Jeremy Glaser: How to know when a high payout ratio is a golden opportunity or a red flag. I'm Jeremy Glaser with Morningstar.com. I'm here today with Morningstar DividendInvestor Editor Josh Peters, to take a look at a few firms that have very high payout ratios and if investors should be interested. Josh, thanks for talking with me this morning.
Josh Peters: Good to be here.
Glaser: Josh, people usually think of a very high payout ratio is being something to be really worried about. But are there some cases in which it could be a sign that investors should be actually interested?
Peters: When you start looking at a payout ratio, you've got to keep a couple of things in mind. You don't want to set any sort of particular threshold and just say anything above this figure is automatically not going to work unless it's over 100%, really anything under there I think you can start to take seriously.
The kind of things that you want to look at, are the kind of things that I find with one of my favorite stocks, Altria Group.
First of all, it does not have a great deal of financial leverage. Their debt load relative to their cash flow, we think is quite manageable. So, you don't have a great number of other parties that are really lined up in terms of the cash line ahead of your dividend payments.
Second, cash flows from year-to-year tend to be very steady. They have shown good growth, even though consumption of cigarettes has been declining in the United States, the prices the companies have been able to charge has been going up. So, you've got that also working for you. There hasn't been big downward variability in their cash flows.
Another point is, very strong competitive position, they're continuing to hold about half of the domestic market. Since companies in the industry can't advertise, you know really attack each other publicly and directly. They've got very good chance of holding on to that market share without having to spend a tremendous amount of money.
Then finally you've got to look at the capital reinvestment requirements of the business. You think about a utility that might have to invest back hundreds of millions or billions of dollars out of its earnings every year just to grow at 2% or 3% or 4%. Altria doesn't really have to reinvest anything back into the business in order to get its growth, because its growth is all coming through price increases. That doesn't cost a lot of money.
So, you add these different factors up and Altria actually looks like the kind of business that can generate a large growing steady stream of cash that doesn't have to be reinvested, it can actually be paid out to shareholders. That's why the company is targeting paying out 80% of profits on an annual basis as dividends and with that goal having being announced earlier this year, I'm looking for a pretty nice dividend increase from Altria here probably before the end of August.
Glaser: Do you have any other names that you hold that also fulfill this criteria?
Peters: Another name that I actually think is a little bit better of a deal right now, at least just in terms of price is Paychex; the payroll processor for mostly small and mid-sized businesses. Paychex has been in a real funk, when you look at the stock price or earnings per share over the last couple of years, you're not going to find a lot to inspire you because as unemployment has gone up, that means employment is going down, that's fewer pay checks to process, and naturally smaller businesses tend to be a little less stable, and it's been a real headwind in terms of growth.
Second factor for them as they hold the money before the pay checks are cashed, as interest rates come down their earnings on that float that they hold have come down. So, this has been kind of a one, two punch. And this has brought Paychex to the point where they are actually paying out just over 90% now of earnings as cash dividends. Normally, that would be a very high figure.
The kind that should scare you often in just about any situation, but again you start looking at the business, here we are at the – hopefully, I think, the bottom of the cycle in terms of employment trends perhaps things just ever so gradually starting to get a little bit better and Paychex has continued to cover its dividend with earnings. Because their capital investment requirements are so low, really all you need to do in order to process more pay checks is just hire more people, give them a desk, have them go out and sell more services, you don't need to build steel mills or oal refineries or anything.
Their free cash flow actually exceeds the reported earnings, so they've been able to grow their cash balances fairly nicely even while paying out these very large dividends.
As for debt, they have none, so that keeps things pretty simple. And their competitive situation is very, very strong too. It is a huge hassle for a client to go about switching payroll service providers, means having to essentially rewire your whole HR process, and Paychex over the years has developed more services like outsourced human resource functions, 401(k) plan management, things like that bind their customers even more tightly to their suite of services.
We really don't look at the company as facing a lot of competitive threats. So, totally different line of business than Altria, but also in a very good position to continue paying out a very large proportion of earnings as dividends, and once earnings start to pick-up, once the economy picks up and interest rate picks up, I expect them to start raising their dividend again at a pretty good rate.
Glaser: On the flipside, what pay-out ratios scare you right now?
Peters: Any kind of pay-out ratio that can scare you if the business is volatile enough. You might look at it this way that for a food company usually given its capital investment requirements, the sort of very modest cyclicality of the business, competitive threats kind of going back and forth, 60% seems to be ceiling. If it was steel mill or something like that at the top of the cycle, 20% payout ratio might be too high, just because how far earnings can come down.
So, when I see something like Annaly Capital Management, which is a REIT that actually specializes in holding leveraged portfolios of mortgages. Knowing that it has to pay-out at least 90% of its earnings to stay compliant with the tax code, that's a dividend that is bound to go way up and way down depending on cyclical conditions related to interest rate, it doesn't have any definable competitive advantages. I mean, it's really just a price taker trying to invest whatever the market can give them. There is a lot of leverage in the business, although I will applaud them for maintaining a good balance through the crises and preserving shareholder value and a lot of their peers got into much more trouble.
But there is no reason to expect that the current dividend rate can be maintained if the gap between short-term and long-term interest rates starts to narrow. So, I look at this as being really a much more speculative play, what we call the yield curve as opposed to something where you can say, this is a dividend, I can count on quarter-after-quarter, year-after-year with steady growth. It's just that not their kind of business. I just as soon let speculators own it and prefer to direct my investment funds elsewhere.
Glaser: It seems to always come back to competitive advantag.
Peters: A lot of it does. It's not the only factor, but it's almost like every other factor starts to flow from there. You'd see businesses that have wide are very well defined narrow economic moats, they tend to have better balance sheets because there is no need to load up a good business with a lot of debt to try to engineer returns that it couldn't otherwise do. Business that's got a moat, definable competitive advantages, probably going to have steadier earnings because they're not merely price takers they have cost advantage, or price advantage something that will durably fend of competition.
These kinds of factors which are very easy to overlook when you are first thinking about dividends and dividends tend to lend themselves to a lot of quantitative analysis, can the company pay on the basis of the results of the last 12 months. You really do need to think like a businessman, be thinking 5, 10, 15 years out and thinking about competitive advantages because those are what are going to support at least safe dividends in the down times and growing dividends in the good times over that longer period of time.
Glaser: Josh, thanks so much for talking with me today.
Peters: Thank you, Jeremy.
Glaser: For Morningstar.com, I'm Jeremy Glaser.