Wednesday, April 14, 2010

* Four Dividend Stocks Stepping Up In The Downturn

I have often heard that a person's character is determined by how they behave when no one else is looking and during difficult times. In much the same way, we can learn a lot about a company's management when they face adversity. One metric I look at closely during a downturn is cash generation relative to earnings.

When looking at payout ratios, I prefer using a free cash flow payout instead of the traditional dividend payout based on GAAP earnings, which contains a lot of non-cash "noise." Some sectors, such as consumer staples and pharmaceuticals, are expected to do well during a downturn. For example, stocks such as Kimberly Clark Corp (KMB) and Abbott Laboratories (ABT) that sell products less dependent on economic conditions were able to grow both earnings and free cash flow between 2007 and 2009. What about industrials and other cyclical stocks whose results are tied to the economy?

One sign of a great management team is the ability to increase free cash flow when earnings are falling. Below are some companies that accomplished this feat over the last couple of years:

Commerce Bancshares (CBSH) | Yield: 2.20%
- Earnings (2007/2009): $2.56/$2.07
- Free Cash Flow (2007/2009): $3.68/$5.74
- Years of Consecutive Dividend Increases: 42

Emerson Electric Co. (EMR) | Analysis | Yield: 2.24%
- Earnings (2007/2009): $2.66/$2.27
- Free Cash Flow (2007/2009): $2.90/$3.37
- Years of Consecutive Dividend Increases: 53

Lowe's Companies, Inc. (LOW) | Analysis | Yield: 1.40%
- Earnings (2007/2009): $1.99/$1.49
- Free Cash Flow (2007/2009): $0.38/$0.58
- Years of Consecutive Dividend Increases: 47

3M Co. (MMM) | Yield: 2.50%
- Earnings (2007/2009): $5.06/$4.89
- Free Cash Flow (2007/2009): $3.51/$4.33
- Years of Consecutive Dividend Increases: 51

The ability of a company to grow its dividend throughout the economic cycle is highly dependent on the management's ability to generate cash in a downturn. This doesn't just happen. Management must be proactive and guide the company down a path that it otherwise would not go. Working capital must be a focus with inventories lowered, receivables aggressively pursued and payables stretched out to their maximum term. Another focus is deferring replacement capital without jeopardizing safety and long-term viability. It is all a delicate balancing act, requiring intimate knowledge of the company.

Often running a business for cash is detrimental to short-term GAAP earnings. For example, when when you produce less inventory than you are selling, you experience lower fixed cost absorption which increases current expenses, but also increases cash flow. Smart analysts understand this and focus on cash, not GAAP earnings.

Full Disclosure: Long ABT, EMR, KMB, MMM. See a list of all my income holdings here.
(Photo: Steve Woods)

Tags: [ABT] [CBSH] [EMR] [KMB] [LOW] [MMM]