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The Rundown on 3 Recent Dividend Hikes

Josh Peters, CFA

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Josh Peters. He is the editor of Morningstar DividendInvestor newsletter and also our director of equity-income strategy. We are going to take a closer look at three recent dividend increases.

Josh, thanks for joining me today.

Josh Peters: Good to be here, Jeremy. One of my favorite topics. And not tongue-in-cheek like taxes being a favorite topic, but an actual favorite topic.

Glaser: Realty Income (O), one of your favorite companies, recently raised their dividend again. Was this expected or are you surprised at the size of it?

Peters: The timing has been a little uncertain, which is uncharacteristic for Realty Income. It's a company that has been public since 1994. They typically raise their dividend four times a year. They pay it 12 times a year on a monthly basis. And you had a pattern where, typically, in the years where they show good growth in earnings--usually because they have a lot of profitable acquisitions that they have made--that they would produce a larger dividend increase in August.

Well, after they had a new CEO come in, the question came up with the board, why August as opposed to later in the year or early the following year, once we've done our budgets and we have a better idea of where we stand? So, they decided to move it. It took a little bit of extra waiting. After a fantastic 20% total increase in the dividend during 2013, dividend growth was less than 1% in 2014. But here in January, you had a 3% increase in the dividend rate--that's up closer to 4%, year over year. And we think that that is now the kind of trajectory the dividend is likely to be on from here. I'm looking for a long-term dividend-growth rate of about 4%.

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Glaser: Coca-Cola (KO) also raised their dividend. This story seems to be that investors were very worried about Coke and then feeling a little better about it. What's your take on the company?

Peters: I think that they are really focused on the operations, and they're just letting the currency issues do what they are going to do. It's been a massive headwind for profit growth for Coke as so much of the business generates profits overseas. And with the strength of the dollar against almost every other currency on earth, you translate those earnings back into dollars--even if they have grown in the local currencies--and it's less. And this has real relevance for the dividend, because even if the earnings have grown in local currencies, you are still paying that dividend in dollars. So, you had a lot of upward pressure on Coke's payout ratio.

Just a couple of weeks ago, I figured that Coke has raised its dividend every year for more than 50 years in a row, so they are going to do it again. The question is, how large will it be? And I thought pretty small. I was looking for a move from 30.5 cents a share, quarterly, to $0.32. That's a little less than 5%. Instead, they came out with $0.33. So, now, this is better than an 8% dividend increase.

That's actually, I think, a good number for them longer term. What they can achieve through modest top-line expansion between pricing and volume, a little bit of improved margins, some share buybacks, reducing the share count, kind of that algorithm that you put together should get you into that 7% to 8% range. What was unique is that they did it even though it was driving the payout ratio into the mid-60s again because of the pressure of currency on earnings. So, I think you probably won't have many more increases like this if the dollar continues to strengthen as it has. But that's not a really likely outcome; the dollar is eventually going to peak out and other currencies will come back. That could then turn into a tailwind for Coke and a lot of other multinationals. There has been so much complaint about the way they are running the business, but you still have core operating income growth in the mid-single digits. If that's what Coke does when the business is lousy--when they themselves feel like they are not performing up to their full potential--then I'm pretty comfortable that we can do well with this stock yielding 3% and growing, say, at least 5% or probably more like 7% or 8% long term.

Glaser: Public Service Enterprise Group (PEG) raised their dividend. What's your take on that?

Peters: This has been a story that's gotten better. Whereas Coke has had currency pressures here in the first year [in which] I've owned it, Public Service Enterprise Group I've owned now for close to three years. It started out with very little dividend growth. It was just 0.5 cents a share, quarterly, in the first year that I owned it. Then, it was $0.01. And now this year, it's $0.02--which translates into more than 5%. That acceleration in dividend growth has tracked very nicely with the growth of their regulated business in New Jersey--the transmission and distribution operations.

They also have a very large wholesale-generation business in which the profitability depends on commodity prices, whereas with natural gas and regional-power prices, the profits there have come down in recent years because natural gas has been cheap. But that regulated unit doing very well in a favorable regulatory climate and having lots of investment opportunities, it shifted the mix to where it's now the dominant earner. PSEG Power is still a very large business, but they've gotten more comfortable with the idea of faster dividend growth. The only drawback here is now the stock has run up quite a bit, just since announcing this dividend increase. I'd like to buy some more, but I'm inclined to wait for a bit of a pullback before that happens.

Glaser: Josh, thanks for your take on those [increases] today.

Peters: Thank you, too, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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