It’s common these days for personal finance gurus, financial advisors, and, of course, mutual fund company CEOs to lament the proliferating flavors of ETFs (exchange traded funds.) And I’d agree that we probably really don’t need an ETF that gives the owner three-times downside leverage to the price of oil, or one that specializes in an index of cyber-security stocks, or yet another ETF that slices and dices emerging markets according to some catchy set of initials.
But last I looked nobody was holding a gun to my head to make me buy any of these alternatives. And I more often than not these days find myself appreciating the ability to fine-tune exposure to a sector using the “tweaks” of an ETF.
Which is exactly the case for ETFs that invest in preferred stocks. These are vehicles designed to appeal to dividend income investors since preferred shares pay higher rates of dividends than do common shares. And, theoretically, they are less risky than a portfolio of common shares since preferred dividends get paid first and are less liable to be slashed by a company looking to preserve cash.
I say “theoretically” since not all preferred dividends look equally safe these days–investors and analysts are nervous right now about bad debt and cash flow at some banks with big exposure to the energy sector. And a cut in dividend isn’t the only potential source of risk to a portfolio of preferred stocks. For example, banks are big issuers of preferred shares and the financial sector has been one of the worst performers of 2016 what with the aforementioned risk of bad loans in the energy sector and the uncertain direction of the yield curve because of negative interest rates at most of the world’s biggest central banks and a conviction that the U.S. Federal Reserve isn’t going to raise interest rates in 2016 as expected earlier. Banks make more money when the yield curve sharpens. That was expected to take place in 2016; it hasn’t yet; and looks disappointingly less likely, the market has concluded, this year.
All of which makes the difference between the iShares U.S. Preferred Stock ETF (PFF) and the Market Vectors Preferred Securities ex-Financials ETF (PFXF) so exactly to the point. If you think financials are ready for rebound, then the iShares Preferred ETF is your choice. About 62% of the fund’s holdings are preferred shares in the financial sector and with a rebound you can expect to collect the ETF’s 5.82% yield and some appreciation as the financial sector recovers. If, on the other hand, you think problems in the financial sector have further to run, your choice would be the Market Vectors Preferred ex-Financials ETF, because the ETF, as it’s name says, eschews financials. The portfolio for this ETF holds preferred shares from the likes of Tyson Foods, ArcelorMittal, Alcoa, and United Technologies rather than the preferred shares from HSBC, Ally Financial, Barclays, Wells Fargo, and Citigroup that make up the top five holdings at iShares Preferred. The biggest sector weightings for the Market Vectors Preferred ETF are in real estate investment trusts (35%), electric utilities (26%) and telecom (10%.)
The yield on the Market Vectors ETF is a little higher at 5.97% versus 5.82% (as of January 31) and the risk, in my estimation, is a little lower. (Fees are slightly higher at Market Vectors at 0.53% versus 0.47%.) I added the Market Vectors Preferred Securities Ex-Financias ETF to my dividend income portfolio on February 23 at the closing price at day of $19.26.
Kinder Morgan’s (KMI) decision to cut its dividend to 50 cents a share certainly wasn’t popular with the market and especially not with the income investors who had stuck with the company when it rolled its MLP (master limited partnership) Kinder Morgan Energy Partners into the Kinder Morgan general partner at the end of 2014. At the time of the consolidation Kinder Morgan had said it would pay a dividend of $2 a share in 2015 and projected a 10% annual increase in dividends through 2020. The December 8 announcement of a 75% cut to the dividend devastated the stock. Kinder Morgan shares are down roughly 50% from $32.68 back in October to a close at $17.42 on Tuesday, February 23.
But as painful as that drop has been, the dividend cut has positioned Kinder Morgan to be one not just one of the survivors but actually one of the few winners from the bust in the U.S. oil and gas sector. By cutting the dividend Kinder Morgan has moved into a position where it doesn’t need to tap equity or debt markets–at the current high cost that the financial markets are charging energy companies to raise capital–in order to fund its planned capital spending budget for 2016. After paying the new lower dividend, the company projects cash flow of $3.6 billion in 2016, up from $1.2 billion in 2015. That’s enough to fund the company’s $3 billion plus in projected capital spending for 2016. And at this point it looks like the company will be able to fund its 2017 capital plan internally as well. (Kinder Morgan has a backlog of some $18 billion in capital spending projects it could invest in. In the current environment the company is high grading those projects, looking for those that provide the biggest return on investment. It’s that dynamic plus the company’s sizable cash flow that has led an investment manager–probably Ted Wechsler–at Warren Buffett’s Berkshire Hathaway (BRK.B) to buy about $460 million in shares of Kinder Morgan recently.)
The advantages of being able to invest using internal cash at a time when the cost of external capital is so high for energy companies and when market turmoil is resulting in delays in competing projects are obvious. The company projects that these investments plus returns on current assets will generate about 88 cents a unit in growth to 2020. That’s a compound annual growth rate of about 7%, Credit Suisse calculates. That kind of growth would enable Kinder Morgan to restore some of the dividend it slashed in December, especially if sometime during that period financial markets cut the price that energy companies have to pay for external capital. At Tuesday’s closing price of $17.42 Kinder Morgan showed a dividend yield of 2.88%. Not stunningly high but not a bad place to start if the company is able to increase dividend payouts after 2016 or 2017.
The big question, of course, for any investor is how accurate those cash flow projections are likely to be.
These projections look as solid as projections can be. About 90% of the 2016 earnings before depreciation and amortization projection is fee-based rather than price-based so Kinder Morgan’s pipeline and storage system is relatively well buffered from the price of oil and natural gas. Of that 91% about 75% is take or pay–meaning Kinder Morgan gets paid whether the customer uses its pipelines or not–the rest is volume based. Of that volume-based 25%, about 80% is attributable to natural gas and refined product pipelines where, Credit Suisse believes, risk of volumes falling is relatively low. Kinder Morgan also looks relatively well protected from further deterioration in energy company balance sheets with 82% of its top 25 customers rated investment grade or better.
Kinder Morgan projects that a drop to $20 a barrel for West Texas Intermediate and to $1.75 per million BTUs for natural gas would result in only a $120 million hit to its budgeted dividend coverage.
Credit Suisse has a $20 one-year target price on Kinder Morgan. I think any gains in the price will depend on a turn in sentiment on energy stocks–and I’m not willing to call that yet. But cash flow does look very positive for dividend income investors.
Tomorrow, October 23, I will add shares of Verizon (VZ) to my Dividend Income Portfolio. Verizon’s shares closed at $45.89 on October 22 with a 5.06% yield.
Verizon reported third quarter earnings on October 20. By and large the numbers were so-so.
Earnings of $1.04 a share beat Wall Street estimates of $1.02 a share by a not so whopping two cents a share. Total revenue in the wireless segment grew 5.4% year over year. The number of retail subscribers increased by 4.3%. However, retail total postpaid average revenue per account (ARPA) dropped 5.5%.
But for income investors there was one really important and exciting number. In the quarter total retail churn dropped to 1.21%, down from 1.29% in the third quarter of 2014.
Why is the churn rate so important? For Verizon and other wireless companies one of the biggest expenses is acquiring customers. Which means that any customer that doesn’t have to be replaced—who renews when the current contract expires—is extra valuable.
And you can see that drop in churn reflected in the big increase in cash flow. Cash flow from operations rose to $28.4 billion for the first nine months of 2015 versus $23.2 billion in the first three quarters of 2014. Free cash flow for that nine-month period was $15.9 billion against $10.5 billion in the first nine months of 2014. (The falling churn rate isn’t solely responsible for that increase but at a time when competitors are going aggressively after Verizon’s customers, a falling churn rate in an extremely important sign.)
That’s a lot of that cash stuff that income investors want to see. Remember that paying a 5.06% dividend takes a lot of cash and remember that in the current global economy slow growth in individual markets and volatile currencies can take a sudden bite out of the cash available to sustainably pay that hefty dividend.
Verizon’s falling churn rate and its huge free cash flow are big “sustainability insurance” policies.
The company paid out $6.4 billion in dividends in the first nine months of 2015. That was easily exceeded by the $15.9 billion in free cash flow and the $28.4 billion in cash flow from operations in that period. Verizon spends a good chunk of cash each year on building out infrastructure and new products. Currently the company is spending big on its efforts to become a mobile purveyor of original content. And Verizon’s dividend history doesn’t show a record of generous increases in the quarterly payout. But at least with the company’s lines on cash flow, you can feel that the dividend is very safe.
That’s not a minor point for dividend investors looking to diversify a dividend portfolio heavy on energy holdings as my dividend income portfolio currently is. Energy plays offer very high yields right now but I don’t think we can say that those dividends are secured by a river of cash flow. At a time when finding sustainable cash flow in the energy sector is subject to uncertainty, I like the security of Verizon’s falling churn and rising cash flow.
Exxon’s dividend is up to 3.75% and latest quarterly report says dividend is safe even at current oil prices
Update: August 3, 2015. Dividend income investors don’t buy ExxonMobil (XOM) because it pays the highest dividend in the market or in the oil sector. They buy it—and I bought it for my Dividend Income portfolio on May 21, 2015—because it pays a relatively high, safe yield.
How does that trade off look after a truly horrible second quarter earnings report delivered on July 31? Exxon shares fell by 4.6% after the company reported its worst quarterly profit since 2009. Earnings of $4.2 billion, or $1.00 a share, were down 52% from the $8.8 billion or $2.05 a share reported in the second quarter of 2014.
As of the close on Friday, July 31, shares were down almost 13% for 2015 and 17% for the trailing 12 months. Shares were down 9.2% since I added Exxon to my Dividend Income portfolio.
Actually the trade off still looks pretty good. Thanks to that punishing drop in share price Exxon’s dividend yield as climbed to 3.68% from 3.35% at the time of my purchase.
And despite the huge drop in earnings, Exxon doesn’t look to be in any danger of turning cash flow negative or of having to cut its dividend. In fact on July 29, the company voted to maintain its quarterly dividend at 73 cents a share after raising its dividend to that level on February 6 from 69 cents a share. (The record date for Exxon’s most recent dividend payout is August 13.)
That’s because even after seeing earnings cut in half Exxon earned $4.2 billion in the quarter. And the company’s cash flow besides being really hefty shows plenty of room for reductions that don’t touch the dividend.
For example, cash flow, a more important measure than earnings for seeing if a company might need to cut its dividend, came to $8 billion in quarter that ended on March 31. Capital spending came to $6.8 billion. The company used another $1.8 billion to buy back shares and spent almost $3 billion on dividend payouts.
For that quarter Exxon grew cash by a bit less than $600 million.
Can you see how easy it would be to reduce cash outflows in order to preserve the dividend?
How about reducing capital spending? Capital spending was down 12% in the first half of 2015 and was down 16% in the second quarter from the same periods in 2014.
Or how about reducing stock buybacks in the quarter by $500 million from $1 billion?
Exxon’s ability to offset a crushing drop in oil prices with increased earnings from its refinery and distribution business also adds to the safety factor for this stock. What are called downstream earnings—that is earnings from refining oil and then selling it through gas stations–rose to $1.5 billion in the quarter from $831 million. That wasn’t nearly enough to offset the $2 billion decline in earnings from the company’s upstream business—oil production—but it sure doesn’t hurt an oil company to have a sizeable business that makes more money as oil prices fall.
Shares of ExxonMobil fell below $80 a share on Friday, July 31, to their lowest level since 2012. And there’s certainly a good chance that shares will move lower in the current quarter since crude oil prices have moved lower than they were in the second quarter. Supply growth from OPEC and the end (probably) of sanctions against Iran are likely to increase supply in coming months. West Texas Intermediate, down to $47.12 a barrel on July 31, could retest lows from $40 to $45, although analyst projections still see West Texas Intermediate closing the year at $60 a barrel or better.
But at $60 Exxon’s dividend is safe and the company has room to defend the current dividend at $45 as long as the market doesn’t get stuck at that level far into 2016.
Morningstar currently has a one-year target price of $98 on the shares. Standard & Poor’s is projecting $90.
Me? I wouldn’t mind seeing short-term dip that brought the yield up to 4% or more since, as I read Exxon’s cash flow, the company has plenty of powder available the ability its dividend. (On Monday August 3, shares of ExxonMobil fell another 1.45% and the dividend yield climbed to 3.75%)
Not something I’d say about a lot of companies in the oil and gas sector.
The perfect dividend stock is one that pays a high current yield—let’s fantasize and imagine a yield of 5%–and that is also raising its annual dividend payments at a rate that will produce a future yield (on your purchase price) way above that initial 5%.
Such perfection is rare. Most of the time investors have to pick one–either current yield or future yield. And our choice between the two alternatives should be influenced by the state of the financial world. For example, when interest rates and inflation are stable, a current high yield might be preferable because the value of that dividend isn’t being eroded by rising interest rates or inflation. On the other hand, when either interest rates or inflation are headed upwards, a future dividend that was growing at a faster rate than market interest rates or than inflation has extra value since it’s a way that a dividend income stock, in comparison to the fixed payouts from a bond, can, maybe, keep up or surpass interest rates and/or inflation.
On the eve of the first increase in the Fed funds interest benchmark interest rate since 2006, I think the edge goes to dividend stocks showing a strong pattern of strong increases in dividend payouts.
And that’s why the 25% dividend increase voted by Cummins (CMI) on July 14 caught my eye. That increase pushed the current yield to slightly over 3%. (The yield was 3.02% at the close on July 20.) And it promises, if the company continues its recent (nine-years and counting) history of 25% annual dividend increases, to give you a yield of 9.2% on your original purchase price (of $128.97 at the July 20 close) at the end of five years. (By the way, the recently declared quarterly dividend of $0.975 is payable on September 1 to shareholders of record on August 21.
I’m adding shares of Cummins to my Dividend Income Portfolio as of today July 21.
The big question, of course, is whether the company will be able to continue to increase its dividend payout at anything like the recent rate.
On a purely financial basis the odds look good. The payout ratio over the trailing 12 months has climbed to a still reasonable 31.8% from 20.18% in 2012 so the company has room to increase its dividend. (Payout ratios above 70% or so aren’t easily sustainable for a company that is still investing in its business and in developing new products, as Cummins is.) The company isn’t carrying a lot of debt—the debt to equity ratio is a low 22%–so Cummins doesn’t face that drag on its ability to pay a higher dividend.
Cummins’ market, though, does present a challenge right now. In its last quarterly earnings report Cummins guided to a revenue increase of just 2% to 4% for 2015 as weaknesses in the Chinese and Brazilian market for trucks (and thus for the diesel engines that Cummins makes) continue. Heavy and medium truck sales in China are forecast to fall 15% in 2015 and in Brazil by 28%.
But margins are forecast, by Standard & Poor’s, to climb in 2015 and 2016 on continued cost cutting and improvements in capacity utilization. S&P projects operating earnings per share of $9.96 in 2015 and $11.38 in 2016, up from $9.13 in 2014.
The wild card in these projections is the state of the North American market for heavy and medium duty trucks. Some competitors have pointed to their belief that the demand for trucks in that market has hit a cyclical peak. That’s certainly a danger to revenue at Cummins although the company has a history of adding market share when the market slows that reduces the likelihood that any cyclical decline in market-wide sales would take a big bite out of Cummins’ revenue.