By: Dividend Sensei
Dividend Profile: Safe, Fast Growing Dividend Equals Marketing Beating Return Potential
The most important factor in any income investment is the dividend profile, which is what primarily determines long-term returns. It consists of three parts: yield, dividend safety, and long-term payout growth potential (proxy for earnings and cash flow growth).
|Company||Yield||TTM FCF Payout Ratio||Projected 10 Year Dividend Growth||10 Year Annualized Potential Total Return|
|A.O Smith||1.2%||36%||11% to 12%||12.2% to 13.2%|
|S&P 500||1.8%||40%||6.2%||4% to 8%|
(Sources: Multipl, Gurufocus, FastGraphs, John Bogle, Gordon Dividend Growth Model, Morningstar)
While A.O Smith might have a small yield today, what it lacks for in current income it more than makes up for with dividend safety and growth potential. That safety is from a combination of two factors. First, the company generates impressive and fast growing free cash flow (10% FCF margin) for an industrial company. It pays out just 36% of that to fund the dividend meaning the payout has a strong safety buffer. The other reason is the fortress like balance sheet which gives it incredibly financial flexibility and allows it to invest in strong growth while rewarding income investors with clockwork like dividend increases.
|Company||Debt/EBITDA||Interest Coverage Ratio||Current Ratio||Debt/Capital||Average Interest Rate|
(Sources: Gurufocus, FastGraphs, Morningstar, CSImarketing)
The company’s leverage ratio is less than 1/4th of its peers, and its interest coverage ratio (operating cash flow/interest cost) is sky-high. Meanwhile the current ratio (short-term assets/short-term liabilities) is similarly rock solid. Any figure above 1.0 is safe. This is what allows A.O Smith to borrow at low interest rates which are nearly 10 times lower than its sensational return on invested capital of 32% (an indication of excellent management and capital allocation).
Over the long-term if A.O Smith can achieve the 11% to 12% EPS and FCF/share growth that analysts (and I) think it can, then the company should be able to deliver about 12.5% total returns over time. The S&P 500’s annualized total return since 1871 has been 9.2%, and the market is only expected to generate 4% to 8% returns over the next decade (from current valuations). This means A.O Smith is likely to be a fantastic long-term dividend growth investment.
Valuation: A World Class Company At A Fair Price
I invest by the Buffett mantra that “it’s better to buy a wonderful company at a fair price than a fair company at a wonderful price”. A.O Smith is certainly a wonderful company, but what about its valuation? What’s a fair price for the stock? There is no 100% objectively correct way to know, since there are dozens of ways to value any company. However by using multiple approaches, we can minimize the chances of overpaying. I generally use a combination of three valuation techniques.
First is the total return potential from the dividend profile. This is based on the Gordon Dividend Growth Model, which has proven accurate since the 1950’s. It states that over the long-term a stock’s total return approximates yield + dividend growth (proxy for earnings and cash flow growth). To recommend a stock I need to see market beating potential (otherwise why not just own an index fund). To own it myself I need to see double digit return potential. On both counts A.O Smith passes my first test.
The second approach is comparing its PE ratio to its 20 year average and approximating what growth rate is baked into the stock (using a model pioneered by Benjamin Graham, Buffett’s mentor and the father of modern value investing).
|Forward PE Ratio||20 Year Average PE Ratio||Implied 10 Year EPS Growth Rate||Yield||5 Year Average Yield||13 Year Median Yield|
(Sources: Gurufocus, FastGraphs, Benjamin Graham)
PE ratios, like most valuation metrics, are mean reverting over time, meaning they tend to cycle around a relatively fixed point that approximates fair value. A.O Smith’s forward PE ratio is 7% above its 20 year average indicating it might be slightly overvalued. However it’s also only baking in 6.5% long-term EPS growth which is about half what the company is likely to generate. This implies it’s potentially undervalued.
Finally I compare a stock’s yield to its historical yield, both on a medium and long-term basis. Yields, like PE ratios, are generally mean reverting over time and so long-term historical yields approximate fair value. Based on its five year average yield A.O Smith appears about 9% undervalued, but is fairly valued based on its 13 year median yield. Factoring in all of these different methods I estimate the stock is worth $59 per share and so about 1% overvalued right now. That’s essentially fair value, and for a world class, Grade A blue chip like this (and a dividend aristocrat to boot), I’m more than happy to call A.O Smith a buy right now.
Estimated Fair Value
|Discount To Fair Value|
(Sources: Gurufocus, FastGraphs, Simply Safe Dividends, Benjamin Graham)
Assuming of course, you’re comfortable with its risk profile.
Risks To Consider
The two biggest risks to A.O Smith’s future lie in its greatest growth markets. Specifically as it grows its China and India businesses it will experience more currency risk from periodic fluctuations in the Chinese Renminbi and Indian Rupee relative to the dollar. If the US dollar appreciates against these currencies then local sales translate into less US dollars with which to pay its dividends. In other words, if the US dollar appreciates (as it’s doing now thanks to rising US interest rates) then A.O Smith can experience short to medium-term growth headwinds.
And of course we can’t forget that a potential US trade war, if it occurs and gets bad enough, could disrupt the company’s global supply chain, hurting its margins and sales in developed markets. And while it builds most of its Chinese and Indian products locally (insulating it from Chinese and Indian tariffs), if a trade war gets bad enough then local government interference, or rising nationalist sentiment, might cause it to lose market share and sales.
Fortunately, such a trade war is still unlikely (though risks are rising), and the world class management team has more than proven itself adaptable enough to keep the dividend safe and growing throughout any tariff conflicts.
Bottom Line: A.O Smith Is The Best Low Risk Way To Invest In China And India’s Strong Future Growth Potential
China and India are going to be where much of the world’s future economic growth takes place. This means there are vast fortunes to be made, but also lost if you invest in the wrong companies. A.O Smith is a proven and trustworthy dividend aristocrat, whose experienced and disciplined management team has proven itself capable of delivering excellent long-term total returns courtesy of a quarter century of strong dividend growth. And while the stock isn’t currently undervalued, I have no qualms about recommending this little known blue chip at so close to fair value. Because with the strong growth catalysts facing the company I am very confident that it will richly reward investors with continued fast dividend growth and market beating total returns for decades to come.