Dividend Profile: Fast Growth And Market Crushing Return Potential Make Up For Low Current Yield

The most important part of any income investment, and what ultimately drives total returns, is the dividend profile. This consists of three parts: yield, payout safety, and long-term growth prospects.

Sources: Management guidance, Morningstar, Gurufocus, FastGraphs, BlackRock, Vanguard, Multpl, Gordon Dividend Growth Model, Simply Safe Dividends, Benjamin Graham

Now it’s true that FedEx’s low current yield is not anything to get excited about. But what that current yield lacks in size is more than made up for its strong safety and excellent growth prospects. For example, FedEx has raised its dividend at a double digit rate for 16 consecutive years. That’s because its payout ratio is just 13% meaning the dividend is extremely well covered by earnings and future payout ratio expansion is likely to see the dividend grow faster than earnings. For example, in the past 10, 5 and one years FDX’s dividend has averaged 16%, 26%, and 30% annual growth, respectively. Or to put another way FedEx is a dividend growth darling with an accelerating dividend growth rate.

The other half of the dividend safety formula is the balance sheet. In a highly capital intensive industry such as this you want to make sure that a company’s debt levels aren’t so high as to threaten its ability to grow while maintaining a safe and fast growing dividend.

• Debt/EBITDA: 1.8 (industry average 3.6)
• Interest Coverage Ratio: 15.7 (industry average 7.7)
• S&P Credit Rating: BBB
• Average Interest Rate: 3.1%

Fortunately FedEx’s debt levels are very safe, with a leverage ratio (Debt/EBITDA) that’s half the industry average. Similarly its operating cash flow cover its interest costs (interest coverage ratio) very well. In fact the interest coverage ratio is about double that of its peers. This explains why FDX has a strong investment grade credit rating that allows it to borrow at long-term fixed rates at an average interest rate of just 3.1%. That’s six times lower than its returns on invested capital meaning that every dollar of debt is being put to good use to grow the business and ultimately earnings and dividends.

Over the long-term FedEx is likely to continue growing its dividend at double digits, based on management’s long-term EPS growth guidance. Payout ratio inflation might cause the dividend growth rate to clock in at 15% to 20% over time. But to estimate total returns  it’s best to use the Gordon Dividend Growth Model or GDGM. Since 1956 this has proven accurate for stable business model companies like FedEx. This model says that long-term total returns approximate yield + dividend growth (proxy for EPS and cash flow growth).

In other words FedEx’s total returns will consist of the current yield + capital gains as shares tend to grow in line with earnings. Fortunately with about 12.5% long-term EPS growth forecast by its world class management team (that’s good at hitting guidance) this means that FedEx’s total returns are likely to come in about 13.6% over the next decade. That’s assuming no changes in valuation. For context the S&P 500 has a long-term median dividend growth rate of 6.2% which is far lower than what FedEx is offering. This is why the GDGM estimates that the S&P 500 is capable of just 8% total returns over the next 10 years. However, from today’s valuations Morningstar, BlackRock and Vanguard estimate that the market will deliver just 2% to 5% annualized total returns.

Thus FedEx’s below paltry yield is more than made up for by a rapid dividend growth rate ( about three times as fast as the market) and vastly superior total return potential. But wait, it gets better. Because when we factor in the likely return boost caused by FedEx’s extremely low valuation, then this fast growing blue chip has the potential to become one of the best performing stocks of the next decade (and achieve about double the total returns of the last 30 years).