5 Strong Dividend Yielding Stocks With Solid Dividend Cushion Ratios

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Includes: ABB, CAH, HRB, QCOM, WU
by: Valuentum
Summary

At Valuentum, we focus on forward-looking free-cash-flow based analysis coupled with a balance sheet assessment when it comes to evaluating the dividend health of a company.

The most attractive dividend payers, in our view, are not only those that have raised their dividends consistently historically, but those that appear poised to do so moving forward.

Let’s look at five companies that couple attractive dividend yields with solid Dividend Cushion ratios. We’ll dig into their respective dividend prospects and discuss our opinion of their valuations.

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By Valuentum Analysts

We believe that assessing the forward-looking free-cash-flow and balance-sheet dynamics of a business, in conjunction with the firm's dividend payout ratio and other items, is a more reasonable approach in determining whether a firm has the capacity to continue paying and growing dividends than the dividend payout ratio alone. This line of thinking has led us to develop the forward-looking Valuentum Dividend Cushion ratio. The Dividend Cushion measure is a ratio that sums the existing net cash (total cash less total debt) a company has on hand (on its balance sheet) plus its expected future free cash flows (cash from operations less all capital expenditures) over the next five years and divides that sum by future expected cash dividends (including expected growth in them, where applicable) over the same time period.

Basically, if the ratio is significantly above 1, the company has financial capacity to pay out its expected future dividends, by our estimates. The higher the ratio, the better, all else equal. An elevated ratio doesn't ensure the company will keep paying dividends, however, as management's willingness to do so is another key consideration, but the ratio acts as a logical, cash-flow based ranking of dividend health, much like a corporate credit rating, for example, ranks a company's ability to pay back debt (default risk).

Income investors generally would like to see a Dividend Cushion ratio much larger than 1 for a couple of reasons: 1) the higher the ratio, the more "cushion" the company has against unexpected earnings and cash shortfalls, and 2) the higher the ratio, the greater capacity a dividend-payer has in boosting the dividend in the future. In this article we will dig in to the dividend prospects of five companies in which we have varying levels of confidence in the payout.

Qualcomm (QCOM)

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QUALCOMM has gobs of free cash flow to allocate to future dividend payments, but ominous anti-competition complaints hang over the company. The high level of drama surrounding the firm increases uncertainty.

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Assessment of Company Dividend Strategy

Key Strengths

As the complexity of technology accelerates, QUALCOMM sets out to solve the problems such complexity poses, and providing advancing technology at significant scale is one of the firm's mantras to continue to transform its business and the world. It sees its core mobile addressable market growing to $33 billion by 2020 from $23 billion in 2015, but has also identified dozens of billions of dollars in adjacent and additional growth opportunities. The termination of the NXP Semi deal means its balance sheet won't take on significantly more debt, but it owed a $2 billion termination fee and now holds a net debt position. It is shareholder friendly and has returned ~$59 billion to shareholders since fiscal 2003 via share repurchases and dividends.

Potential Weaknesses

QUALCOMM's Dividend Cushion ratio has taken a hit due to its net cash position flipping to net debt in fiscal 2018, and it held ~$4.2 billion in net debt at the end of the fiscal year (inclusive of short term debt). The recent addition of a significant amount of debt to fuel share repurchases may not be the most prudent capital allocation strategy, and a $2 billion termination fee paid to NXP Semi as a result of the deal being called off has also impacted balance sheet health. Free cash flow has also been volatile of late. It is too early to tell whether recent anti-competition complaints will impact the dividend, but we are taking a cautious stance on the developments as they have the potential to challenge the core of QUALCOMM's licensing model.

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ABB (ABB)

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ABB targets a steadily rising annual dividend over time. The firm pays its dividend in Swiss Franc, so US investors should expect some currency-related volatility.

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Assessment of Company Dividend Strategy

Key Strengths

ABB is the world’s largest builder of electrical grids and looks set to experience some nice tailwinds in its operations in the coming years. ABB boasts a healthy Dividend Cushion ratio that is supported by the company’s strong free cash flow generation and reasonable balance sheet. We like its target of generating free cash flow of at least 90% of net income. The firm's solid yield adds appeal to its seemingly safe dividend, but currency exchange rates can impact the payout. Average annual free cash flow generation of more than $2.9 billion from 2015-2017 has been sufficient in covering annual run-rate cash dividend obligations of ~$1.6 billion. Management has stated it has a high priority for maintaining a steadily rising, sustainable dividend.

Potential Weaknesses

Faults in ABB's dividend payout seem to be few and far between. We're not ruling out more share repurchases in the future, which could impact the pace of dividend expansion moving forward as it increases the magnitude of a competing allocation of capital. Investors should also be aware of the impact macroeconomic and geopolitical uncertainty can have on ABB's business as its projects often require a degree of visibility in terms of sovereign policies and secular trends. It is important to note the firm's payout is in Swiss Francs, so US investors should expect volatility due to foreign exchange rates. Otherwise, we feel ABB's dividend is solid.

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Western Union (WU)

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Western Union scores well on our dividend metrics, but competitive pressures to its business cannot be ignored.

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Assessment of Company Dividend Strategy

Key Strengths

Western Union has grown its dividend in impressive fashion in recent years. The firm's Dividend Cushion ratio indicates it has significant room for continued growth as well. The company generates solid free cash flows thanks to its capital-light business model, which drives its Dividend Cushion ratio. Western Union has returned over 90% of free cash flow to shareholders through dividends and share repurchases in recent years. This speaks to the shareholder-friendliness of management's capital allocation strategy, as does its above average dividend yield. The firm is looking to the consumer-to-consumer market for growth, but innovation in the digital sphere will be necessary to remain competitive. Nevertheless, we're expecting continued growth in the payout.

Potential Weaknesses

Western Union's dividend is on solid ground. However, recent competition and other factors have led to stagnant revenue and earnings performance lately. Though this is not a cause for concern for the health of its business, it may be an indication that it is time for management to shift its capital allocation focus from returning cash to shareholders to investments in its business. Western Union's balance sheet is not a cause for concern thanks to the cash-like instruments included in 'Settlement Assets,' but it is worth noting that total debt stood at nearly $3.3 billion at the end of the third quarter of 2018. Given the firm's solid Dividend Cushion ratio, we don't see any weakness in its payout, but we will be monitoring its capital allocation strategy moving forward.

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H&R Block (HRB)

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H&R Block's Dividend Cushion ratio is solid, but we're watching trends surrounding its business closely as it recently decided to pursue a lighter physical footprint as it works to adapt to changing times.

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Assessment of Company Dividend Strategy

Key Strengths

H&R Block provides an essential service to a large portion of the population, and international expansion represents the firm's most attractive growth opportunity. Its brand recognition and ability to raise prices helps buoy performance. The firm has begun expanding its operations in Canada and Australia and recently launched services in Brazil and India as well. Its asset-light operations (capital expenditures are expected to be between 3%-4% of total revenue) allow it to generate substantial free cash flow, which averaged ~$553 million in fiscal 2016-2018, well in excess of annual run rate dividend obligations of $200 million. The firm has paid 210+ consecutive quarterly dividends, a streak we expect to continue for the time being.

Potential Weaknesses

Perhaps the largest obstacle to the pace of dividend expansion at H&R Block in the near term is competing allocations of capital. Management boasts of its substantial returns of capital to shareholders, but a significant portion of such returns have come via share repurchases, particularly in fiscal 2016. The firm plans to opportunistically buyback shares moving forward. H&R Block's worldwide client volumes have not performed well as of late. The growing number of individuals that prefer to file their own taxes poses a threat to not only its operational health, but also the health of its payout over the long run. This was evident after H&R Block announced plans to close 400 US offices as online filing and other factors reduced demand.

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Cardinal Health (CAH)

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Cardinal Health's dividend has room for growth, but its business is facing multiple near-term challenges. A larger net debt position is weighing on its Dividend Cushion ratio.

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Assessment of Company Dividend Strategy

Key Strengths

Cardinal Health is everywhere – it serves more than 24,000 US pharmacies and provides resources to nearly 85% of the hospitals in the US. The company’s strategic priorities include, among others, growing its scale and breadth in generic distribution, while expanding in China and other non-US markets. Replacing its lost business with Walgreen’s is near the top of the list as well. Revenue growth has picked up after years of stagnation (the mark in fiscal 2015 was flat with fiscal 2011 levels), but operating earnings tell a different story, up 40% over the same time period. Free cash flow has averaged ~$1.9 billion during the past three fiscal years (2016-2018), far in excess of its annual run rate cash dividend obligations (~$581 million).

Potential Weaknesses

The executive team prides itself on “balanced” capital deployment, but over the 3-year period ending fiscal 2018, the company has allocated ~$9.9 billion to acquisitions and $1.8 billion to share buybacks, while ~$1.7 billion went to the dividend. We think Cardinal Health could do more for income investors, especially when capital spending has been only ~$1.2 billion over the same time period. The company lost its distribution contract with Walgreens in August 2013, showing that competition is no slouch (AmerisourceBergen won the deal). Long-term debt stood at ~$8 billion at fiscal 2018 end, but it does have a decent cash balance ($1.8 billion). Generic drug pricing deflation is worth watching as it relates to Cardinal's bottom-line performance.

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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.