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By Josh Peters, CFA | 11-20-2013 02:00 PM

Investors May Clean Up With This Dividend Payer

An above-average dividend yield and defensive characteristics make this consumer defensive firm a solid total-return story, says DividendInvestor editor Josh Peters.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by Josh Peters. He's the editor of Morningstar DividendInvestor and also our director of equity income strategy. We're going to take a closer look at Clorox and see if it still looks appealing to dividend investors.

Josh, thanks for joining me today.

Josh Peters: Good to be here, Jeremy.

Glaser: I think that most viewers are probably familiar with Clorox, but can you give us just a little bit of background about the company and why it's one that you found so attractive in the past?

Peters: Clorox combines three of the favorite things that I find when I am looking at any one business. First, it has an above-average dividend yield, which is a little over 3% at current prices. You've got decades of history of the dividend being paid and rising every year without fail, going back more than 20 years. Second, it's economically defensive. People are going to continue to buy things like bleach even during recessions; that gives the company a very stable cash flow profile with which to fund that dividend.

And then, it's the company's competitive position. We've recently upgraded our economic moat rating to wide from narrow. Not much has changed about the business, but watching the company perform over the last couple of years has given us that much more confidence that the very high profit margins and returns on capital that Clorox has been generating in recent years are going to continue long into the future. And that economic moat helps both protect the dividend on the downside and encourage profitable growth. So, between the high dividend yield, economically defensive characteristics, and the wide economic moat rating, it's really a triple play.

Glaser: Let's look at that dividend growth then. Clorox is obviously not a fast-growing business. Will they be able to generate that cash flow to keep growing that dividend enough to keep investors' total return looking good?

Peters: I think so. Clorox is very much a total-return story. The company doesn't have a whole lot of exposure to emerging markets. It's mostly a North America-focused business. The company hasn't wanted to barge into all sorts of markets far afield that they might not have those competitive advantages in. I think that's a sign of corporate discipline that I find very attractive.

So you're really looking at maybe 3%, 4%, 5% type of revenue growth going forward. The company has been emphasizing new products more recently and having good success with that. We can see perhaps where growth can get a little bit better than the 3% average of the last decade.

But if you think about it, that level of growth, that's just maybe 1 or 2 percentage points of volume growth a year plus inflation. Now those are not heroic assumptions. From there, because the company's competitive position is so strong, we have confidence that the company will gently become a little more profitable over time, that net income will grow faster than revenues. And the company also has the opportunity, with its excess free cash flow over and beyond what it pays in the dividend, to buy back shares every year, reducing the share count and making the dividend a little bit larger on a per-share basis in the years that follow.

So, when you add these different factors together, I think you're looking at a roughly 7% rate of long-term dividend growth for Clorox. That's a little bit lower than it's been in the last few years. The company's payout ratio has been growing as management's become more confident about their ability to make a very generous dividend payment and keep making it.

But with a 7% long-term dividend growth, assuming that the stock price moves up in tandem with that, which is what I would expect, plus that 3%-plus yield, then you are looking at a total return prospect that's in the 10% area, again, from a business that doesn't have that much risk.

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