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3 Dividend Al Capones Dominating the Market

Ian Wyatt Chief Investment Strategist Steve Mauzy, CFA Contributing Editor

I'm frequently surprised at how infrequently investors fail to consider the obvious. By that, I mean they overlook the most profitable investments that sit in plain sight before their eyes. Perhaps these investments seem “boring,” because they are dependable workhorses. They are, after all, among America's biggest blue-chip companies and everyone knows their names and their products. So there can't be much upside potential...right? Actually, there is plenty of upside potential – for both price appreciation and income. That being so, The Wall Street Journal reports most investors avoid these companies; only 8% of investors own them, and many of these investors own them within a diversified mutual fund, thus diluting their value and wealth-generating potential. These blue-chip investments are deserving of direct ownership. In fact, they should be a core holding of any investment portfolio. I say that because these companies are such tremendous cash-generating machines that they are practically assured of returning your initial purchase price each year in dividends. Think about that: every year you earn 100% on your initial investment. All you have to do is buy and never sell. How is this possible? Dividend growth is the key. Each year, these companies reliably hike their payout, so each year you receive more money on your initial investment. Each year your income and your yield rise. Over time, your investment value rises as well (though your cost basis remains the same). The correlation between rising dividend payouts and share appreciation is strong. This makes sense; as the payout increases, investors are willing to pay a higher price for the elevated cash flow. The following three companies have decades of annual dividend increases – and decades of price appreciation – behind them. More important, they have decades of annual dividend hikes in front of them. Their strong brands and wide economic moats virtually guarantee investors a rising cash flow stream (and rising price appreciation) for decades to come. I’d like to introduce you to three companies I call “Dividend Al Capones.” Like Capone, these American businesses control vast empires that generate extreme amounts of cash.

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These companies are deeply entrenched and politically connected. They cut down the competition and do everything in their power to protect their money flows, which are massive.

Last year alone, these three Dividend Al Capones paid out a whopping $16 billion in dividends. Dividend Al Capone #1 McDonald's: Lovin' Those Dividends Success is often a matter of focusing on the basics, and the basics are the focus of many dividend-paying stocks. Many simply master the mundane and then continue performing it as the years go by. Consider fast food. No one has mastered the mundane task of selling food on the quick like McDonald's (NYSE: MCD) – the world's number one hamburger purveyor with over 34,900 restaurants worldwide. McDonald's restaurant count far exceeds number-two Burger King Worldwide's (NYSE: BKW) 13,260 restaurants, and number-three Wendy's (NYSE: WEN) empire of 6,540 locations. Size doesn't always correlate positively with performance, but in McDonald's case it does. In the realm of publicly traded fast food stocks, McDonald's has been a top performer, with its share price tripling over the past 10 years. Impressive to be sure, but not quite as impressive as McDonald's commitment to its dividend policy - one which management has engaged with renewed vigor in recent years. In 2004, McDonald's paid $0.55 in dividends per share. In 2013, it paid $3.12. That works out to a 19% compound-annual increase over the past 10 years – roughly a doubling of the dividend payout every four years.

McDonald's Dividends Paid Per Share

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Any company can impress income investors with a high yield or annual increases, but the yield and the annual increase become less impressive when they are generated through capital consumption or increased borrowing. A look at the payout ratio provides immediate insight into the long-run viability. Dividends that regularly consume over 75% of annual earnings, though sustainable, raise a red flag over the company's ability to make required capital expenditures. The red flag is further raised when the payout ratio is combined with a high debt load – a debt-to-equity ratio of one or higher. McDonald's debt-to-equity ratio has remained comfortably below one for the past 10 years, and only once over that time, in 2007, has the payout ratio exceeded 55% percent of earnings-per-share. That occurred when the company increased its dividend a mighty 50% to $1.50 per share from the previous year's $1.00 payout. The extraordinary increase wasn't due to management mortgaging the future to pay for the present but to management's bullish belief in the company's future, which has subsequently been proven correct. Success rarely goes unnoticed and McDonald's shares are trending higher; therefore, they might appear less of a value to price-centric investors. The revelatory news is that price and value are infrequently synonymous. Continual share price increases are rational reactions to rising EPS. McDonald's earned $1.79 per share in 2004. The company has successfully increased its EPS year after year, with the trailing 12-month EPS now at $5.56. Today, the P/E ratio based on trailing earnings is just 17. Over the past 10 years the P/E multiple has been as high as 33 and as low as 10, which suggests that while McDonald’s share price may be near an all-time high, the shares remain a value. The dividend also remains very attractive, offering a competitive yield of 3.4%. This puts McDonald’s ahead of perennial dividend growers Coca-Cola (NYSE: KO), which yields 2.9%; IBM (NYSE: IBM), 2.2%; and Johnson & Johnson (NYSE: JNJ), 3.0%. But as Mark Twain noted, “The past does not repeat itself,” before he added, “but it does rhyme.” And though it's unlikely McDonald's annual dividend increases will match the previous decade's 19%, it is likely to rhyme with a 10% average annual rate. A rate more attuned to recent EPS growth and one that accounts for the possibility of a misstep (even during McDonald's “dead” period – 2001 to 2004 – EPS grew at a 12% average annual rate). To be sure, McDonald's isn't a go-go growth company. Instead, the company is a mature-growth/efficiency stock. Net profit margin, at 12% 10 years ago, is at 20% today. Return on equity, which was at 16% in 2004, is now at 40%. The strategy of “re-franchising,” or selling company-operated stores to private operators, is a prime reason for the improved efficiency number. McDonald's posts 80% operating margins on franchised stores compared to 20% on company-operated stores. Innovation is another variable in growth and efficiency. The McCafe offerings, Dollar Breakfast Menu (perfect for the age of austerity), and snack wraps are unquestionable successes. These innovations help drive customer same-store traffic, which continues to trend higher month to month.

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Then there is the formidable McDonald’s brand, which is recognized around the world. Even in challenging economic times, the company has been able to maintain strong performance, thanks in a large part to its established brand, value proposition and strong customer loyalty. In the dark days of 2002 and 2003, when quality and innovation languished and change was on the horizon, McDonald's was still able to grow dividends, thanks in large part to the mulligan given to it by its loyal customer base – a byproduct of a powerful brand. When the even darker days of 2008 and 2009 are vetted, investors find that McDonald's not only survived, it prospered – evinced by an 8.7% dividend increase in 2008, followed by a 25.9% increase in 2009. McDonald's value proposition is simple and straightforward: the company will continue to increase earnings through opportunities in new markets, operating efficiencies and product development. Higher earnings, in turn, will lead to higher dividends. And as the following chart suggests, as dividends go, so goes McDonald's share price.

McDonald's Dividend and Share Price Growth

After a somewhat sluggish 2013, McDonald's is positioned to return to meaningful dominance. To be sure, the competition receives significant attention for investments in new-product development. But McDonald's has made it clear it intends to re-establish its pricing value gap over Burger King and Wendy's, and has made meaningful progress toward that goal. McDonald's menu continues to expand. Last year, the Dollar Menu & More added five more beef and chicken burgers. Three $2 items also are new to the menu: the Bacon Cheddar McChicken, Bacon Buffalo Ranch McChicken, and the Bacon McDouble. McDonald's budget selection now includes 26 items: 11 different lunch/dinner sandwiches, four breakfast choices, five sides, four beverages, plus 20-piece McNuggets ($5) or 4-piece McNuggets ($1.99).

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As McDonald's achieves more of its goals, the share price will climb, as will dividends and earnings. I see the company earning $6.00 per share in 2014. I have a $105 price target based on a 17.5 multiple applied to this year's expected EPS of $6.00. When price appreciation is combined with the dividend yields, investors should expect McDonald's to deliver at least 15% total return for 2014. McDonald's has increased its dividend every year for the past 37 years. I expect that streak to be extended for another 37 years, by which time investors will be regularly receiving their initial share purchase price in dividends. Dividend Al Capone #2 Altria: A Big Brand and Big Profits If you are open to the idea of owning a tobacco stock, there is only one real choice. Not only does this stock provide a safe yield that is covered by operating earnings, but it also has a long history of raising payments to shareholders. As a result, its share price has fared well, even during poor times for the stock market. Just as important, the company has a proven history of withstanding the legal and regulatory barbs that tobacco attracts. The premier tobacco company I'm speaking of is Altria (NYSE: MO). You know Altria for its Marlboro cigarette brand, one of the most widely recognized and valuable brand names in the world. Despite all the negative press cigarettes are forced to bear, the Marlboro brand is formidable. Millward Brown, a global market research agency, estimates the world market value of the Marlboro brand at $69 billion – which puts Marlboro an impressive eighth among all corporate brands. Why is the Marlboro brand so highly valued? Because of market penetration and pricing power. Philip Morris USA, Altria's cigarette segment, commands 47% of the U.S. market. Total market penetration for Marlboro alone is 43%, while Altria's lesser-known brands - Merit, Virginia Slims, Parliament and Benson & Hedges – pick up the other eight percent. The tobacco business might seem a stodgy business, but Altria is hardly dull. The company has been on the move over the past 10 years. Prior to 2007, Altria was a massive conglomerate. In addition to its cigarette business, Altria owned Kraft Foods (NASDAQ: KRFT), the second-largest packaged food company in the world, as well as Miller Brewing. Altria sold a majority interest in Miller to South African Brewers in 2002 (Altria still retains a 28.7% stake) and Kraft was spun off to Altria shareholders, who in 2007 received 0.68 shares of Kraft stock for every Altria share. The spin-offs made financial sense. Well-branded beer and food are stable business, but they are less profitable than tobacco. Money and time was freed up to allow Altria management to focus on what it knows best – the tobacco business.

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Altria is particularity good at the domestic tobacco business. In March 2008, it spun off its international cigarette operations, Philip Morris International (NYSE: PM). Altria shareholders received one share of PM for each Altria share. The rationale for the spin-off was that it would shield the international tobacco business from the legal and regulatory constraints facing its domestic counterpart and at the same time protect Philip Morris USA from any international litigation and constraints that might arise. These sales and spin-offs shrunk Altria's size by more than half, but they cleared the way for management to focus on the still-lucrative domestic tobacco market. And for shareholders, these moves have helped to unlock value. While these moves mean little to new Altria investors today, they demonstrate the "shareholder first" commitment of the management team.

The real economic value of a powerful cigarette brand like Marlboro is price-inelasticity. This means that a consumer's perceived value doesn't drop off precipitously as the price of the product rises. This allows the company selling the product (i.e., Altria) to more easily pass sales and excise taxes on to consumers.

Average state and federal excise taxes on a pack of cigarettes increased 14-fold between 1970 and 2013, from $0.18 to $2.54 a pack. (The amount varies significantly from state to state, even city to city: New York City imposes a $1.50 per-pack cigarette tax.) Over the same period, the average price per pack of cigarettes increased nearly 16-fold, from $0.38 to $6.03 a pack. The price increases were less harmful to Altria than its competitors. From 2000 through 2013, Marlboro's percentage of the cigarette market grew to 43% from 35%. It's no secret that overall cigarette consumption is on the decline. Rising prices play a part, to be sure, but the decline is just as much due to growing health consciousness surrounding smoking's health risks. After peaking at 640 billion cigarettes in 1981, consumption in the United States dropped to 326 billion in 2011. The volume of cigarette sales is expected to decline by 1% to 2% each year during the next five years. Altria depends on pricing power to counter the consumption slide. Because cigarette sales have been steadily declining, revenue and profit margins are maintained through price increases (which is why price inelasticity is such a valuable benefit). Altria experienced a slight decline in cigarette volume in 2012 compared to 2011, with cigarette volume falling 0.2%, but cigarette revenue increased by 3.4% and cigarette operating income increased by 1% because of two price increases imposed during the year. This isn't to say that there aren't pockets of growth in the tobacco industry. Altria's greatest growth potential resides in smokeless tobacco, principally chewing tobacco and snuff. Though chewing tobacco has been associated with various oral ailments, it is less hazardous than smoking and isn't as tightly regulated. The smokeless market is a growth niche within the tobacco sector in the United States. Volume is expected to grow at 6% average annual rate over the next few years.

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To compete in the growing smokeless tobacco market, Altria acquired the world's largest smokeless tobacco company – UST Corporation – in 2008. The deal was valued at $11.7 billion and the combination boosted Altria's smokeless presence from virtually nothing to 40% of the market, thanks to UST's formidable brands Copenhagen, Skoal and Red Seal. The UST acquisition is already paying dividends. Altria's smokeless tobacco revenues increased 24.2% to $1.69 billion in 2012 from $1.36 billion in 2009, while operating income more than doubled to $931 million from $381 million. In the first nine months of 2013, the smokeless division $769 million in operating income – a 13.4% increase over the same period in 2012. Altria's cigarette segments average 33% operating margins; the smokeless segment averages 57%. As smokeless tobacco becomes a larger segment of Altria's overall business, I expect the aggregated operating margin of the company will continue to rise. The e-cigarette market also shows promise. The market is estimated to have registered $1.5 billion in sales last year from a mere $10 million in 2007. Nu Mark, a wholly owned Altria subsidiary, entered the e-cigarette category with the introduction of MarkTen e-cigarettes this past August. Wells Fargo estimates e-cigarettes will generate over $5 billion in annual revenue for Altria within the next 10 years, from virtually nothing in 2013. With all the obstacles and headwinds Altria has faced over the years, it's really remarkable that it continues to grow revenue and earnings, especially when its primary market is shrinking. This is a tribute to not only Altria's primary product’s (i.e., Marlboro's) pricing power but to management's extraordinary ability to extract additional profit from each unit sold. Since spinning off Philip Morris International, what remains under Altria's purview continues to thrive. Over the past three years revenue, operating income and EBITDA – a cash-flow proxy – have all improved.

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12/31/2009 12/31/2010 12/31/2011 12/31/2012

Revenue $23,566 $24,363 23,800 $24,618

Operating Income $5,482 $6,228 %6,068 $7,253

% Margin 23.4% 25.5% 25.5% 29.4%

EBITDA $5,743 $6,501 6,316 $7,424

% Margin 24.3% 26.6% 26.5% 30.2%

EPS $1.54 $1.87 $1.64 $2.06

Dividends/Share $1.32 $1.46 $1.58 $1.70

Cash in to Altria translates to cash out for investors. In October 2013, Altria raised its dividend 9.1%, which marked the 45th consecutive annual dividend increase, to $1.92 a share Altria's allegiance to its dividend demonstrates an unwavering commitment to shareholder welfare. Last year, the company's board authorized a $700 million widening of its existing stock-repurchase program. When added to the $300 million of the current initiative authorized this past April, that brings the total amount to $1 billion. The buyback is expected to be completed by the third quarter. Growth where it matters most – earnings and dividends – shows no sign of abating either. Management recently reaffirmed 2013 full-year guidance for reported diluted EPS in the range of $2.57 to $2.62, so at a minimum that's a 24.7% increase over 2012 EPS. I believe that translates to at least a 9% to 10% dividend increase in 2014. In short, Altria will continue to do more with less, which I actually find refreshing. Growth can be an investment fetish. The notion that a company must gallop along with double-digit, top-line growth often conjures an old bromide on the confused merchant's mantra: "We lose money on every sale but we make up for it on volume." As we saw in the late 1990s, many companies were growing like weeds and wound up with life spans just as long. To many investors, promises of growth promote the illusion that growth alone eventually takes care of everything. It often doesn't. Here's another consideration, and one that is quite persuasive. Wharton Business School finance professor Jeremy Siegel wrote an insightful 2005 essay titled "Ben Bernanke's Favorite Stock." Siegel reports that if Federal Reserve Chairman Bernanke held only one individual stock, that stock would be Altria. While Bernanke isn't known as a stock picker, Siegel dug into Altria to understand just why Bernanke would own a single stock. And more importantly, why that stock would be Altria. Siegel found that from 1957 – when the S&P 500 Index was founded – to 2005, Altria produced an average return of 20% annually, handily beating the other 499 index members.

In the eight years since that essay was written, little has changed and the high-return trend for Altria continues unabated. In fact, from 2001 to the present, Altria's stock appreciation alone translates into a 15% compounded average annual growth rate. Tack on an average dividend yield of around 5%, and you get that vaunted 20% average annual return.

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Dividend Al Capone #3

AT&T: The Ultimate Widow-and-Orphan Stock Most young investors I meet are unfamiliar with the concept of widow-and-orphan stocks. When I mention the term it often arouses a perplexed look. Most older investors, on the other hand, are quite familiar with the term, which applies to stocks that reliably and consistently pay dividends, and that once bought are never sold. Widow-and-orphan is really a vestige of 1950s investing lingo. Back then, the world moved at a glacial pace. Change and creative destruction were much less prevalent, so an investor could easily cobble together a diverse group of high-yield dividend stocks, file the certificates in a lock box, and then happily collect dividends for years, if not decades, to come. Fewer stocks offer that high degree of certainty and peace of mind over time, though I can think of a couple that date back to the 1950s that instill confidence today. One are the stocks of the former Standard Oil Company – the company John D. Rockefeller incorporated in 1870 – which was subsequently broken into its contingent parts in 1911 after being ruled an "unreasonable" monopoly under the Sherman Antitrust Act. Here, we probably have another generational issue. Many younger investors might ask, "What's Standard Oil, and if it's such a desirable investment, why haven't I heard of it?" You have, you just don't know it. The larger remnants of Standard Oil go by the contemporary names Chevron (NYSE: CVX) and ExxonMobil (NYSE: XOM). I think both energy companies can be bought and filed away for years. There's another original widow-and-orphan stock that dates back nearly as far as Standard Oil, yet provides a better yield. What's more, it has paid a dividend for a century, and has steadily increased that dividend for the past 29 years. I'm speaking of the former American Telephone and Telegraph Company, better known today by its initials AT&T (NYSE: T) – a rare technology company that has withstood the test of time. For the first 80 years of the 20th century, AT&T was THE telephone company, having been granted monopoly privileges by the U.S. federal government in 1907. AT&T's market privilege ended in 1984 when it was forced to divest itself of its Regional Bell Operating Companies, known as the "Baby Bells." The resulting company had to go it alone in the cold, unforgiving free market as a long-distance land-line service provider. When you are used to being treated like the royal invalid, carrying your own weight isn't easy at first. Competition from MCI and Sprint pressured long-distance rates lower, which eroded AT&T's profitability. There was also a spate of what turned out to be wealth-destroying acquisitions. In 1991, AT&T purchased NCR Corporation to capitalize on the growing PC market. NCR was a failure and was divested in 1996. In 1999, AT&T acquired the Olivetti & Oracle Research Lab from Olivetti and Oracle, yet another failed acquisition. AT&T then moved into cable television, acquiring TCI for $48 billion in stock and assumed debt and Media One for $54 billion in cash, stock, and assumed debt. AT&T intended to use these assets to bridge the so-called "last mile" and break the Regional Bells' access monopoly for data

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and telephone services. By 2005, AT&T was struggling. The increased debt load and the numerous miscalculations were too much to bear. One of AT&T's 1984 divestitures, SBC Communications, came to the rescue by acquiring its former parent for $16 billion. It was a smart combination. The two companies were more emboldened and more progressive as a single entity. A year later, in 2006, another of the original AT&T offspring was taken into the fold when BellSouth was acquired for $86 billion in stock. With the acquisition of BellSouth, AT&T took full control of Cingular Wireless (now AT&T Mobility), making AT&T the second-largest U.S. carrier of wireless customers. In essence, the wireless market is today basically a duopoly between AT&T and Verizon. Together they control 67% of the domestic telecom market, up from 56% in mid-2010. What's more, both offer safe dividends that yield above 4%. In fact, the tale of the tape shows the two companies are quite similar in many financial aspects.

AT&T Verizon

Revenue 2013 $128.7 Billion $120.6 Billion

Dividend Per Share 2013 $1.81 $2.12

Market Capitalization $168.1 Billion $134.1 Billion

2014 Forward P/E Multiple 12.1 X 13.4 X

Current Yield 5.7% 4.5%

Neither AT&T nor Verizon are considered growth companies. But in a market starved for income, dividend and earnings stability matter as much as revenue growth. AT&T trades at a discount to Verizon based on P/E valuation (Verizon's 13.4 versus AT&T's 12.3). The gap is driven by differences in growth expectations and performance in recent years. You might think I'm making more of an argument for Verizon here; I'm not. One of the grand mistakes investors make is to equate superior performance with a superior investment. Price always matters relative to performance. I view AT&T as the better value not only because of its discount to Verizon, but also because I think AT&T has the greater potential for improvement. Potential, though, goes hand-in-hand with uncertainty. To say you'll do something is one thing; to actually do it is another. That said, I like what management is saying ... and doing, particularly regarding returning cash to shareholders. During the fourth quarter of 2013, AT&T spent $1.9 billion to repurchase 54 million shares. For the full year, the company repurchased 366 million shares, or more than 6% of shares outstanding, for $13.0 billion.

Share repurchases are good news for long-term investors: Future earnings and dividends are concentrated on fewer outstanding shares, which leads to improved future per-share performance.

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Management is also noticeably improving operation performance. For 2013, AT&T’s revenues totaled $128.7 versus $127.4 billion in 2013. Revenue growth obviously isn't impressive, but AT&T operates in a mature industry. Gains are produced by improving operational and financial structure efficiency.

2012 2013 % Improvement

Operating Expenses $114.4 Billion $98.3 Billion 14.1%

EPS $2.31 $2.50 8.2%

In the fourth quarter of 2013, AT&T continued to make strong gains in wireless revenue, which accounts for 56% of its revenue. In fact, the segment posted revenue growth of 4.8% year-over-year. AT&T was able to add 566,000 wireless postpaid new additions. In addition, the number of subscribers on usage-based data plans continues to increase. Roughly 73%, or 37.7 million, of post-paid smartphone subscribers are on usage-based plans, This compares to 66%, or 31.7 million, a year; and 56%, or 22.1 million, two years ago. The point I want to emphasize is that AT&T is well positioned to deliver solid earnings per share growth. To that end, management expects EPS to grow at a mid-single-digit rate in 2014. If management executes like I expect it to, I see AT&T's P/E multiple expanding to closer match Verizon's. Therefore, my 12-month price target is $40.00 per share based on a rising P/E multiple applied to the 2014 EPS estimate of $2.65. That's 10% price appreciation. But factor in a dividend yield of 5.7%, and investors should expect a 15% return over the next 12 months. That's a darn good return for a stock that I view as a utility/bond hybrid. Telecommunications is a highly regulated business and earnings and cash flow are highly predictable. AT&T's low beta of 0.45 means its shares tend to move only 50% as much as the overall market. In short, AT&T is a low-volatility investment with upside potential and an annual dividend that increases every year and currently yields 5.7%. Compare that to the 1,0% on a one-year certificate of deposit or the 2.7% on a 10-year Treasury note, and 5.7% looks very appealing. It looks even better when you factor in a reasonable probability of achieving a 15% total return (and that excludes the dividend increase sure to come later in the year). AT&T might not be the widow-and-orphan stock it was a century ago, but conservative income investors should feel comfortable buying and filing away this stock for the next few years, enjoying the benefits of a rising annual dividend steam without worrying about loss of principal. Happy Investing, Ian Wyatt Steve Mauzy, CFA Chief Investment Strategist Contributing Editor High Yield Wealth High Yield Wealth

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Disclaimer

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