Quick Ideas

Six months ago in September 2011, several dividend bloggers created a Dividend Growth Index of 24 companies. Eight members each chose three investments.

My three picks were Walmart (WMT), Novartis (NVS), and Energy Transfer Equity (ETE).

In the last 6 months, Walmart is up from around $52 to over $60 and has paid out over $0.75 worth of dividends in the period. Novartis has been flat, although a nice dividend of over 4% has been received, which is paid out annually. Energy Transfer Equity has gone up from under $35 to over $41, while also paying out $1.25 in distributions along the way.

There aren’t many updates on my three picks. Dividend growth investing, at its best, is like watching paint dry. “No news” is good news. That being said, ETE completed its merger with Southern Union, which diversifies their assets and income, is particularly good for their MLP structure, and is one of the reasons why I picked them. So that’s good news.

It should be cautioned that much of the price appreciation in these picks was due to an increase in the general market. Based on metrics like Capitalization/GDP and the Shiller P/E, the market is moderately overvalued compared to its historic average. Caution and prudent valuation methodology is advised for current stock picks.

Here are links to the other members in the Dividend Growth Index, so you can see how their stocks are doing.

The Dividend Guy
Dividend Growth Investor
My Own Advisor
Wealthy Canadian (Inactive?)
The Dividend Ninja
Dividend Mantra
The Passive Income Earner

Full Disclosure: I am long ETE and NVS. You can see my dividend portfolio here.

Dividend Stock Newsletter:
Sign up for the free monthly dividend investing newsletter to get market updates, attractively priced stock ideas, resources, and exclusive investing strategies:

There are currently four, and only four, major companies that are rated with a perfect AAA credit rating by Standard and Poor’s. This isn’t a perfect proxy for risk, but the default rate for AAA companies is historically very low, which to a certain extent also implies a degree of stability for common stockholders.

Measurements of Financial Strength

There are five balance sheet metrics I consider to be key here:

Total Debt/Equity: Total debt divided by total shareholder equity. The lower, the better.

Current Ratio: Current assets divided by current liabilities. It’s a measure of liquidity; and the higher, the better.

Interest Coverage Ratio: How many times over operating income covers interest expense on debt. The higher, the better.

Total Debt/Income: Total debt divided by annual income. A look at how quickly the company could pay down debt if management wanted to. The lower, the better.

Total Goodwill/Equity: Percentage of shareholder equity that consists of goodwill. Goodwill isn’t bad, but it’s an accounting asset rather than a tangible asset.

Many of these metrics vary by industry. A good balance sheet for the fast-paced, non-capital-intensive software industry is different than a good balance sheet for a slow-moving, capital-intensive infrastructure business that generates steady cash flow. So, these metrics are best compared both to their peers, as well as examined in the absolute sense, to determine a good balance sheet.

A balance sheet isn’t everything, since less quantitative aspects like diversification and reliability of revenue are key aspects of stability as well. That’s the sixth metric to look at here.

So, here are the four dividend growth companies with a perfect AAA credit rating:

Johnson and Johnson (JNJ)

Johnson and Johnson (JNJ), is one of the largest blue-chip companies, has several decades of consistent dividend increases without a miss, and currently yields 3.49%.

As a diversified health care company, Johnson and Johnson’s revenues and profits are spread out rather well. They have a pharmaceutical business, a medical device business, and a consumer beauty and health business. The pharmaceutical business had sales of $24.4 billion in 2011, which makes them the eighth largest pharmaceutical business in the world, and no drug consisted of more than 25% of the total. The medical device business had sales of $25.8 billion, which makes them the number one largest medical device maker in the world. This segment is itself divided up into numerous groups, and none of them produce more than 25% of the total sales of this segment. The consumer health segment had $14.9 billion in sales, which makes it the sixth largest consumer health business. The biggest group in the segment, which is OTC pharmaceuticals, accounted for less than 30% of the sales of this segment, and is itself comprised of numerous products.

So as can be seen, Johnson and Johnson’s sales are highly diversified, with their biggest drugs, biggest medical devices, and biggest consumer products, each only providing a fairly small percentage of the total sales. This diversification is what it allowed it to absorb a major string of recalls over the last few years with no disruption to the dividend and with no major balance sheet or free cash flow shortfall.

Their total debt/equity is a very conservative 35%, and the interest coverage ratio is over 25, which is quite high. Goodwill only makes up a third of the shareholder equity, the debt/income ratio is around 2, and the current ratio is over 2. Overall, by all metrics, Johnson and Johnson has a solid balance sheet. Combined with a diversified revenue stream, the credit rating appears well earned.

Microsoft Corporation (MSFT)

Microsoft is currently rated as having an AAA credit rating as well. The numbers certainly support it, but do the revenue diversification and safety support it as well?

First, it’s worth going over the numbers. Microsoft’s debt/equity ratio is under 20%, and their interest coverage ratio is over 70. Their current ratio is a bit below 3, and goodwill makes up less than 30% of shareholder equity. Total debt/income is considerably below 1. The company has over $50 billion in cash sitting on its balance sheet. By all metrics, the numbers are excellent.

In terms of revenue diversification, Microsoft is reasonably diversified, but not to the extent of Johnson and Johnson. The company brought in $22.1 billion in revenue and $14.1 billion in operating income from the business division, which produces most of their software applications like Office. Their other primary segment is Windows, which brought in $19 billion in revenue and $12.2 billion in operating income. Their third largest segment, Server and Tools, has more promising growth opportunities, but only accounted for $6.6 billion in operating income. The Entertainment division has had very strong performance, but brings in rather small income, and their online businesses of MSN and Bing have negative profits. So it’s mainly about Windows, business software applications like Office and Sharepoint, and Server software. Their revenue is a bit more concentrated than Johnson and Johnson’s, and tech can range more rapidly.

I recently published a rather lengthy analysis of Microsoft. Overall, I’d say Microsoft deserves their perfect credit rating, since they have considerably more cash than debt, and so the risk to bondholders is minimal. But from a common stock standpoint, Microsoft is considerably riskier than Johnson and Johnson, in my view. They do offer one of the more consistent dividends in the tech industry, with annual growth over much of the last decade, and a yield of 2.46%.

Exxon Mobile (XOM)

Exxon Mobil is one of the largest public companies in the world. The enormous revenue and earnings are fairly diversified as well. The largest chunk by far, comes from upstream operations, with downstream operations and chemicals bringing in secondary major sources of income. In 2011, their upstream business brought in $34.4 in net income, while the downstream and chemical businesses each brought in approximately $4.4 billion in net income.

The company is highly diversified geographically, with operations, projects, and proved reserves on all continents. In addition, the company has diversification among conventional and unconventional resource types, and both oil and gas, with gas expected to play a more important role over time.

The company’s balance sheet is quantitatively strong as well. Total debt/equity is only around 10%, and the interest coverage ratio is extremely high (well over 100) due to the low debt and low interest rates. The current ratio is actually a bit below 1, but they do have some longer-term equity positions, and total debt/income is below 1 (actually below 0.5).

Exxon Mobil currently offers a fairly small dividend yield of 2.17% with decades of consistent dividend growth, and my most recent published analysis of the company can be found here.

Automatic Data Processing (ADP)

Automatic Data Processing, like the other companies here, has decades of consistent annual dividend increases without a miss. The company provides human resource outsourcing, benefits, payroll, taxes, time and attendance, and administrative services, and is several times larger than their largest direct competitor. In my previous discussions on economic moats, I pointed out that Automatic Data Processing has high switching costs to its many clients, since they hand over an essential and complex part of their business to ADP to handle. The dividend yield is currently 2.83%.

The company has virtually zero debt, the current ratio is over 1, and goodwill makes up only about half of shareholder equity.

With such a clean balance sheet, combined with a large and “sticky” client base, ADP certainly deserves its perfect credit rating in my view. I recently published an analysis of ADP, where I discussed why they stand to benefit from increased interest rates.

Conclusion

Looking over the four companies, JNJ and ADP are probably the safer bets, while XOM is more cyclical and MSFT has the largest uncertainty at any given time. They can all serve potential places in a dividend growth portfolio. I view JNJ, XOM, and MSFT being at reasonable valuations at the current time, while I view ADP as a tad bit expensive, and would write long term puts on the stock if I were interested in acquiring shares at a lower cost basis.

Full Disclosure: I am long MSFT, JNJ, and XOM at the time of this writing. You can see my dividend portfolio here.

Dividend Stock Newsletter:
Sign up for the free monthly dividend investing newsletter to get market updates, attractively priced stock ideas, resources, and exclusive investing strategies:

This is the sixth and last in a series of articles highlighting dividend growth companies that have large and durable economic advantages, or “moats”, that protect their business operations and allow years or decades of strong profitability. When looking for long-term investments, one typically wants to find a business that is performing well not simply because management is on top of their game right now, but rather because the business itself has fundamental and difficult-to-replicate advantages over its competitors. The previous article described four businesses with natural monopolies.

This sixth and final description of a moat is the Network Effect. It comes last in the series, since it is most elusive among dividend growth companies, and tends to be far more common in technology and online companies.

When a business benefits from the network effect, it means that its products or services become more valuable as more people use them. This creates a huge barrier of entry for competitors, because it’s a virtuous cycle. As more people use a network, its products or services become inherently more valuable, and therefore even more people use the network, which leads to more value, and so forth. At that point, a competitor could copy the products and services, and even improve upon them, and yet without any sort of major catalyst, their products and services still won’t be as good.

Although powerful network effects can be difficult to find in the world of companies that pay dividends, here are three of them:

American Express (AXP)

Among the most visible examples of the network effect in action among blue-chip companies is found in the card industry. As more consumers use charge cards, debit cards, and credit cards of a specific brand, the larger amount of pressure there is for merchants to accept payment from cards of that brand, and the more they accept those cards, the more desirable those cards are for consumers.

It’s important to note that there are two main kinds of card companies. There are the pure networks of Visa and Mastercard, and the credit companies of American Express and Discover. Visa and Mastercard do not directly hold any consumer debt. Banks issue those cards instead, and Visa and Mastercard provide the global payment processing network. Visa has the largest network, and therefore arguably the largest network effect. Then there are the credit card companies of American Express and Discover that issue cards and hold consumer debt, and are therefore fundamentally different than the other two.

Of all of these network and credit companies, American Express is the largest in terms of revenue. They target affluent individuals, small businesses, and corporations. They differentiate themselves with higher fees and more services. Due to the regulatory risks and slower growth of being in a different industry, as well as the strong hold that Visa and Mastercard have on bank-issued cards, American Express stock does indeed deserve a lower valuation. However, I believe American Express stock should be a decent choice going forward, based on the current valuation.

There aren’t particularly appealing dividend yields in this industry. It’s unfortunate that the best example of a network effect in the blue-chip world, has a host of low dividend yields and lack of consistent dividend growth history. Even American Express, with the largest yield of the bunch, only has a 1.33% dividend yield. The valuations of these stocks vary considerably. There are high valuations for Visa (trading for around 30 times earnings) and Mastercard (trading for around 28 times earnings), since they have great growth prospects. At the same time, there are lower valuations for American Express (trading for 13 times earnings) and Discover Financial Services (trading for 8 times earnings). All of them have low dividend payout ratios, including American Express which pays out less than 20% of earnings as dividends, and unfortunately hasn’t grown the dividend since 2008.

McGraw-Hill (MHP)

McGraw-Hill is the parent company of Standard and Poor’s (S&P) and J.D. Power and Associates, and is a major publisher.

Rating agencies like S&P currently have high barriers of entry due to the network effect. There is therefore an oligopoly. The more common and ubiquitous their ratings are, the more necessary it is for a business to be rated by them. Their ratings quality has been called into question for numerous reasons, including failing to adequately judge risk before the financial collapse. There is consistent litigation risk.

McGraw Hill stock fortunately has a slightly larger yield and more consistent dividend growth than American Express. The company has grown its dividend consecutively every year since the 1970’s, and currently offers a 2.16% dividend yield. The most recent dividend increase, however, was only 2%. I don’t find MHP stock to be an appealing value at the current price.

Microsoft (MSFT)

As previously mentioned, there is no shortage of network effects in the tech and online world.

Ebay, for instance, has its services strengthened in proportion to the number of users. The more users that exist on Ebay, the more it makes sense to use that service for auction needs. Ebay’s Paypal is in a similar network effect position to the card companies. The larger the market share of online payments that Paypal can capture, the more consumers and merchants will use Paypal, and therefore more consumers will follow.

Other examples are the Social Media sites. Facebook, Twitter, and Google+ are the big three to mention, but any niche social media site qualifies as well.

Google, Amazon, and Apple battle for dominant networks. It’s more about platforms than about products at this point. They strive to get their devices in the hands of more people, which makes their application ecosystem more attractive for developers. As a higher quantity and quality of apps are developed, the platform itself is strengthened in a virtuous cycle of media/content delivery and consumption. These are some of the strongest network effects around. Amazon focuses on the physical realm as well, and the larger its platform is, the bigger the network effect becomes.

Microsoft is coming towards a similar position. While they’ve missed out on much of the mobile market share, Microsoft has always used the network effect to its advantage. Their Windows and Office products became so commonplace, that training and certification programs were introduced. Being able to use their products, therefore, became a standardized and marketable skill. And the more people that had these skills, the stronger and more ubiquitous the products became.

Microsoft has lost some of that dominance, but with the upcoming Windows 8 and Windows Store, they’ll have an app platform across personal computers and potentially into tablets. Microsoft has historically understood the importance of developers in their business. The larger number of consumers that use Microsoft platforms, the more incentive there is for developers to create better and more numerous apps, and the more attractive the platform of apps/media/content is, the more competitive it can be with regards to attracting or retaining consumers.

There will likely continue to be a healthy mix of strong application/media/content platforms, and in particular, I expect Google Play to strengthen Google’s position. Microsoft stock is the only one of the group that offers a dividend, and currently has a yield of 2.45%. The most recent dividend increased was 25%. I’ll be talking about Microsoft more in an upcoming analysis article, and in my next dividend newsletter edition.

Conclusion

In conclusion, economic advantages, or “moats” are critical to establishing a long-term business. These can range from economies of scale, to global brands, to patent shields, to high switching costs, to natural infrastructure monopolies, to network effects. Dividend growers tend to have one or more of the first five types of moats, while moats in the tech world are very strongly based on the platform; the network effect.

Full Disclosure: I am long MSFT at the time of this writing.
You can see my dividend portfolio here.

Dividend Stock Newsletter:
Sign up for the free monthly dividend investing newsletter to get market updates, attractively priced stock ideas, resources, and exclusive investing strategies:

This is the fifth in a series of articles highlighting dividend growth companies that have large and durable economic advantages, or “moats”, that protect their business operations and allow years or decades of strong profitability. When looking for long-term investments, one typically wants to find a business that is performing well not simply because management is on top of their game right now, but rather because the business itself has fundamental and difficult-to-replicate advantages over its competitors. In the previous articles, examples of unrivaled economies of scale, powerful brands, huge patent shields, and high switching costs were provided.

Some companies have natural monopolies over their territories of operation.

This generally takes the form of heavy infrastructure investment into an area, which makes it impossible or nonsensical for a competitor to replicate the same infrastructure in an overlapping way, since poor returns wouldn’t be able to justify the investment.

Companies that have natural monopolies do of course still face risks; they must manage revenues, costs, and margins, and they must work with government regulators that wish to ensure that customers are not taken advantage of by natural monopolies. In addition, monopolies are not always black and white; sometimes a business may have complete control over an area, while other times, they may share a duopoly with another company when there is sufficient demand, which is still usually an appealing situation to be in.

These natural monopolies, when managed well, can provide rather lucrative and stable cash flows, due to the moat that is created by such a situation.

Below are four examples of dividend growth companies that I view as having natural monopolies:

Enterprise Products Partners L.P.

Enterprise Products Partners (EPD) is now the largest publicly traded MLP. The partnership has over 50,000 miles of pipelines for natural gas, NGL crude oil, refined products, and petrochemicals. They also have enough storage for over 190 million barrels of NGL and 27 billion cubic feet of natural gas. They also host fractionation, marine services, and import/export terminals. Pipelines in major hub areas are never complete monopolies, but when they build pipelines and other facilities in strategic locations, and when they provide transportation to key markets, they set themselves up with an expensive asset base that makes little sense for competitors to directly replicate. Instead, major players in this area tend to work out complimentary projects and joint ventures.

In addition, since EPD acquired its general partner, Enterprise GP Holdings, in 2010, the company now has a lower cost of capital thanks to not having large incentive distribution rights (IDRs). IDRs require limited partners to pay greater and greater percentages of their cash inflows to their general partner as they increase their distributions. This works well in the beginning, because it is a strong incentive for the general partner to grow the distribution payouts to the limited partners, since the bulk of the general partner’s ability to bring in good returns is hinged on their ability to pay distributions to limited partners, but the problem with IDRs is that once distributions increase over a number of years, they can be oppressive and hold down distribution growth. A number of limited partnerships, including EPD, have bought out their general partner to eliminate this problem.

Unfortunately, while I think that EPD is a great business, I do think the valuation is a bit expensive, so personally I’d only look to potentially purchase on a pullback. Units currently offer a distribution yield of 4.79%, and the distribution has grown by an annualized rate of 5.8% over the last five years.

Brookfield Infrastructure Partners L.P.

Brookfield Infrastructure (BIP) is one of my personal favorite partnerships, since there isn’t really any other partnership out there to directly compare it to. With a market cap of around $3.4 billion, it’s on the smaller side, but the partnership owns assets on multiple continents, and they’re mainly monopoly-type assets. A sample of BIP assets include the enormous Australian DCBT coal export terminal, Australian railways, UK port operations, a major Chilean electricity transmission network and toll roads, as well as timberlands in North America. Many of these assets are either utilities, which tend to be natural monopolies, or are based on specific and limited geographic features, such as ports, timberlands, export terminals, etc.

Unlike EPD, BIP does have incentive distribution rights to pay. But as a Bermuda-based publicly traded partnership, it has slightly different characteristics than MLPs, and one of those is that IDRs are capped at 25%. This is a good quantitative position, as the general partner is aligned with limited partners in benefiting from an increased distribution per unit, but not to the point where this distribution makes the cost of capital too expensive (unlike MLPs that can go up to IDRs of 50%).

As far as the distribution is concerned, BIP offers a 5.02% distribution yield after recently increasing its distribution. Unlike MLPs, BIP only targets to pay out 60-70% of its funds from operations (FFO) as distributions, so there is ample left over for acquisitions, distribution growth, and so forth. Over the past three years, the annualized rate of distribution increase has been over 12%. The recently announced $0.375 quarterly distribution is 21% higher than the quarterly distribution of $0.31 from this time last year. BIP’s valuation of course changes over time, and I generally find it appealing whenever the distribution yield is above 5%.

Canadian National Railway

Canadian National Railway (CNI) is the largest railway in Canada, and also has considerable lines in the U.S. Their rail system spans the Atlantic Ocean to the Pacific Ocean through Canada, and stretches down to the Gulf of Mexico through the U.S. Railways can be a healthy monopoly, since once tracks are put down over a long area, that transportation need has already been provided for, and competitors need to look elsewhere. Railways such as CNI transport petroleum, metals, forest products, coal, grain and fertilizers, as well as many other goods. Due to the strong geographic positions that are natural for railways, rather than facing steep competition from other railways, the future for CNI is mainly based on good management and macroeconomic conditions. Seeing as how railways have inherent energy efficiencies over other forms of transportation such as trucks, I view their position as rather entrenched and positive.

Current analyst estimates are for an annualized EPS growth rate of nearly 11% over the next two years. When combined with the 1.93% dividend yield and the fact that CNI grew the dividend by an average of 12% annually over the past five years, I view this as a rather strong stock. I’d personally look for a slight pullback to bring the yield up to 2% before entering or adding to a position.

Waste Management

Trash is a dirty but profitable business. It’s especially profitable for the major players, the owners of the landfills, and Waste Management (WM) happens to be the largest trash collector in North America. Landfills are naturally unattractive assets, and people generally don’t want them anywhere near where they live. This creates natural difficulties in opening up new ones, so the companies that already own them, do have certain moats against competitors.

The business model is rather (economically, though not aesthetically) attractive:
-Customers pay Waste Management to remove their waste.
-Waste Management recycles the material that is recyclable and gains some cash flow.
-Waste Management can use a combustion process to turn waste into energy- enough to power about 650,000 homes which provides another stream of cash flow.
-Waste Management deposits a lot of trash into landfills, and generates additional cash flow by charging fees for lesser waste companies to also deposit trash into their landfills.
-Waste Management uses the methane that comes up from landfills to produce electricity for which they can generate more cash flow. They generate about 500 Megawatts of electricity this way, which can power about 400,000 homes.

Waste Management does however face some strong competition. The industry is consolidating, and large competitors have challenged WM’s pricing power. Landfill ownership and the large amount of assets and infrastructure needed for collecting, sorting, energy production, and maintenance are a strong defense, but some of the top competitors boast the same assets, and unlike some of the other industries on this list, trash companies are a bit more mobile with their competition. I’d look for a pullback of a couple of bucks, down to the low $30’s before I’d view the stock as having a solid entry price. Specifically, the current dividend yield is 3.86%, and I’d look for a valuation that provides for a yield comfortably above 4%. The company has grown the dividend at an annualized rate of approximately 7.8% over the past five years.

Conclusion

Keep in mind that a good company only makes a good long-term investment if it’s purchased at a reasonable price. A trend that readers may have noticed in this article is that, in general, stocks are a little bit pricey at the current time, and I observe that this sentiment is rather common at the moment. I’ll be discussing this in my dividend newsletter later this week, and providing a number of what I consider to be fairly appealing stocks at current prices. There are bargains out there, but generally not big ones, and there are certain areas of the market that seem to still be fairly valued rather than richly valued.

Full Disclosure: At the time of this writing, I own units of BIP.
You can see my dividend portfolio here.

Dividend Newsletter:
Sign up for the free monthly dividend investing newsletter to get market updates, attractively priced stock ideas, resources, and exclusive investing strategies:

This is the fourth in a series of articles highlighting dividend growth companies that have large and durable economic advantages, or “moats”, that protect their business operations and allow years or decades of strong profitability. When looking for long-term investments, one typically wants to find a business that is performing well not simply because management is on top of their game right now, but rather because the business itself has fundamental and difficult-to-replicate advantages over its competitors. In the previous articles, examples of unrivaled economies of scale, powerful brands, and huge patent shields were provided.

Some companies have businesses where it’s naturally difficult to switch to a competitor. This increases pricing power and makes revenue more stable.

For example, if you’re running a business, and you’ve outsized most of your human resource operations to another company, it would be a large hassle to switch to their competitor. They’d have to mess up rather terribly to get you to switch; minor price increases wouldn’t be enough. Or, for a consumer example, if you have money saved in a bank, have credit cards and checks with that bank, then switching is a hassle. As long as they’re operating reasonably well, you’re not going to switch.

This is in contrast to, for example, buying Pepsico (PEP) products or shopping at Costco (COST). They may have other economic advantages, like brand strength and scale, but their switching costs are fairly low. If at any time a competitor was superior in your eyes, you could easily switch with little or no cost or difficulty for yourself simply by buying a competitor’s products next time.

Below are five examples of dividend growth companies that have high switching costs:

Automatic Data Processing

Automatic Data Processing (ADP), is the aforementioned business outsourcing company. They handle human resource needs, payroll, computing processes, direct deposits, tax reports, employee time and attendance, hiring services, record-keeping, and some other software services. ADP is five times larger than their largest direct competitor.

The company has more than three decades of consecutive annual dividend growth, and is one of only four non-financial U.S. companies with an AAA credit rating. Low interest rates are currently negatively affecting ADP, since they hold tens of billions of dollars worth of client funds and then invest them in conservative and liquid interest-producing securities, but for the long term, ADP’s position looks rock solid.

Dividend Yield: 2.94%
Total Debt/Equity: 0%
Price to Free Cash Flow (FCF) Ratio: 17.2
Dividend Payout Ratio: 47%
Most Recent Dividend Increase: 9.7%
Full Automatic Data Processing Analysis

Microsoft Corporation

Microsoft (MSFT) has set up a near monopoly on the business personal computing environment. Employees become trained in using certain software, and so switching software requires substantial re-training, especially for a large enterprise. I’ll tell you right now as an engineer, my organization is currently undergoing an unrelated but rather major software switch and the time-cost of this is rather enormous. And major enterprise IT hardware/software capital investments can last for a while.

At least, that’s how it worked for the last decade, but the company faces new challenges today. Microsoft’s moat with regards to consumer software may be threatened by the various free options available, but their business position remains strong, and any reductions in Windows sales are being balanced out by increases in the Server and Tools division. It’s the business environment rather than the consumer market where software moats can be formed.

A few key estimates and facts released by Microsoft with regards to 2011 fiscal year performance:
-The Windows segment revenue was slightly down, and operating income was modestly down, mainly due to a problematic PC market. The company estimates that PC sales to businesses grew by 11% compared to the previous year, but that PCs sold to consumers fell by 1%, with the biggest loss coming from netbooks. Overall, PC sales were slightly up, but the bulk was in emerging markets where prices are lower.
-The Server and Tools Division, Business Division (Office), and Entertainment Division all posted very strong growth in 2011.
-The Online Services Division continued to lose money.

Dividend Yield: 2.56%
Total Debt/Equity: 19%
Price to FCF Ratio: 9.8
FCF Dividend Payout Ratio: 22%
Most Recent Dividend Increase: 25%

Realty Income Corp

Real estate can naturally result in high switching costs. Realty Income (O) is a REIT that owns over 2,600 properties in 49 states, and leases these spaces out to commercial tenants. Moving is a hassle for a family, but the hassle is even greater for commercial tenant that tries to move a business. Plus, Realty Income signs long term leases and is known for high occupancy rates, large diversification, and a well-run business.

Realty Income, known as “The Monthly Dividend Company” pays out a dividend every month of the year and has a pretty good record of increasing their distributions annually. With a nearly $5 billion market capitalization, Realty Income Corp is a decently large REIT.

Dividend Yield: 4.79%
Most Recent Dividend Increase: <1%

National Health Investors Inc

National Health Investors (NHI) is another REIT, and one with a larger dividend yield and more dividend growth. This business focuses on long-term care and senior housing, which naturally results in high switching costs. NHI owns properties directly and also invests via mortgages. With over 100 properties in over 20 states, the business is rather diversified. The largest chunk of their property interest consists of skilled nursing facilities, but they also own over 30 assisted living facilities, and a handful of medical offices and acute care facilities.

NHI’s dividend procedure is a bit noteworthy, and in my opinion, very smart. They pay out regular quarterly dividends, which they typically increase annually. On top of that, they often pay an annual special dividend to relieve extra capital and provide more income for the owners. This is a strategy that from a dividend growth investing viewpoint, I wish more regular companies would utilize. NHI represents an example of a business that has strong defenses without being particularly large, which is why I’ve selected it for this article over some larger health care REITs.

Dividend Yield: 5.52%
Most Recent Dividend Increase: 5.7% (and if counting the special dividend, 15%)

AT&T Inc.

AT&T (T) is a large telecommunications company that provides wireless data/voice services, wired data/voice services, and advertising publishing. Switching costs are low-to-moderate for consumers, because contracts are often signed but can be fairly easily switched away from at expiration. Switching costs for businesses are more substantial; both wireless and wired services are rather “sticky” with business customers.

Losing exclusivity with Apple products is a setback, and the company does have substantial debt and retirement benefit liabilities. But the interest coverage ratio remains strong, and the dividend continues to grow and is comfortably covered by free cash flow. Increasing amounts of bandwidth usage and increasing levels of technological sophistication among business and consumer mobile phones are good trends for the company.

Dividend Yield: 5.81%
Total Debt/Equity: 63%
Price to FCF Ratio: 12.0
FCF Dividend Payout Ratio: 67%
Most Recent Dividend Increase: 2.3%

Keep in mind that a good company only makes a good long-term investment if it’s purchased at a reasonable price, so readers should only buy when they consider valuations to be appropriate.

Full Disclosure: At the time of this writing, I own shares of MSFT.
You can see my dividend portfolio here.

Dividend Stock Newsletter:
Sign up for the free monthly dividend investing newsletter to get market updates, attractively priced stock ideas, resources, and investing tips:

This is the third in a series of articles highlighting dividend companies that have large and durable economic advantages, or “moats”, that protect their business operations and allow years or decades of strong profitability. When looking for long-term investments, one typically wants to find a business that is performing well not simply because management is on top of their game right now, but rather because the business itself has fundamental and difficult-to-replicate advantages over its competitors. In the last two articles, examples of unrivaled economies of scale and particularly powerful brands were provided.

Some companies keep competitors away by patenting their products. This gives them a number of years where they can get all of their research and development to pay off with nice profit margins. If a company is big enough, they can successfully layer or ladder dozens, hundreds, or thousands of patents so that at any given time, only a subset of their patents are expiring, and new ones are replacing them. That way, most of the product portfolio is continually refreshed with a strong set of patent shields. When a company organizes hundreds or thousands of engineers and scientists, and then layers their products with patent shields, this creates a pretty formidable defense against competitors. Some of the largest patent-holding companies often buy companies just for their patents.

The following is a list of dividend-paying companies with good patent shields. I’ll break this article up into two parts: the diversified health care section, and the industrial/tech section. Rather than making this list unwieldy by providing every company with a good patent collection, I’ve highlighted twelve of them.

It’s not just the number of patents that matter, it’s how effectively a company uses those patents. Tech companies generally have the largest numbers of patents. Health care companies generally have fewer patents, but they can protect multi-billion-dollar drugs. A focus on free cash flow (FCF) is emphasized in the company descriptions.

Johnson and Johnson

Several of Johnson and Johnson (JNJ)’s seven billion-dollar drugs have lost or are preparing to lose patent protection. Fortunately, JNJ buffers its pharmaceutical segment (constituting only one third of total company sales) with a huge medical device segment and a consumer products segment, as well as billions of dollars spent on R&D and acquisitions. The company has a had a rough ride over the last few years with recalls and patent expirations, in addition to the general economic downturn. The balance sheet remains AAA, the free cash flow remains particularly strong, patent losses going forward are mild, and I expect the next five years to be better, financially, than the last five years.

Dividend Yield: 3.49%
FCF Dividend Payout Ratio: 51%
Most Recent Dividend Increase: 5.5%
Total Debt/Equity: 0.30
Price to FCF Ratio: 14.8

Abbott Laboratories

Abbott (ABT) has a large set of patent-protected drugs and devices, with the blockbuster drug Humira leading the way. Humira has been immensely profitable, but does face some competition going forward. Abbott has plans to split into two companies, so investors that are currently satisfied with the diversified health care business with a long string of consecutive dividend increases may not be as inclined to own a pure pharmaceutical company, but on the other side of the coin, the two companies could rise in market cap to be worth more than the company is currently valued by the market.

Dividend Yield: 3.45%
FCF Dividend Payout Ratio: 35%
Most Recent Dividend Increase: 9.1%
Total Debt/Equity: 0.67
Price to FCF Ratio: 10.3

Novartis

Novartis (NVS), the large Swiss diversified health company, has a large pharmaceutical segment as well as a variety of smaller businesses that have helped the business as a whole to produce 14 consecutive years of dividend growth. Unfortunately, the top drug of Novartis, Diovan, will be going off patent this year, and it accounts for more than 10% of sales. This has been known, however, and I feel that the current valuation fully takes this into account. Novartis is also interesting on this list for having a large generics segment. They have the capacity to capture other top drugs that are going off patent for a fraction of their profits. Plus, they have their own pipeline of drugs to replace or grow from their current sales.

Dividend Yield: 4.27%
FCF Dividend Payout Ratio: 46%
Most Recent Dividend Increase: 4.8% (CHD)
Total Debt/Equity: 0.31
Price to FCF Ratio: 11.4
Full Novartis Analysis

Becton Dickinson

For those less interested in the drama of multi-billion dollar patented drugs and drug pipelines, diversified medical device manufacturers with solid engineering and capital allocation may be a reasonable alternative, although they are of course not without risk themselves. Becton Dickinson (BDX), with its robust size and global manufacturing plants, produces medical and surgical supplies, as well as drug delivery systems, diagnostic tools, and bioscience products.

Dividend Yield: 2.32%
FCF Dividend Payout Ratio: 32%
Most Recent Dividend Increase: 9.7%
Total Debt/Equity: 0.56
Price to FCF Ratio: 14.9

Medtronic

Medtronic (MDT) is a medical device producer that’s more than twice as large as Becton Dickinson and offers a similarly modest dividend yield. Unlike Becton Dickinson, Medtronic’s focus is on complex products to treat chronic diseases, including cardiovascular devices such as pacemakers, spinal devices, and various other areas. Health care budgets around the world are being more critically viewed, but Medtronic has strong and diversified positions in both developed and emerging areas.

Dividend Yield: 2.39%
FCF Dividend Payout Ratio: 27%
Most Recent Dividend Increase: 7.8%
Total Debt/Equity: 0.61
Price to FCF Ratio: 11.6

3M Company

3M Company (MMM) is a broad engineering conglomerate that produces useful products for industry and transportation, health care, consumers, displays and graphics, safety and security, and communications. The company is particularly focused on meeting needs for growing areas, such as water filtration, renewable energy, personal safety, trends toward worker protection in developing countries, and health care in both developed and developing countries. I think 3M stock is a bit expensive right now, but with a moderate pullback, a reasonable entry price could occur.

Dividend Yield: 2.50%
FCF Dividend Payout Ratio: 41%
Most Recent Dividend Increase: 4.8%
Total Debt/Equity: 0.36
Price to FCF Ratio: 16.5
Full 3M Company Analysis

Emerson Electric

Emerson Electric (EMR) is another broad engineering conglomerate that provides process management and industrial automation technologies, as well as network power products for data centers and telecommunications companies. They also produce climate technologies and appliances and tools. As computing becomes more and more ubiquitous across the world, and as server-based computing becomes more in focus, Emerson’s business with regard to data centers stands to benefit. Plus, I believe that industrial automation and process management have a strong future ahead.

Dividend Yield: 3.08%
FCF Dividend Payout Ratio: 40%
Most Recent Dividend Increase: 14.5%
Total Debt/Equity: 0.50
Price to FCF Ratio: 14.7

Illinois Tool Works

Illinois Tool Works (ITW) is an extremely diversified and decentralized collection of engineering businesses. The company has a strong history of strategic acquisitions, and brings in revenue from numerous areas including transportation ($2.53 billion in sales), industrial packaging ($2.28 billion), power systems ($1.94 billion), food equipment ($1.87 billion), construction products ($1.76 billion), polymers and fluids ($1.36 billion), decorative surfaces ($1.01 billion), and other areas (another $3+ billion). Slightly more than half of revenue comes from outside of North America. ITW is one of the top 100 patent filers in any given year, and currently holds close to 20,000 patents.

Dividend Yield: 2.58%
FCF Dividend Payout Ratio: 51%
Most Recent Dividend Increase: 5.9%
Total Debt/Equity: 0.46
Price to FCF Ratio: 20.4
Full Illinois Tool Works Analysis

Dover Corporation

It’s worth noting that Dover (DOV), Emerson, and 3M are the three companies on this list that have each increased their respective annual dividends for over 50 consecutive years. There are only a handful of companies in existence that have accomplished that. Dover unfortunately does have a pretty low dividend yield, but they compensate it with solid EPS and dividend growth. Dover is similar to Illinois Tool Works in that they consist of a decentralized collection of engineering businesses with a number of patents.

Dividend Yield: 1.94%
FCF Dividend Payout Ratio: 24%
Most Recent Dividend Increase: 14.5%
Total Debt/Equity: 0.45
Price to FCF Ratio: 13.2
Full Dover Analysis

Microsoft

Microsoft (MSFT) may have recently broken its “magical” $30 barrier that technical analysts might be wary of, but Microsoft’s low valuation (P/E of less than 11 and P/FCF of less than 10) and potentially good growth prospects mean it’s still undervalued in my view. The company, which was in the top 10 companies for U.S. patent winners in 2011, faces the challenges and opportunities of a changing business model mildly away from market-saturated personal computers and towards both servers and mobile devices. Microsoft holds dominant positions in PC operating systems and office software, is preparing the Windows 8 launch, and is growing its server and tools segment considerably. Less enthusiastically, they have produced a well-reviewed mobile operating system but hasn’t yet developed any meaningful market share with it.

Dividend Yield: 2.64%
FCF Dividend Payout Ratio: 22%
Most Recent Dividend Increase: 25.0%
Total Debt/Equity: 0.19
Price to FCF Ratio: 9.5
Article: The Maturation of Large Cap Tech Stocks

Intel

Intel (INTC) also faces the challenges of the shift away from market-saturated personal computers and towards servers and mobile devices. Intel has an extremely dominant position in the PC processor market, and also has a strong showing with regards to servers, but has given up the dominant market share in mobile computing to ARM Holdings. At the same time ARM tries to move vertically upward into netbooks and other moderate power/mobility devices, Intel hopes to move vertically downward into the mobile markets. Nonetheless, Intel has huge R&D expenditure, uses a systematic tick tock approach to continued product improvement, has a superb balance sheet and a sizable dividend yield, and the stock is currently priced for no growth.

Dividend Yield: 3.15%
FCF Dividend Payout Ratio: 39%
Most Recent Dividend Increase: 15.9%
Total Debt/Equity: 0.15
Price to FCF Ratio: 13.6

International Business Machines

IBM (IBM) unfortunately has the lowest dividend yield on this list, despite years of consecutive dividend growth. Considering, however, that IBM continually receives more patents than any other corporation on the planet (over 6,000 new patents in 2011 alone, and the holder of the #1 patent recipient spot every consecutive year for almost two decades), the company must be included in a conversation regarding patents. Instead of spending their tremendous free cash flows mostly on dividends, IBM spends the cash mostly on share buybacks. The $200+ billion company has a strong economic advantage in enterprise computing, and over the last decade has transformed itself into more of a software and service business and away from a hardware business. The company, however, does still provide a full array of software and hardware, as well as services, and with so many products and patents, IBM has a sold worldwide market position.

Dividend Yield: 1.55%
FCF Dividend Payout Ratio: 22%
Most Recent Dividend Increase: 15.4%
Total Debt/Equity: 1.34
Price to FCF Ratio: 14.9
Full IBM Analysis

Full Disclosure: At the time of this writing, I am long JNJ, NVS, MDT, BDX, EMR, and MSFT.
You can see my dividend portfolio here.

Sign up for the free monthly dividend investing newsletter to get market updates, attractively priced stock ideas, resources, and investing tips: