Increasing Dividend Payouts – Are Current Policies Appropriate?

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Graham Copley / Nick Lipinski

203.901.1629/203.883.1927

gcopley@/nlipinski@ssrllc.com

April 6th, 2015

Increasing Dividend Payouts – Are Current Policies Appropriate?

  • We compare current payout ratios for our universe of stocks to long-term levels to see which companies could reasonably increase dividends. The analysis shows that both EMN and TRN could and should raise dividends today.
  • Over the past 15 years the top 20 dividend growth stocks within Industrials & Materials have significantly outperformed the rest of the universe, regardless of the rate environment.
  • Several of our companies could return to their LT payout by raising dividends at the expense of capex, and still be spending above depreciation. Several others could move towards their LT payout but cannot attain it fully without depleting capex below depreciation levels – the full calculations for the potential dividend increases are shown at the company level in the Appendix.
  • Exhibit 1 shows the potential upside for each stock after the proposed dividend increase, assuming the share price reacts to maintain current yields. We also show the stock effect is the share price moves only to reflect 50% of the yield increase, which we see conservative.
  • We analyze the alternative use of that cash as capital spending and how many years it would take at a normal return on capital to equal the TSR of an increase in the dividend today, assuming the stock sees 50% of the upside implied if prices react to maintain current yields. Exhibit 7 plots the 50% upside seen in Exhibit 1 versus the number of years of capital spending needed to achieve equivalent upside. EMN and TRN are the inexpensive valuation outliers in the chart.
  • We note that a few of the highlighted companies are at somewhat elevated debt levels versus historical norms and so may be constrained in pursuing an increased dividend policy, but on the whole our analysis would not change the ability of a company to pay down debt – it simply suggests a repositioning of capital spending toward dividends (moving cash from one bucket to another).

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview

There is little doubt that high yielding stocks have particularly benefitted from the low rate environment that has prevailed for the better part of the past five years, but there is evidence that the higher dividend growth stocks within the Industrials & Materials space have outperformed the rest of the universe regardless of the level of interest rates – Exhibit 2.

Our dividend analysis can be summarized in three parts:

  • Identify which stocks are currently below their long term payout ratio
  • Calculate the potential increase in yield from a return to that LT payout, financed solely out of capital expenditures (fully if doing so would keep capex above D&A, otherwise whatever increase is possible by bringing down capex to maintenance)
  • Compare the potential upside from the dividend increase to the return that would be generated if that cash is spent as capex, and how long it would take, at a normal return on capital, to equal the upside provided by a dividend increase today

Exhibit 2

Source: Capital IQ, SSR Analysis

Companies Currently Below Their Long-Term Payout Ratio

Exhibit 3 summarizes the stocks in our coverage that are currently below their long term payout ratio, excluding those companies that have two year average capex below two year average D&A (one of the central assumptions of our analysis is that, as a general (conservative) rule of thumb, maintenance capex should be no lower than D&A). We have also excluded FCX and NEM, which have recently cut their dividends. Note that of the companies shown in Exhibit 3, CCK is the only one that does not currently pay a dividend – two separate $1B+ acquisitions over the past 18 months have made deleveraging a more immediate concern, but the highly cash flow generative nature of the business makes CCK a good candidate to eventually reinstate a dividend.

Exhibit 3

Source: Capital IQ, SSR Analysis

The Potential Yield Increase

Exhibit 4 graphically represents the methodology behind our proposed dividend increase, using WWD as an example. The green bars represent equivalent figures – the dividend increase implied by a return to the long term payout is deducted from capex. Note all calculations are done a per share basis for simplicity. In this example, WWD would be able to completely finance a move back to its LT payout from capex and still be spending above maintenance D&A levels. In those instances where the LT payout ratio would bring capex below D&A, we have taken only the amount that reduces capex to maintenance – in no part of the analysis have we depleted capex below D&A.

Exhibit 4

Source: Capital IQ, SSR Analysis

By this method we arrived at the potential yield increases for the identified companies – these are shown in Exhibit 5. ATI is the outlier here (yield of 5.3% after the proposed increases is 2.9 percentage points here than the current 2.4%) and is excluded from the exhibit.

Exhibit 5

Source: Capital IQ, SSR Analysis

Exhibit 1 summarized the stock upside that could be seen if prices react to maintain current yields after this proposed increase.

The Capital Spending Alternative

To illustrate the capital spending alternative to an increased dividend, we use EMN as an example in the tabular calculations in Exhibit 6. Note that because capital spending does not disappear, each year accounts for and includes the previous year’s capex – this is shown in Row B. Each year’s return on capex is the cumulative capex cut in Row B multiplied by the long term ROC trend in Row F (8% for EMN). Row D sums each annual return (Row C) cumulatively.

As shown in Exhibit 1, the stock price reaction needed for EMN to maintain the current dividend yield post-increase is 43% – assuming a constant multiple and that only 50% of this upside is realized, we would be looking for capital spending to generate ~21% EPS upside from current normal levels. This equates to $1.59 in the EMN example, which would be achieved sometime early on in the seventh year as shown in Exhibit 6 below.

Exhibit 6

Source: Capital IQ, SSR Analysis

All told, we can compare the upside from the potential increase in yield (shown in Exhibit 1) to the number of years of capital spending required to generate equivalent upside. ATI is again the outlier, greatly skews the plot, and has been excluded from the exhibit accordingly.

Of the stocks highlighted in this analysis, EMN is the obvious valuation play, currently trading more than two standard deviations below normal on our model – see our stock specific research from earlier in the year. TRN also shows valuation support.

Exhibit 7

Source: Capital IQ, SSR Analysis

A Note on Debt Levels

Understanding that some of these companies have elevated debt levels which might constrain their dividend policies, we note that the overall analysis does not significantly alter the capacity of the company to pay down debt. This work merely proposes a reallocation of funds, away from excess capital expenditures and toward dividends.

Exhibit 8

Source: Capital IQ, SSR Analysis

Appendix:

Stocks that could return to LT payout ratio and still have capital expenditures above depreciation:

Stocks that could move towards the LT payout ratio, but would see capital expenditures fall below depreciation at full:

IFF: “Our current intention is to pay dividends approximating 30%-35% of yearly earnings; however, the payment of dividends is determined by our Board of Directors (“Board”) at its discretion based on various factors, and no assurance can be provided as to future dividends.”

EMN: “Free cash flow is expected to be approximately $850 million to $900 million and this is a nice improvement over 2014. As a reminder, our priority for free cash flow over the next 24 months is deleveraging our debt. While doing so it is reasonable for investors to expect that we will continue to increase our dividend and we expect to offset dilution with stock repurchases.”

TRN: Plans for conservative capital allocation possibly altered by recent clearing of litigation issue; M&A a priority

©2015, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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