Delivering a New YUM! – What’s in it for Dividend Investors?

 

Summary:

In 2016 YUM! Brands will spin-off its Chinese division into YUM! China for the benefits of investors.

The New YUM! will rely on a very strong cash flow generation business model with 96% of its restaurants operated by franchisees.

Since the transformation is not yet completed, there is still a buying opportunity that has presented itself.

DSR Quick Stats

Sector: Consumer Cyclical – Restaurants

5 Year Revenue Growth: 2.93%

5 Year EPS Growth: 3.63%

5 Year Dividend Growth: 13.94%

Current Dividend Yield: 2.19%

What Makes YUM! Brands (YUM!) a Good Business?

In three words, you can resume what YUM! Brands is… Tacos, Chicken, Pizza:

yum1

Source: YUM! website

YUM! Brands operates the brands of Kentucky Fried Chicken, Taco Bell, and Pizza Hut, with over 42,500 restaurants in over 125 countries. The company was spun off from Pepsico in 1997, and maintains a partnership with that company. Ironically, the company now plans to spin-off its Chinese division by the end of 2016. At the moment, this is like saying goodbye to 52% of its revenues, but will also leave lots of problems behind in exchange for a perpetually increasing dividend (more on this plan later).

Although not the largest in terms of revenue, YUM! Brands is the largest restaurant operator in the world in terms of the number of locations. YUM wants to positioned its company as a pure franchise play after the transformation with 96% of its restaurants operated by franchisees. The best part of franchise business models is their ability to generate a constant cash flow for investors.

Ratios

Price to Earnings: 27.25
Price to Free Cash Flow: 27.89
Price to Book: 35.69
Return on Equity: 85.53%

Revenue

yum2

Revenue Graph from Ycharts

As the number of restaurants in China skyrocketed from 1,792 in 2005 to 3,906 in 2010 and then over 7,000 by the end of 2015, the currency impact and recent bad press events in China (2014 and 2015) has hit their revenue growth.

After the spin-off, revenues are expected to grow in a more stable and predictable way as the company will sell the Chinese volatile operations in exchange for a 3% licence fee to give YUM! China the exclusive right to operate KFC, Pizza Hut and soon Taco Bell. The search for low-volatility revenues is the first reason to spin-off the Chinese restaurants.

How YUM! fares vs My 7 Principles of Investing

We all have our methods for analyzing a company. Over the years of trading, I’ve been through several stock research methodologies from various sources. This is how I came up with my 7 investing principles of dividend investing. Let’s take a closer look at them.

yum3

Source: Ycharts

Principle #1: High Dividend Yield Doesn’t Equal High Returns

My first investment principle goes against many income seeking investors’ rule: I try to avoid most companies with a dividend yield over 5%. Very few investments like this will be made in my case (you can read my case against high dividend yield here). The reason is simple; when a company pays a high dividend, it’s because the market thinks it’s a risky investment… or that the company has nothing other than a constant cash flow to offer its investors. However, high yield hardly come with dividend growth and this is what I am seeking most.

yum4

Source: data from Ycharts.

When I created my portfolios at DividendStocksRock back in 2013, the company yield wasn’t interesting enough for a company in the consumer cyclical industry. You can find many other higher yielding company in this sector. However, by looking at the constant dividend growth trend and the recent push of the yield over 2%, I started to look into the company a bit more. YUM meets my 1st investing principle.

Principle#2: Focus on Dividend Growth

My second investing principle relates to dividend growth as being the most important metrics of all. It not only proves management’s trust in the company’s future but is also a good sign of a sound business model. Over time, a dividend payment cannot be increased if the company is unable to increase its earnings. Steady earnings can’t be derived from anything else but increasing revenues. Who doesn’t want to own a company that shows rising revenues and earnings?

Since the company started to pay dividends only in 2004, the company can’t have a 50 year dividend history. However, in 2015, YUM! has achieved its 11th consecutive year with double digit dividend growth.  This is quite impressive for any type of company. This is the kind of statistic that makes you understand why you can’t ignore a low dividend yield payer, right? There is no question that YUM meets my 2nd investing principle.

Principle #3: Find Sustainable Dividend Growth Stocks

Past dividend growth history is always interesting and tells you a lot about what has happened with a company. As investors, we are more concerned about the future than the past. this is why it is important to find companies that will be able to sustain their dividend growth.

yum5

Source: data from Ycharts.

Being able to propulse your dividend payment into double digits year after year doesn’t mean you will be able to maintain it. Interesting enough, the company has been able to maintain a relatively stable payout ratio over the years. Even better, the payout ratio is around 56% and the cash payout ratio is at 62%. Therefore, the cash flow generation is able to maintain such strong dividend growth in the future. It will become even easier to plan after the spin-off completion at the end of 2016. YUM meets my 3rd investing principle.

Principle #4: The Business Model Ensure Future Growth

YUM! Shows an impressive number of restaurants spread among three distinct brands. The business is the global leader in chicken, pizza and mexican style restaurants in terms of number of restaurants. This gives it a unique economic moat that is very hard to cross.

The new YUM! Business model will be solely based on a franchise model which enables predictable and continuously increasing cash flow generation. The number of Chinese restaurants will continue to grow at a very fast pace, following the growth of the middle-class. This will lead to ever bigger franchising fees without having the problem to deal with Chinese market volatility. For these two reasons, YUM meets my 4th investing principle.

Principle #5: Buy When You Have Money in Hand – At The Right Valuation

I think the perfect time to buy stocks is when you have money. Sleeping money is always a bad investment. However, it doesn’t mean that you should buy everything you see because you have some savings put aside. There is some valuation work to be done. In order to achieve this task, I will start by looking at how the stock market has valued the stock over the past 10 years by looking at its PE ratio:

yum6

Source: data from Ycharts.

YUM seems to have generated much hype recently as the company used to trade around a 20 PE ratio for the majority of the past 10 years. Recently, it has gone up to 45 and it is now down to 27. Obviously, the best moment to buy YUM would have been at the beginning of 2016 since the stock is now up close to 9% ytd. Does it mean it’s too late to join the party? Let’s use the dividend discount model (DDM) to see if the company is trading at a fair value.

In order to do so, I will use a 10% dividend growth rate for the first 10 years. This seems quite generous, but if you consider the company has increased its payment in the double digit range for the past 11 years and they are about to create even more cash flow, it seems almost too low. Keep in mind the 5 year average dividend increase is 13% at the moment. After the first 10 year period, I expect the company to drift to a more conservative level of 7% growth rate. Since the company is evolving in a cyclical market, I can’t use a 9% discount rate. I would rather play conservative and use a 10% discount rate. After all, the stock is trading at a PE ratio of 27.25.

 

Input Descriptions for 15-Cell Matrix INPUTS
Enter Recent Annual Dividend Payment: $1.84
Enter Expected Dividend Growth Rate Years 1-10: 10.00%
Enter Expected Terminal Dividend Growth Rate: 7.00%
Enter Discount Rate: 10.00%

 

Here are the results of my calculations:

 

Calculated Intrinsic Value OUTPUT 15-Cell Matrix
Discount Rate (Horizontal)
Margin of Safety 9.00% 10.00% 11.00%
20% Premium $152.65 $100.83 $74.97
10% Premium $139.93 $92.43 $68.72
Intrinsic Value $127.21 $84.03 $62.47
10% Discount $114.49 $75.62 $56.23
20% Discount $101.77 $67.22 $49.98

 

Source: Dividend Monk Toolkit Excel Calculation Spreadsheet

As you can see, even by being conservative with my assumptions, I still get a 5% discount on the current price. There will also be some speculation in regards to what is coming next. I think there will be more cash flow generated leading to a higher dividend growth rate in the first 10 years. In any case, YUM meets my 5th investing principle.

Principle #6: The Rationale Used to Buy is Also Used to Sell

I’ve found one of the biggest investor struggles is to know when to buy and when to sell his holdings. I use a very simple, but very effective rule to overcome my emotions when it is the time to pull the trigger. My investment decisions are motivated by the fact that the company confirms or not my investment thesis. Once the reasons (my investment thesis) why I purchased shares of a company  are no longer valid, I sell and never look back.

Investment thesis

I think the investment thesis is pretty obvious by now. The company is moving towards a stable, growing and low volatility free cash flow generation stream business model. Plus, YUM will benefit from a stronger economy in the US in the upcoming years and will also earn increasing franchise licence fees from its Chinese spin-off without having to deal with its volatility. An investment in YUM at the moment is also a play on the success of the future spin-off.

Risks

The first risk I see is that the transaction doesn’t create the impact management wants us to believe. The Chinese stock market volatility might not help the elaboration of a successful spin-off and investors may be left behind.

The second risk is more related to the overall business as there is much important competition in the fast food industry. We see how McDonald’s (MCD) is struggling to find growth vectors over the past few years. YUM is no different in this sector where the switching cost for customers is near zero.

The investment thesis is strong enough to claim that YUM meets my 6th investing principle.

Principle #7: Think Core, Think Growth

My investing strategy is divided into two segments: the core portfolio built with strong & stable stocks meeting all our requirements. The second part is called the “dividend growth stock addition” where I may ignore one of the metrics mentioned in principles #1 to #5 for a greater upside potential (e.g. riskier pick as well).

Having both segments helps me to categorize my investments into a “conservative” or “core” section and a “growth” section. I then know exactly what to expect from it; a steady dividend payment or higher fluctuation with a great growth potential.

 

Considering the new YUM!, we can expect YUM to be part of a strong core dividend portfolio. Since the stock price is already trading at high multiples, I don’t expect to see it go through the roof in the upcoming years. However, its steadily increasing dividend is a good argument for any income seeking investor. YUM is a core holding.

Final Thoughts on YUM! – Buy, Hold or Sell?

I must admit that I’ve been somewhat seduced by YUM’s impressive dividend growth rate over the past 11 years. However, keep in mind that the new YUM! will be different and we don’t know exactly how this will reflect on the dividend payment. At the moment, I think YUM is an interesting play for more courageous investors that are willing to invest in the future cash flow generating machine this company will become.

Disclaimer: I do not hold YUM! in my DividendStocksRock portfolios.

Disclaimer: The opinions and the strategies of the author are not intended to ever be a recommendation to buy or sell a security. The strategy the author uses has worked for him and it is for you to decide if it could benefit your financial future. Please remember to do your own research and know your risk tolerance.

Aflac – Steady As She Goes

 

Summary:

  • Aflac revenues have suffered from the strong US currency over the past 3 years. Now that the biggest part of the USD impact is behind us, AFL might post some interesting numbers.
  • Aflac benefits from a strong core business in Japan, but sales growth won’t be astonishing in the upcoming years due to low interest yield in that country.
  • Aflac shows all the characteristics of a strong core dividend growth portfolio holding. However, it looks overvalued.

DSR Quick Stats

  • Sector: Financial (Financial Services)
  • 5 Year Revenue Growth: 0.13%
  • 5 Year EPS Growth: 3.51%
  • 5 Year Dividend Growth: 6.75%
  • Current Dividend Yield: 2.67%

What Makes Aflac (AFL) a Good Business?

AFLAC Incorporated (NYSE: AFL) is a large international supplemental insurer. They provide cash that can cover several types of expenses to those receiving payouts due to illness or death. This is supplementary to primary medical insurance which helps cover medical expenses but leaves other expenses without a solution. This Fortune 500 company was founded in 1955, and has a large presence in Japan and the US. AFLAC stands for the American Family Life Assurance Company.

The company made a big move in Japan in the 1970s by selling insurance against the risk of cancer when people were becoming particularly mindful of cancer. Decades later, approximately three-quarters of Aflac’s diverse premiums now come from Japan.

Aflac primarily targets places of employment for its insurance products, rather than individuals outside of work. The company offers plans to employers that allow them to provide Aflac insurance as part of their benefits package to employees without paying any cost themselves.

The premise behind an insurance company is that they spread risk out over a wide number of people and businesses. They collect premiums (payments) from clients and in return those clients are covered in case of serious loss. From an insurance business standpoint, it’s ideal to collect more in premiums than you pay out for losses. This is not the primary form of earnings, though. An insurance business, after collecting all of the premiums, hold a great deal of assets that, over time, are paid out for client losses. An insurance company constantly receives premiums and pays out for losses, so as long as they are prudent with their business, they get to constantly keep this large sum of stored-up assets. As any investor reading this knows, a great sum of money can be used to generate income from investments, and that’s how an insurance company really makes money. Aflac invests its collected of assets primarily in fixed income securities to receive upwards of $3.4 billion in annual investment income.

Ratios

Price to Earnings: 10.21
Price to Free Cash Flow: 3.7
Price to Book: 1.418
Return on Equity: 14.24%

Revenue

afl1

Revenue Graph from Ycharts

It is no surprise that revenues are down since 2013. The company makes 75% of its revenue in Japan. The USD/YEN has just been terrible for Aflac:

afl2

Source: ycharts

We can expect a lower currency impact moving forward.

How AFL fares vs My 7 Principles of Investing

We all have our methods for analyzing a company. Over the years of trading, I’ve been through several stock research methodologies from various sources. This is how I came up with my 7 investing principles of dividend investing. Let’s take a closer look at them.

afl3

Source: Ycharts

Principle #1: High Dividend Yield Doesn’t Equal High Returns

My first investment principle goes against many income seeking investors’ rule: I try to avoid most companies with a dividend yield over 5%. Very few investments like this will be made in my case (you can read my case against high dividend yield here). The reason is simple; when a company pays a high dividend, it’s because the market thinks it’s a risky investment… or that the company has nothing else but a constant cash flow to offer its investors. However, high yield hardly comes with dividend growth and this is what I am seeking most.

afl4

Source: data from Ycharts.

Aflac has kept a dividend yield between 2.50% and 3.50% since the financial crisis. At the same time, the dividend payment has never stopped increasing. This is a very good sign to see a company showing a relatively stable yield with a strong trend of payment increases. There are no signs the dividend payment is at risk for now.

AFL meets my 1st investing principle.

Principle#2: Focus on Dividend Growth

My second investing principle relates to dividend growth as being the most important metric of all. It proves management’s trust in the company’s future and is also a good sign of a sound business model. Over time, a dividend payment cannot be increased if the company is unable to increase its earnings. Steady earnings can’t be derived from anything else but increasing revenue. Who doesn’t want to own a company that shows rising revenues and earnings?

Aflac is part of the selective group of dividend aristocrats. These companies have successfully increased their dividend for at least 25 consecutive years. AFL is now showing 33 years of consecutive dividend increases. Over the past 5 years, the company has increased its payout by 6.75% CAGR making its dividend payment double every 10 years on average.

AFL meets my 2nd investing principle.

Principle #3: Find Sustainable Dividend Growth Stocks

Past dividend growth history is always interesting and tells you a lot about what happened with a company. As investors, we are more concerned about the future than the past. this is why it is important to find companies that will be able to sustain their dividend growth.

afl5

Source: data from Ycharts.

With a loyal client base, this company is an impressive cash flow machine. You can see how the company is keeping a very low payout ratio, but an even lower cash payout ratio. The dividend payment is set for continuous growth for many years. It’s not by chance that AFL became a dividend aristocrat. The management team is very cautious with its cash flow and makes sure the dividend growth will continue.

AFL meets my 3rd investing principle.

Principle #4: The Business Model Ensure Future Growth

Aflac has a notable business model. Rather than targeting individuals, Aflac insurance agents target businesses. Aflac works with employers to give employees the option to purchase Aflac Insurance via payroll deductions, similar to their other benefits. This “cluster-selling” technique keeps costs comparatively low, and gives the company a major competitive price advantage. It creates a win-win situation with employers it does business with.

By focusing on supplemental insurance for illnesses such as cancer, the company has hit an ever growing niche for now. The company enjoys strong cash flow coming from Japan as it enjoys a great brand recognition. This should help the company to increase its presence in the USA in the upcoming years. Growing in the States will ultimately hurt its margin, but the company need to find another growth driver.

In my opinion, Aflac doesn’t own the strongest business model. Other competitors could hit AFL on the cancer insurance playground to slow the company down. Because of its expertise in its niche, AFL currently meets my 4th investing principle but it needs to be on the watch list.

Principle #5: Buy When You Have Money in Hand – At The Right Valuation

I think the perfect time to buy stocks is when you have money. Sleeping money is always a bad investment. However, it doesn’t mean that you should buy everything you see because you have some savings put aside. There is valuation work to be done. In order to achieve this task, I will start by looking at how the stock market valued the stock over the past 10 years by looking at its PE ratio:

afl6

Source: data from Ycharts.

As you can see, there used to be a hype around AFL a few years ago in terms of stock valuation. The market used to pay a higher multiplier (up to 19 at its peak) over the past 10 years. After 2012, this is another story as the USD currency gained strength and hurt AFL revenues over the past 3 years. The stock price looks cheap overall if we compared to its multiple prior to 2008. However, this doesn’t tell me much about its current and future value. This is why I’m also using a double stage dividend discount model:

 

 

Input Descriptions for 15-Cell Matrix INPUTS
Enter Recent Annual Dividend Payment: $1.64
Enter Expected Dividend Growth Rate Years 1-10: 6.75%
Enter Expected Terminal Dividend Growth Rate: 5.00%
Enter Discount Rate: 9.00%

 

Since the company evolves in a very stable environment, I use a 9% discount rate. I’ve selected a 6.75% growth rate for the next 10 years which is a similar rate to what the company showed in the past 5 years. However, I reduced it to 5% afterward to keep a conservative valuation.

Calculated Intrinsic Value OUTPUT 15-Cell Matrix
  Discount Rate (Horizontal)
Margin of Safety 8.00% 9.00% 10.00%
20% Premium $79.78 $59.51 $47.37
10% Premium $73.13 $54.55 $43.42
Intrinsic Value $66.48 $49.59 $39.47
10% Discount $59.84 $44.63 $35.53
20% Discount $53.19 $39.68 $31.58

 

Source: Dividend Monk Toolkit Excel Calculation Spreadsheet

Unfortunately, the company stock appears to be overvalued by 20% at the moment. I would need to increase my dividend growth rate after 10 years from 5 to 6% in order to have a fair value. If the company shows a stronger dividend growth potential, then it seems to be at best fairly valued.

AFL doesn’t meet my 5th investing principle.

Principle #6: The Rationale Used to Buy is Also Used to Sell

I’ve found one of the biggest investor struggles is to know when to buy and when to sell their holdings. I use a very simple, but very effective rule to overcome my emotions when it is the time to pull the trigger. My investment decisions are motivated by the fact that the company confirms or not my investment thesis. Once the reasons (my investment thesis) why I purchased shares of a company  are not valid anymore, I sell and never look back.

Investment thesis

Aflac works in a very interesting niche. A while ago, AFL specialized in supplemental policies for specific diseases and illnesses. Since it was a side product for many insurers, Aflac was able to developed an expertise and grow this business under the radar of many. Today, the company benefits from cheaper pricing and strong underwriting margins since they know their markets and are able to assess their risk better than any other companies in this specific niche.

Second, Aflac’s main core business comes from Japan. This country generates 75% of its revenue. What is interesting is that 95% of Japanese keep their policy and the average “client’s life” with Aflac products is 20 years. This means a lots of premiums paid each month! More recently, Aflac was able to enter into banks and post offices to sell their products, two places where the Japanese are used to purchasing such products. This should help support their sales in the upcoming years.

Risks

The deregulation in Japan that enabled AFL to enter banks and post offices doesn’t only bring sweet candies. There is a sour taste to it. In fact, this deregulation also enabled other insurance companies to compete directly with Aflac on its own ground. While the company has built a strong expertise in its niche, it won’t be long before other businesses will do the same.

While the company is pretty strong in Japan, it is another story in the US. It is harder for AFL to keeps its client (75% of Americans tend to switch policies at one point in time). This leads to inevitable margin reduction.

Aflac has a sound business model and meets my 6th investing principle.

Principle #7: Think Core, Think Growth

My investing strategy is divided into two segments: the core portfolio built with strong & stable stocks meeting all our requirements. The second part is called the “dividend growth stock addition” where I may ignore one of the metrics mentioned in principles #1 to #5 for a greater upside potential (e.g. riskier pick as well).

Having both segments helps me to categorize my investments into a “conservative” or “core” section or into a “growth” section. I then know exactly what to expect from it; a steady dividend payment or greater fluctuations with an improved growth potential.

Aflac is a dividend aristocrat evolving in a relatively conventional market.  I believe the company will be able to grow its revenues and earnings but will definitely not explode at one point in time. This why I believe AFL should be part of a core portfolio.

Final Thoughts on AFL – Buy, Hold or Sell?

Overall, I think a purchase of AFL is a purchase of a solid and increasing dividend. However, do not expect anything else from AFL for the upcoming years. In comparison, the stock price rose 10% over the past 5 years while the S&P 500 rose 52%.

Then again, AFL is a very strong core portfolio holding showing clockwork dividend increase potential. I think that at this point, AFL is a hold.

Disclaimer: I hold AFL in my DividendStocksRock portfolios.

Disclaimer: The opinions and the strategies of the author are not intended to ever be a recommendation to buy or sell a security. The strategy the author uses has worked for him and it is for you to decide if it could benefit your financial future. Please remember to do your own research and know your risk tolerance.

Spring 2016 Newsletter

The markets have rallied back up, and once against have fairly rich valuations. But there is considerable uncertainty in the market, and some high quality companies are trading at lower prices than they were a few months ago.

Here’s a list of three companies that I believe are reasonably valued, and that may become even more attractive if another market decline were to occur.

Magellan Midstream Partners LP (MMP)

I briefly mentioned Magellan in my December newsletter, and I certainly believe it deserves a more direct focus here. It’s a fairly conservative pick in the troubled pipeline industry, offering a decent yield and strong distribution growth. It’s my current preferred selection in the industry.

Unlike many other pipeline operators, Magellan primarily focuses on transporting refined products, and they’re the largest refined products pipeline company in the country. They have 9,500 miles of refined pipelines, 50+ terminals, and 40+ mm barrels of storage facilities, and access to about 50% of the country’s supply. To round that out, they also have 1,600 miles of crude products pipelines and 20+ mm barrels of crude storage facilities. Lastly, they have 5 marine storage facilities.

Their focus on refined products is what has largely protected them from the oil price crash. Their unit price has taken a big hit due to a reasonable valuation correction, but their actual operating numbers remain strong, and the distribribution remains very safe. This is because most of their volume is demand-based rather than supply-based. As long as U.S. consumers and businesses keep using large amounts of gasoline, diesel fuel, jet fuel, petrochemicals, lubricants, asphalt, and oil-based plastics, then Magellan should continue to do very well.

The company currently pays a distribution yield of about 4.5%, with double-digit distribution growth over the last decade and a half. The distribution growth from 2014-2015, straight through this crash of oil prices, was just over 15% for the year. MMP management expect 10% distribution growth in 2016 and at least 8% distribution growth in 2017.

They currently have over 1.3x distribution coverage, meaning they have over 30% more cash flow than they pay in distributions, which is much higher than most other MLPs. Magellan aims to keep this number above 1.1, so they’re far above their target and playing it safe. They also have a lower than average debt/EBITDA ratio of under 3, and one of the industries highest credit ratings at BBB+.

The partnership does face some headwinds from low commodity prices that affect about 15% of their business, and reductions in supply from some basins as well as the potential for defaults from some of their troubled customers that can affect Magellan’s performance to a degree.

A long term risk to Magellan is a reduction in the use of oil products. An example would be Tesla’s upcoming Model 3, or Chevrolet’s upcoming Bolt, which both aim to be roughly $30k all-electric vehicles with 200+ mile battery ranges between charges. The electric car industry is fragile, with little market penetration, reliances on federal subsidies, and a lack of charging infrastructure. But as lower priced electric vehicles with ranges that can comfortably fit any normal commute become commonplace, this could change. Overall though, industry estimates for the market growth of these kinds of vehicles aren’t large enough to materially affect Magellan through 2020 at least.

One of the strongest points in Magellan’s favor is the fact that they have no incentive distribution rights (IDRs) to pay. Many MLPs have to pay up to 50% of their cash flow to their general partners, but Magellan is 100% owned by the public. So, Magellan has all of the tax advantages of being an MLP, but doesn’t have to deal with the downside of IDRs. This effectively means they have a lower cost of capital than most of their peers. When IDRs cap out at 25% or so, like Brookfield Infrastructure Partners, then they’re not much of a drag on growth. But when IDR caps are as high as 50%, like many MLPs are, it can limit the types of investments that an MLP can profitably make while still increasing its per-unit distributions. Magellan is free of this problem entirely.

They also don’t currently rely on raising capital with equity. Many MLPs ran into trouble in 2015 when they relied on selling units to raise cash, but their unit prices were cut in half or worse, leading to that suddenly being a poor way to raise money. Magellan has the option to raise equity capital if a huge opportunity comes along, but they don’t need it for general growth and operating expenses, and haven’t increased their number of outstanding units in the last 5 years. They keep the distribution coverage high enough that they pay a growing distribution while using excess cash to internally fund investments for growth, and rely on conservative levels of debt financing.

Wrapping It Up Into a Valuation

Magellan’s most recent quarterly distribution was $0.785/unit, which is $3.14/unit annualized. This is a distribution yield of about 4.5%. Since inception, their distribution growth rate has averaged about 13% per year.

The performance, therefore, has been oustanding. A 4-5% distribution yield with a 10-15% distribution growth rate over a decade or more translates into market-crushing performance. So for the forward period, I’m not going to use those numbers. Instead, I’ll use more conservative estimates that assume Magellan must slow down, must face more headwinds, must deal with a more saturated pipeline industry, must face the rise of electric vehicles, and so forth.

Here’s a dividend discount model analysis of MMP, using 8% distribution growth for the next decade and 5% thereafter, and a 10% target rate of annualized return:

MagellanValuation

Source: Dividend Monk Toolkit Excel Calculation Spreadsheet

The result is a valuation estimate of $83. In comparison, Morningstar currently has a fair value estimtae of $76, and Argus Research has a price target of $85.

The current price in the low $70’s places it about 15% below my fair value estimate, implying that expected returns going forward should be over 10%/year with a margin of safety. It’s not a very high hurdle to step over, and therefore I believe that Magellan is a great risk-adjusted opportunity.

If you want an even larger margin of safety than the current price offers, Magellan units have very attractive option premiums. You can sell a July 16, 2016 cash-secured put with a strike price of $65 for about three dollars. This means that during the next four months, if Magellan stock goes below $65, you may have to purchase it for $65, which counting the premium would give you a cost basis of about $62. Then, you’d have a great cost basis to hold it for the long-term. Or, if Magellan remains above $65, you would keep your three dollars per unit, which translates into a return of about 4.8% for just a four month period, and you could write another option at that point, and continue this strategy until you own it.

CSX Corporation (CSX)

I believe it’s time to buy the railroads, and it’s really a toss-up between CSX and UNP at this point, in my opinion. They’re the two largest remaining pure-play Class I railroads in the United States, and UNP operates in the western two-thirds of the country while CSX operates in the eastern third of the country.

UNP is, by many metrics, the slightly better company. Their long stretches of track along the lesser-populated region of the country are good alternatives to trucks, and they have access to Mexico for the transport of cars. But this comes with an earnings multiple that is about 2 higher than CSX, and a slightly lower dividend yield.

Mike recently published articles on both of them, and I think both are strong investments. An investor would likely do fine diversifying into both of them, if they want railroad holdings for the entire continental United States. For this article, I’ll focus on CSX.

Downtrodden

The global crash in commodity prices has hurt the U.S. railroads. Coal in particular is down, both as a source of energy and as an ingredient in steel. Low natural gas prices have all but made coal obsolete as an energy source for new energy plants, especially considering that it’s one of the dirtier sources anyway. Export coal volumes are hurt by the strong U.S. dollar and a weak Chinese economy. Metallurgical coal used in steelmaking is down as well, also due to Chinese weakness and other global issues.

Many other goods in the economy have declining volume, and the massive reduction in diesel prices has made trucking more affordable, which can eat into railroads market share. As such, CSX has seen its stock price drop from about $37 to now around $25.

Despite the big stock price hit, the company is doing fine. Although revenue was down 13% for 2015 compared to the year prior, 2015 EPS was higher than 2014. Going into 2016, the company expects mild EPS declines compared to 2015, as continued volume weakness, especially from coal, is offset by reducing the number of engines and workers. Thanks to the the advances in automation technolgies over the last two decades, the railroads now have highly flexible business models that allow them to shrink and expand to meet cyclical demand, which is good for just about everyone except of course the rail workers. All in all, CSX deserved a price correction, but losing a third of the stock price puts it into oversold territory, in my opinion.

Analysists expect EPS in 2016 to be $1.86 compared to $2.00 in 2015. But with current information, they expect CSX’s 2017 EPS to be back up to over its 2015 figure. We’ll see what happens, but the point is, CSX adusts to changes in volume.

An Opportunity

A project is expected to be completed this year that will double the capacity of the Panama Canal, and increase the maximum size of ships that can pass through. This is expected to increase shipping volume between Asia and the east coast of the United States.

Currently, materials and products that ship between the eastern half of the United States and Asia are usually shipped between Asia and the west coast and then railed between the west coast and the eastern half. But with direct access to ports along the east coast with larger container ships thanks to the panama canal expansion, the two western U.S. railroads are expected by some analysists to lose market share to the two eastern U.S. railroads. Ports along the east coast are expanding to allow for these larger ships, in expectation of this increase. Some estimates are that the intermodal market share for CSX could increase from 20% to 25% over the next five years. When comparing CSX to UNP, that’s a factor to consider, especially with CSX consistently being at the lower valuation.

Both remain strong picks, in my view.

Dividend Growth

Estimating the actual volume growth or shrinkage of railroads over a long period of time is nearly impossible, due to how cyclical it all is. The good news is that unlike many other industries, you don’t need very accurate estimates; you just need to know how management intends to allocate their capital, assuming no fundamental changes radically reduce rail volume.

Revenue for CSX in 2016 is not much higher than it was in 2008, for example, and yet EPS has almost doubled during those eight years. Shareholder returns from railroads come mostly from dividends and sharebuybacks; not from core growth.

If over the next ten-year period, CSX has 0% net volume growth and 2% annual pricing growth in line with inflation, then revenue growth will average 2% per year. The dividend yield is about 2.8%, and the company historically buys back stock and reduces its share count by about 2-4% per year, which makes sense given that they have an earnings yield of about 7%, which mostly goes to dividends and buybacks.

Adding this together, if the dividend payout and debt/equity ratios stay relatively static, you can reasonably expect a 2.8% dividend yield and a forward dividend growth rate of about 4-6%, based on 2% annual price increases and 2-4% buybacks. That comes out to a total rate of return of about 6.8%-8.8% per year, with zero volume growth, from a boring railroad investment. Any volume growth would be in addition to that.

Rockwell Automation (ROK)

This is a good candidate to buy on dips. The company has excellent long-term growth prospects but the valuation is at the high end of what’s fair, with a current P/E ratio of about 18.

Rockwell is a provider of industrial automation products and services. This includes selling automation hardware and software to companies, and also includes experts that can implement those products for a company. Their products can cover both discrete and process solutions, and they have useful lifecycles of over ten years in most cases. Their software and hardware are unique, with high switching costs. Customers tend to be quite “sticky”, and therefore Rockwell has a durable competitive advantage.

I run the electrical engineering department of a small organization that I work for, and we’ve been using the same automation products from one of Rockwell’s competitors since I took the job, despite changing most other things over time. My predecessor used them, and I still use them, simply because they work well enough and the software engineers would have to change a lot of code to start working with a new system. I continue to buy tens of thousands of dollars of those systems, even as they increase the price regularly, because price isn’t our only decision point. I’ve examined other systems, and have never found a compelling reason to switch to a different one. In short, software switching costs can be high due to the need for re-integration and additional software writing and testing, and it creates a moat and pricing power.

Although Rockwell is in a low-growth period due to global economic issues, they’re a leader in an industry that has nowhere to go but up. Rockwell estimates that the global potential market for their products increased from $65 billion in 2010 to $90 billion in 2015.

Strong Cash Flow

Rockwell has had fairly unimpressive revenue growth over the last ten years, but they’ve enjoyed strong EPS growth, book value growth, and dividend growth. Their balance sheet is safe but not spectacular. What really shines is their free cash flow; they’re one of the uncommon companies that consistently generate more in free cash flow than they report as earnings. So, while the price to earnings ratio is currently 18, the price to free cash flow ratio is under 15. Suddenly the company looks a lot more attractively priced.

The company doesn’t waste it, either. Over the last five years, the company has increased its dividend by over 15% per year on average, while consistently reducing their outstanding share count. The current dividend yield is about 2.7%. Forward dividend growth should slow down as we enter a more difficult period for global growth, but Rockwell remains in a position to produce consistent dividend growth.

Wait For It…

Rockwell was at its high in 2014, at over $125/share at one point. In January of 2016, during the market correction, Rockwell stock traded nearly as low as $90/share. Now, it’s back up to $107. The market has been bipolar about it, constantly changing market price due to variances in global growth expectations.

Buying at $107 would be a solid purchase, in my opinion. But the stock is also a good candidate for selling puts, based on the price of the premiums, the stability of the company, and the volatility of the stock.

You can sell a July 2016 put for a strike price of $100 and earn a $4 premium. If the stock declines to under $100 in the next four months, then you’d buy it for a cost basis of $96, which is only 13x current FCF. If the company remained over $100 by expiration in mid July, you’d keep the premium anyway, and enjoy a return of over 4% in a period of a little over four months, and write another option. You can get paid like this to eventually buy at a very attractive cost basis.

Conclusion

Although overall market valuation remains fairly high at the moment, there are plenty of opportunities to establish long-term positions in cyclical industries. Railroads, best-of-breed pipelines, and industrials are all facing troubles at the moment, but their long-term potential remains optimistic and their valuations remain reasonable.