3 Undervalued Dividend Growth Ideas

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Includes: AAPL, AMAT, JCOM
by: Valuentum
Summary

We want to find stocks that will increase their dividends for 25 years into the future, not use a rear-view mirror to find the most attractive names of the past.

In this article, we're looking for strong dividend growth stocks, meaning that in addition to considering the fair value estimate range, the Dividend Cushion is also very important.

Let's dig into our thoughts on the dividend growth and capital appreciation potential of j2 Global, Applied Materials, and Apple.

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Image source: Valuentum

By Valuentum Analysts

There is a lot behind the Valuentum process for capital appreciation and dividend growth, respectively, but let's dig into the latter a bit more in this article. We're looking for strong dividend growth stocks, meaning that in addition to considering the fair value estimate range, the Dividend Cushion is also very important. We still look to find highly-rated stocks on the Valuentum Buying Index and those that are undervalued in our dividend growth research, but we may be more open to ideas that have strong dividend growth prospects, on the basis of the forward-looking Dividend Cushion ratio.

Most dividend analysis that we've seen out there is primarily backward-looking - meaning it rests on what the firm has done in the past. Although analyzing historical trends is important, we think assessing what may happen in the future is even more important. The S&P 500 Dividend Aristocrat List, or a grouping of firms that have raised their dividends for the past 25 years, is a great example of why backward-looking analysis can be painful. One only has to look over the past few years to see the removal of well-known names from the Dividend Aristocrat List - including General Electric (GE) and Pfizer (PFE) - to understand that backward-looking analysis is hardly worth your time. After all, you're investing for the future, so the future is what you should care about more.

We want to find stocks that will increase their dividends for 25 years into the future, not use a rear-view mirror to build a portfolio of names that may already be past their prime dividend growth years. The Valuentum Dividend Cushion measures just how safe the dividend is in the future. It considers the firm's net cash on its balance sheet (cash and cash equivalents less debt) and adds that to its forecasted future free cash flows (cash from operations less capital expenditures) and divides that sum by the firm's future expected dividend payments. At its core, it tells investors whether the firm has enough cash to pay out its dividends in the future while considering its debt load. If a firm has a Valuentum Dividend Cushion above 1, it can cover its dividend, but if it falls below 1, trouble may be on the horizon.

Without further ado, let's take a look at three companies that we find to have attractive dividend growth profiles in addition to potentially attractive valuation opportunities. Included in this article are j2 Global (JCOM), Applied Materials (AMAT), and Apple (AAPL).

j2 Global (JCOM)

j2 Global is a leading provider of Internet services through its two business segments 'Business Cloud Services' and 'Digital Media.' Its 'Business Cloud Services' segment provides cloud services to businesses of all sizes and licenses its intellectual property, while its 'Digital Media' segment specializes in the technology and gaming markets. The firm was founded in 1995 and is headquartered in Los Angeles.

Investment Highlights

• Over 80% of j2 Global's 'Cloud Services' segment revenue (more than 40% of total revenue) is generated via fixed subscriptions; variable cost subscriptions and other license revenues account for the balance in the segment. We like the visibility this revenue stream provides.

• Roughly 29% of j2 Global's 2017 revenue was derived from fax-to-email related services and products, meaning its success is in part dependent upon the continued use of fax. One of the key demand drivers in this area is the lack of a universally accepted method for electronically signing documents. Widespread adoption of such a method would materially impact the company

• j2 Global is exposed to the economic cycle via its customers, and any downturn could lead to a material reduction in usage rates, customer acquisitions, and retention. Acquisitions are core to its growth strategy, opening it up to identification, integration, and execution risk. Large deals are not typical, but its balance sheet health should be monitored.

• In addition to its visible revenue stream, j2 Global's 'Cloud Services' segment has a scalable subscription-based business model, and its focus on small businesses helps its diversity (customer base of over 3.2 million). Acquisitions should continue complimenting organic growth.

Image source: Valuentum

Dividend Analysis

j2 Global boasts a nice combination of a strong Dividend Cushion ratio and a solid dividend yield, which sit at 2.5 and ~2.4% as of this writing.

Image source: Valuentum

Assessment of Company Dividend Strategy

Key Strengths

Over 80% of j2 Global's 'Cloud Services' segment revenue (more than 40% of total revenue) is generated via fixed subscriptions; variable cost subscriptions and other license revenues account for the balance in the segment. We like the visibility this revenue stream provides, and the business should continue to scale nicely. The segment should continue to help drive free cash flow generation, which is the driver of j2's strong Dividend Cushion ratio, moving forward as a result. Free cash flow averaged $231 million in 2015-2017, easily covering annual run rate cash dividend obligations of $73 million multiple times over. We'll be watching competing capital allocation options such as M&A activity but continue to expect dividend growth.

Potential Weaknesses

While j2 Global's strong Dividend Cushion ratio suggests its dividend is in solid shape, it is not without risks. Roughly 29% of its 2017 revenue was derived from fax-to-email related services and products, meaning its success is in part dependent upon the continued use of fax. The company is exposed to the economic cycle via its customers, and any downturn could lead to a material reduction in usage rates, customer acquisitions, and retention. Minor acquisitions are core to its growth strategy, opening it up to identification, integration, and execution risk. As of the third quarter of 2018, it held a net debt position of $707 million, and we're keeping an eye on this debt load even as we expect solid dividend growth to continue.

Applied Materials (AMAT)

Applied Materials may be the largest supplier of semi equipment, LCD fabrication equipment to the flat panel display industry and photovoltaic manufacturing systems to the solar industry, but substantial competition exists in all areas of its business. The firm was founded in 1967 and is headquartered in Santa Clara, California.

Investment Highlights

• In both semiconductor and display, major changes in device technology provide a catalyst for the firm's growth. With the coming of artificial intelligence, an explosion of data generation from machines is expected to drive demand for data storage and compute models and architectures.

• Applied Materials expects short term headwinds such as macroeconomic risks, global trade tensions, and a pullback in memory investments to eventually give way to demand and pricing stabilization in the back half of 2019. It is targeting non-GAAP EPS of $5.08 in fiscal 2020 and expects its 'Services' and 'Display' segment to grow at 15% and 23% CAGRs, respectively.

• As with its peers, Applied Materials' growth will largely be driven by strength in mobile devices and the proliferation of connected devices in the 'Internet of Things.' The company expects wafer-fab equipment spending to remain at consistently high levels in the near term with 2018 and 2019 combined spending estimated at $100 billion.

• The semiconductor industry has been increasingly driven by consumer demand for lower-cost electronic products with increased capability. The rapid pace of technological change can quickly diminish the value of Applied Materials' current technologies.

Image source: Valuentum

Dividend Analysis

Applied Materials has an excellent Dividend Cushion ratio of 4.4. Dividend growth had been non-existent in recent years until management returned to robust growth in the payout in fiscal 2018. Shares yield ~2.4% as of this writing.

Image source: Valuentum

Assessment of Company Dividend Strategy

Key Strengths

Applied Material's business strategy that enables major technological inflections for customers has earned it the top spot in many of its markets served, resulting in increased sales and EPS since 2013. With that, management has set lofty targets to reach by 2020, including EPS of $5.08, though we think that may be stretching it a bit. Operating cash flow dropped by roughly 35% in fiscal 2015 but has since rebounded significantly. Free cash flow generation averaged more than $2.9 billion from fiscal 2016-2018, covering annual run rate cash dividend obligations of $605 million several times over. Applied has never decreased its dividend, but its balance sheet flipped to a net debt position of ~$1.3 billion from net cash of ~$2 billion a year earlier.

Potential Weaknesses

Although Applied Material retains sufficient liquidity, it cannot be ignored that it recently took on $1.8 billion of additional debt, limiting its financial flexibility. Also, a large stock buyback program has been implemented as it added $6 billion to a remaining $2.8 billion authorization as of the end of calendar 2017. Higher debt service costs and buybacks may absorb earnings and free cash flow and challenge the pace of future dividend growth. But in light of those risks, Applied Material's strong balance sheet and free cash flow generation allow us to feel confident in its ability to continue to raise the dividend. Management's doubling of the payout in fiscal 2018 suggests it has meaningfully increased its willingness to raise the payout relative to recent years.

Apple (AAPL)

Apple is as much a brand as it is one of the world's most innovative companies. The firm is no longer known for its iPods and personal computers, as the proliferation of the iPhone over the past decade has been a sight to behold. The company's execution remains top-notch, and we expect it to continue to roll out innovative products in smartphones and wearable technology.

Investment Highlights

• Apple's rollout of future iterations of the iPhone should propel its fundamentals higher. Though we're not embedding another blockbuster hit in our model, we wouldn't be surprised if Apple delivers another one from its pipeline. It recently upped its Advanced Manufacturing Fund to $5 billion from $1 billion.

• Apple's growing Services segment bodes well for its long-term gross margin performance, and the segment is on track to hit its goal of doubling its revenue from 2016-2020. Apple Pay is now accepted by ~60% of US retailers, and paid subscriptions totaled 330 million at the end of fiscal 2018. Wearables has been an area of strength, and Apple holds ~45% of global smartwatch market share, according to estimates.

• Investors should pay close attention to the firm's gross margin, which fell to just over 38% in fiscal 2018 from 40% in fiscal 2015 and is expected to remain below 40% in the near term. Pricing and cost pressures may be unavoidable, and currency exchange rates should not be ignored as Apple generates more than 60% of its revenue outside the US.

• Apple's cash hoard is more than some of the market caps of the largest firms in the S&P 500. It retains tremendous flexibility, but it plans to take its balance sheet to cash-neutral over time. Its dividend growth potential may be unmatched for now, and buybacks have become a focal point in its cash-neutral strategy.

• Though an end may be far from imminent, the legal battle between Qualcomm (QCOM) Apple took a turn in Apple's favor after a patent lawsuit filed by Qualcomm was thrown out by a German court. Qualcomm had previously won a case that enabled it to ban the sale of older iPhones in Germany--it also recently won a similar ruling in China--but the full slate of iPhones remain available through carriers and resellers. Apple will no longer stock the iPhone 7 and 8 at its 15 retail outlets in Germany. Apple continues to offer its iPhones in China but has made a change to its iOS as a result of the order.

Image source: Valuentum

Dividend Analysis

Apple's dividend growth potential is excellent thanks to its robust free cash flow generation and fortress-like balance sheet. It registers a robust Dividend Cushion ratio of 5.8 and shares yield ~1.9% as of this writing.

Image source: Valuentum

Assessment of Company Dividend Strategy

Key Strengths

Along with being one of the most innovative companies, Apple boasts unparalleled brand strength, giving it a material competitive advantage. We love what it has built through its ecosystem of apps and the presence it has in the everyday lives of consumers. A core tenet of Apple's investment thesis, and its dividend strength, is its massive net cash position, which stood at ~$126.6 billion at the end of fiscal 2018 (inclusive of short-term debt). The company's tremendous free cash flow generation allows such a position to proliferate while continuing to pay a growing dividend. It averaged more than ~$56.5 billion in free cash flow from fiscal 2016-2018, well in excess of annual run-rate cash dividend obligations of ~$13.7 billion.

Potential Weaknesses

With such an impressive Dividend Cushion ratio, we have a difficult time finding large drawbacks in Apple's dividend growth profile. Cash flow from operations faced some pressure in fiscal 2016 and 2017, but any transient weakness in its operational performance should not impact dividend health in the near term thanks to its cash hoard. Competing capital allocation options have the potential to impact the pace of dividend expansion moving forward, specifically through strategic acquisitions of differentiated technology and share repurchases. Buybacks came in at an astounding $72.7 billion in fiscal 2018. We're not particularly fond of Apple's decision to go to a cash-neutral balance sheet, but it is far from a concern at this point in time.

Disclaimer: This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.