy or not.
Takeaway From Home Depot Research
In my mind, Home Depot is an excellent Dividend Growth Stock, which reminds me, we haven't talked about one very important part of the story though if you were paying attention you already have a glimpse of what I'm about to say. Dividend Growth is taken pretty seriously at the Home Depot. Take a look at the "Dividends Paid" line two tables up to see the amount of cash they are returning to shareholders in the form of dividends. Home Depot has a respectable yield of 2.34% as I type this, but they have also been raising their dividend the past few years like they are angry at something. According to David Fish's most recent spreadsheet, Home Depot has raised their dividend for eight straight years and has a 5-year Dividend Growth Rate of 21.6%! But they have also paid a dividend every quarter since 1987.
So judging by history, paying a dividend and growing the dividend looks to be an important part of the company's capital allocation plan. But don't judge just by history, judge by what they say in their most recent Annual Report:
In February 2017, we announced a 29 percent increase in our quarterly dividend to $0.89 per share, which equates to an annual dividend of $3.56 per share. It is our intent to raise the dividend every year.
I don't know if Home Depot can keep up the 20%+ rate of dividend growth, but I think it is pretty clear they plan on raising the dividend for some time to come.
Fun With Math
So currently the Consumer Discretionary sector (one of eleven sectors) makes up about 10% of my portfolio, all of which is my Coach shares. At 10%, I do not feel the need to either add to or reduce my position in this sector. Home Depot, also a member of the Consumer Discretionary sector could replace Coach quite easily. But would I want to do that?
Let's say I sold my 60 shares of COH, which at current levels would generate about $2,850. Let us also say that I took the cash in my account, about $250, plus the proceeds from my sale of COH and purchased 20 shares of HD. What would my dividend stream look like? How would it change?
Well we need to make a few assumptions. First assumption is that COH has a frozen dividend and it will remain frozen until at least December 2019. Second, I am going to assume HD will continue to hike their dividend, and with how easy it is to model this with spreadsheets, I will explore four different HD scenarios - that they hike the dividend 5%, 10%, 15%, and 20%. Keep in mind last time they raised the dividend they did so by 29%, and the 5 year CAGR is 21.6%. So even the 20% number is perhaps conservative.
As you can see, if HD raises the dividend somewhere just over 10% for the next two cycles (starting with the March 2018 payment), my cash payments through the end of 2019 would be basically a wash. However, if the dividend is raised 15% or more, I will be getting paid more per quarter starting with the March 2018 dividend payment.
Dividend revenue for Q2 was up substantially from Q1 with the Omega Healthcare Investors dividend making the biggest difference. Projected revenue for Q3 is expected to increase slightly if no changes are made to the portfolio.
I am on the fence at this time as to what direction I should take with regards to COH and HD. I could take a slight ding to dividend income in Q3 & Q4 this year if I make the switch, but I think there is a very good chance that starting in 2018 I will be ahead of the game. I will have to think about this, and would like to see what you all have to say about it.
As always, thank you for reading!
Disclosure: I am/we are long AIG, AMGN, BAC, BLK, C, COH, HRL, OHI, SCCO, T.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.