Unyielding – The Supposed Thirst For Dividend Growth

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

graham@/lipinski@sector-sovereign.com

October 25th, 2012

Unyielding – The Supposed Thirst For Dividend Growth

  • Industrials and Basic Industries companies are for the most part dividend payers and both relative (to the S&P 500) and absolute valuations have benefitted from yields in a very low rate environment. In general and in aggregate the sectors look fairly valued based on yield relative to interest rates. Metals looks least expensive and E&C the most expensive. High valuations in the Paper sector are supported by yield.
  • Dividend growth rates are generally increasing, with 10 year averages lower than 5 year averages, and 5 year averages lower than 2 year averages for Capital Goods, Chemicals, Electrical Equipment, Metals, Packaging and Transports. Only Chemicals, Electrical Equipment and Transports are trading above normal value today, suggesting that dividend growth is having a limited influence in other sectors.
  • While we have seen some specific positive company share price moves post major divided increases most notably WLK this year – for the most part companies have not been rewarded materially for above trend dividend increases in either 2011 or 2012. This was not the case in 2010, where outsized dividend increases in aggregate resulted in more than 10% outperformance.
  • On average Conglomerates and Chemical companies are committing the highest proportion of earnings to dividends (2 year average). Capital Goods looks like it could and should pay out more, having shown no dividend growth for 5 years.

Exhibit 1

Source: Capital IQ and SSR Analysis – Price Volatility is SD of weekly log-normal price returns over the past 2 years, annualized with a factor of 52 for the 52 trading weeks in a year (source: Capital IQ).

Overview

From an unemotional standpoint, any corporation faces two real options to create shareholder returns; either grow the business in a way that is accretive to the capital spent, or return the capital to shareholders. The Industrials and Basic Material sectors are not really growth stories – they have bursts of occasional growth in many cases, and in others they have GDP like growth – but they are not exciting from a growth perspective. Within the sub-industries are business and companies that are ex-growth – businesses because of redundancy or alternative product competition and companies because they do not have either the technology or cost base to compete in what might still be a growing business.

Understanding when to invest capital and when to return it to shareholders is one of the most challenging problems for the management of any company. In the US, when you set a dividend payment there is an expectation that this is sustainable, so you are reluctant to set a payout that might be challenging in tougher times. When you invest capital, there is no guarantee that you will get the return that you thought you were going to get when you made the decision.

In our initial work in this space we spent some time on the subject of return on capital, and noted that many industries have declining slopes to their longer-term return on capital trends – Exhibit 2. This tells us immediately that in many industries capital expenditures have not generated the returns expected – incremental capital has been used unwisely and perhaps might have been of more value to shareholders as a dividend or a buy-back. Sectors that have the worst record here are chemicals (particularly commodity), metals, paper and packaging. The trend for conglomerates is also poor but at an absolute level of returns that is generally good.

Exhibit 2

Source: Capital IQ and SSR Analysis

Within our coverage group there are dozens of companies who, with the benefit of hindsight, should have paid higher dividend and chased fewer speculative projects. There are just as many companies who would likely see meaningfully higher valuations today if they adopted a dividend policy more appropriate for the real prospects of the business; admitting that they have limited opportunities to deploy capital in an accretive way, and raising payouts instead.

If we look at current very high cash flows and fairly limited capital expenditures, it is clear that many companies and some industries in aggregate could afford to and probably should pay more, particularly those that have more limited earnings volatility. The most obvious sectors are the Transports and Capital Goods sectors, but every sector has scope.

Low capital spending today, driven by both limited need and almost no appetite for speculative spending is resulting in free cash flows and building surpluses that could fund much higher dividends in most sectors. Where it is clear that companies/industries are holding cash because they want to spend it at some point, is for the most part where investor concerns are highest and yields are highest. Interestingly, the Paper industry, which we consider expensive, could probably generate more valuation upside by raising it dividend today – something it could afford to do.

Dividend Yield

On a weighted average basis our sectors yield more than US 10 year debt today, with only E&C averaging below the 1.77% 10 year rate. Within each sector, there is quite a lot of volatility and the numbers are summarized in Exhibit 3. The sector with the greatest consistency is Capital Goods and the sector with the most varied approach to dividends is Packaging.

Exhibit 3

Source: Capital IQ and SSR Analysis

We have been pretty bearish on the Paper sector all year, but here is one metric that makes the space look at least fairly valued. The sector has increased its dividend meaningfully over the last 2 years, but over the last 5 years only marginally as dividends were cut through the crisis in 2008/2009 and so part of the upside the group has seen in the last 2 years has been both a higher yield and greater confidence that the dividend can be sustained.

If we look at yield versus PE for the most part we get the picture we expect, though the correlation is fairly poor – Exhibit 4. The chart shows the support for the Paper sector and shows the current discount for the Metals space, which may be a reflection of concerns that current trough earnings put the dividends at risk. E&C is off trend, although within the margin of error of the analysis. Historically this group has not paid much of a dividend and we do not expect that to change given the volatility that the sector experiences in revenues and earnings. Otherwise, it might be argued that Chemicals, Capital Goods and Conglomerates look a little undervalued.

Exhibit 4

Source: Capital IQ and SSR Analysis

Dividend Growth

Dividend growth varies significantly by sector and even more significantly over the last two years. Different sectors have taken different approaches so far to the mounting piles of cash that most are experiencing. Chemicals and Metals have seen the most significant near-term dividend increases (the table shows data through 2011 and increases have continued for Chemicals in 2012). Electrical Equipment, E&C and Conglomerates show the slowest growth but Electrical Equipment has a very consistent history of dividend increases, bettered only by Transports and Capital Goods, which have equal consistency over the last 10 years but with higher overall growth rates – Exhibit 5.

Exhibit 5

Source: Capital IQ and SSR Analysis

In the Exhibit some of the numbers look a bit inconsistent when you compare 2 and 5 year growth, particularly for Paper and Conglomerates. This is because there were a number of companies that cut dividends during the crisis and are now back to levels that look little changed to 5 years ago but are much higher than 2 years ago.

It is likely that the consistent strong sector performance that we have seen from Capital Goods, Electrical Equipment and Transports has in part been a function of the reliability of the dividend policy from both sectors. Transports and Capital Goods have taken a beating recently and look more interesting on a yield basis today, particularly if the dividend growth seen in recent years can be repeated – earnings growth would suggest that can be repeated, even with some of the shorter-term revisions that we have seen and concerns around global growth.

If we look at Dividend Growth versus forward P/E, Paper and Metals throw the chart off a bit on a 2 year basis, but again Capital Goods looks like a cheap outlier. On a ten year basis, Paper looks like the most significant outlier on the expensive side, but Capital Goods and Metals look interesting on the inexpensive side – Exhibit 6.

Exhibit 6

Source: Capital IQ and SSR Analysis

But Could/Should Companies Be Paying out More?

Many of the sectors are seeing quite significant improvements in returns on capital, a phenomenon that has been going on for the last three years. Relatively slow global demand growth has limited “growth” based capital spending and for many sectors capital spending has been below or close to depreciation for the last couple of years.

Exhibit 7

Source: Capital IQ and SSR Analysis

The greater capital discipline, perhaps forced by more limited growth, has resulted in better returns, better earnings and better share prices in many sectors. But cash flows are high, cash balances are building and interest rates are very low. Investor fear is that temptation is high: could the cash balances be used to do something that upsets the current positive momentum.

A good case in point is the expected rush of investment in the US Commodity Chemical industry as companies look to exploit the cheap streams of natural gas liquids in the US. The investment case is simple – we are going to have gallons of surplus NGLs in the US and therefore a cost advantage versus the rest of the world – we have written in detail about this recently . To summarize the controversy, the return on capital trend for the US commodity chemical group is summarized in Exhibit 8. Throughout the period of declining returns investments in the US and the rest of the world have continued and in almost every case, each investment was exploiting a “cost advantage” or a “technology advantage”. If the industry goes ahead, as we expect it to, the capex number will be multiples of depreciation for years, and any investor with history in the space knows that you do not want to own these names when capital spending is high.

In many cases, a more generous dividend policy might not just return more immediate cash to shareholders – it might also go some way to persuading investors that and expected excessive spending cycle might be more muted. Sectors where cash flows are high and the risk of a major upswing in capex is limited are also those that are highly valued today – such as Electrical Equipment. Paper looks tempting, but the industry has not had cash for decades and so has no real track record of discipline. If investors were more confident that both the Chemical sector (specifically, Diversified and Commodity) and the Capital Goods sector were to adopt a more dividend friendly/capex cautious strategy – both sectors have some significant upside.

Exhibit 8

Source: Capital IQ and SSR Analysis

©2012, 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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