DGI Adventure – 10-05-15 – Dividend Cushion

Mr. Market was in a really great mood today. Way too much
green. Since there wasn’t any anomalous media hype surrounding any of the
stocks on my watch list that meant I probably wasn’t going to be buying anything
today.

But I happened across a very interesting article that led me
to a very interesting website. That very interesting website led me to another
very interesting website. I discovered two analytical procedures that are
focused on dividend growth. I’m compelled to share them, because I might just
add one to my investment thesis structure. That’s a pretty big deal.

The first analysis method I came across can be found here: http://www.realitysharesadvisors.com/divcon/#table

I can’t really use this tool because I can’t easily recreate
it, and I’m not going to pay for Reality Shares Advisors services, although I’m
sure they’re great advisors. It’s a fascinating interactive table though, and
it’s fun to play with. I have a few doubts about this classification system.
There is a link to their whitepaper on the DIVCON table page, or you can link
to it here: http://www.realitysharesadvisors.com/docs/divcon-whitepaper.pdf

In addition to the fact that I can’t recreate their metrics,
my issue is how much weight this puts on analysts opinions. Analysts’ consensus
on dividend growth is 25% of the score weighting and the Bloomberg Dividend
Health Score (which is also based on analysts’ opinions) is 10% of the
weighting.

The fact that it’s a select list of large US companies also
limits how much I can expect to get out of this tool. (WHG for example isn’t on
the list). I still plan to check back on this table though and see if the
stocks I’m watching have a DIVCON score and what it is. I was pleased to find
that all of my recent purchases that are analyzed have a 3 or better.

I came across the second analysis method because I had no
idea what the Bloomberg Dividend Health Score was or where to find it. I still
don’t completely get it, nor could I find it. But I came across another
investment advisor who has their own kind of dividend health tool. That you can
find here: http://www.valuentum.com/articles/20150506

Again, I’m not going to pay Valumentum for stock advice, so
I can’t technically recreate their “Dividend Cushion Ratio” because the key
components of the calculation include projected cash flow, cap ex and dividends
for the next 5 years. These projections come from their analysts, and are not
available to the general public. I’m sure they’re also great advisors though.
No idea how much a subscription costs.

But unlike DIVCON that uses a bunch of input from analysts
that I can’t find, everything I need to come up with a similar ratio is readily
available in financial statements. I don’t have valuementum’s projected numbers
for the next 5 years, but I can still come up with something and project a
ratio.

I really like the idea of this ratio and it’s intuitive to
me that the output is related to the amount of room the dividend has to grow.
Cash you expect to earn less cash you’re planning to invest back into the
company (cap-ex) plus cash you already have less your total debt = projected
cash? IDK. They don’t have a name for it so that’s what I’m calling it. Is
there enough projected cash to cover the current dividend? Is there enough to
cover dividend growth? It’s a super question, with a really simple calculation
to give you an idea of the answer.

Obviously there are a lot of variables; no one knows what
actual cash flows and capex will be. I like the idea of just leaving them at
current levels. If a company passes with that (i.e. ratio is greater than 1), I
can play with the numbers to see how big of a change it would take to get them
to 1. This is essentially a different kind of margin of safety.

An example:

One of the stocks I’m watching closely right now is Cummins
Inc. (CMI). They pass my current valuation process with flying colors. It turns
out their dividend cushion (at least by my calculation) is pretty good too.
Last year they earned $2.2B in operating cash. They invested $1.2B into the
company. They have $1.9B in cash on hand and have total long term debt of $1.7B.
They paid $596M in dividends last year. If we keep the cumulative cash flow variables
the same for the next 5 years, the projected cash is $5.2B (2.2×5 -1.2×5 + 1.9
– 1.7) and cumulative dividends are only $3.7B (assuming a 7.5% DGR), which is
good for a ratio over 1.4.That is a pretty big cushion, and this exercise
reinforces my conviction that CMI is probably a pretty good investment.

Cash from operations could be 14% less (~$1.9B/year x
5years) and the ratio would be 1. Or capex could increase by 62% ($2B/year x
5years) and the ratio would be 1. Or the dividend could grow at a 20%DGR for
the next 5 years and the ratio would be 1. They could also buy back stocks if
they wanted to. I’m not going to take time to figure out what that would look
like…but it would be good for me as an investor.

I’m not sure if or how I want to add this to my investment
thesis structure. For one thing it is an extremely conservative measurement. If
you think about it, you’re saying the company has to be able to pay down all of
its long term debt in the next 5 years and still be able to afford its current
dividend. But then…that’s a great place for a company to be.

Plus what is the target? I don’t really know. I think I like
the idea of comparing “Potential DGR” (i.e. growth rate that would bring the
ratio to 1) to the Reverse DDM Fair Value DGR. The “Potential DGR” needs to be
more than the assumed DGR obviously, but how much more?

I’m going to have to play with it a bit and see.

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