-Seven Year Revenue Growth Rate: 13.6%
-Seven Year FFO/Share Growth Rate: 3.2%
-Seven Year Dividend Growth Rate: 3.9%
-Current Dividend Yield: 4.14%
-Balance Sheet Strength: Stable, Conservative

Realty Income continues to deliver, but the comparatively high valuation has pushed the dividend yield to rather low levels, which reduces the expected long-term rate of return.

Overview

Realty Income Corp. (NYSE: O) is a Real Estate Investment Trust (REIT) that maintains a portfolio of over 3,500 properties in 49 states that are leased to over 200 tenants. The business is rather lean, with a nearly $10 billion market capitalization and under 100 employees.

They focus on acquiring and maintaining properties that already have long-term leases contracted for tenants that they believe operate in healthy industries that absolutely require property for their day-to-day operations. (In comparison, that is, to tenants that may be able to shift some of their business towards the internet, or businesses where their property is a smaller focus of their operations.) Most of their contracts are structured so that the tenant, rather than Realty Income, is responsible for paying property taxes, maintaining the interior, exterior, and land of the property, and for insurance. Realty Income also occasionally trims its portfolio by selling properties that no longer align with their goals.

The ten largest tenants for Realty Income are:
Fed-Ex
L.A. Fitness
Family Dollar
AMC Theatres
Diageo
BJ’s Wholesale
Walgreens
Northern Tier Energy
Super America
Regal Cinema

Over three-quarters of the rental income comes from tenants in Retail, while the remaining quarter is split among Distribution, Office, Agriculture, Manufacturing, and Industrial properties. Currently, over 97% of the properties are occupied.

Revenue

(Chart Source: DividendMonk.com)

Revenue growth over this period has been a significant 13.6% per year on average, and Funds from Operations have grown at 10.9% per year on average over the same period.

As will be shown by the next chart, much of this growth is fueled by issuing new shares, which dilutes the numbers on a per-share basis. Over the course of this charting period from 2005 to 2012, the REIT went from 83.7 million shares outstanding to 133.4 million shares outstanding. Because the REIT pays out most of its incoming funds as dividends, there is only a modest amount that can be reinvested to grow the property portfolio. Therefore, most of the property acquisitions are paid for by issuing new shares.

Funds From Operations and Dividends

(Chart Source: DividendMonk.com)

This chart depicts growth on a per-share basis. FFO per share grew by an average of 3.2% per year over this period, while the dividend grew by an average of 3.9%.

The current dividend yield is 4.14%, and Realty Income pays out 85-95% of its FFO as dividends. Realty Income pays out its dividend on a monthly basis.

Approximate historical dividend yield at beginning of each year:

As can be seen, Realty Income’s yield is at a low point compared to the recent historical average. The valuation has been pushed higher, resulting in a lower yield.

Balance Sheet

Realty Income maintains an investment grade BBB+ credit rating.

As of the most recent quarter, the REIT has $8.76 billion in assets, $3.62 billion in liabilities, and therefore $5.14 billion in shareholder equity.

Investment Thesis

The thing that stands out about Realty Income is its dedication to shareholders. They brand themselves as “The Monthly Dividend Company”, and the bulk of their website is an atypically user-friendly dedication to educating potential shareholders about their business.

The first thing you may notice if you read their annual report is that the depictions are mostly of shareholders, whereas most annual reports by companies focus on their customers. When you look through the colorful annual reports of most businesses, you’ll generally see depictions of their customers, products, and operations. Indeed, Realty Income does depict some of their properties in their report. But at the forefront of their report are pictures depicting shareholders. There are five pages worth of various pictures of the demographic that they view as their shareholders: typically upper middle class, middle-aged or retired, and generally enjoying life. How a company chooses to market itself, including to its own shareholders, is an expression of that organization’s culture.

Realty Income’s role in a portfolio, over the 4+ decades of operation, has generally been to provide solid current income that keeps up with inflation. Payments come monthly rather than quarterly, and as a REIT the payout ratio is rather high, resulting in a decent current yield of 4+% (though historically higher than that). From a diverse and stable set of properties with long-term contracts, Realty Income seeks to provide good retirement income.

American Realty Capital Trust Acquisition
In the first quarter of 2013, Realty Income completed their acquisition of ARCT for $3.2 billion. This adds 515 properties, leased by 69 tenants in 44 states, to Realty Income’s portfolio, and has resulted in an unusually large dividend increase for the REIT of nearly 25%.

The acquisition also increased the overall occupancy rate of Realty Income, and increased the percentage of investment grade tenants. Currently, about two-thirds of Realty Income’s tenants are investment-grade businesses.

Real Estate Investment Trusts Vs. Directly-Owned Real Estate
Owning property is one of the oldest forms of wealth and investment. Of course, real estate can be owned actively with direct property, or passively through publicly traded REITs.

Owning direct real estate can result in a rate of return that exceeds the historical average of the stock market. Individual real estate markets are generally less efficient than stock markets, less liquid, and require more direct time and attention. When operated skillfully with the proper application of leverage, consistent double-digit returns are possible in many markets. The downside is that, as a hands-on approach, it requires a degree of real estate skill and of course time.

In comparison, owning shares in a REIT is a passive activity, but the returns will generally be lower. The reason for the lower returns is that as an investor, you’re paying a premium for the complete convenience. The book value of Realty Income is less than half of the current market capitalization. If, as a direct real estate investor, you owned shares of Realty Income at direct book value, your dividend yield would be doubled to nearly 10%, with dividend growth that generally keeps up with inflation. You’d be looking at low double-digit returns, which historically is better than the S&P 500.

As a publicly traded entity, the liquidity and passivity of the investment results in a fair price that is higher than book value, and therefore lower returns. Historically this REIT has still outperformed the market, but during most of that period, the valuation was lower and the yield was higher than it currently is.

Risks

Realty Income’s performance comes from the team’s ability to acquire and maintain a highly occupied property portfolio. General economic weakness can decrease their occupancy rates as their tenants struggle.

None of Realty Income’s tenants account for more than 10% of overall rental income, but the top six tenants each account for over 3% of rental income each. Of this, their largest tenant Fed-Ex accounts for 5.5% of rental income.

Conclusion and Valuation

Overall, Realty Income is clearly a well-run operation that has historically served investors well. The nature of property inherently gives them somewhat of an economic moat, and the conservative balance sheet and diversified property portfolio give shareholders some protection against loss. The REIT’s strong focus on shareholders and monthly high-yield dividend can be very attractive to those that seek current income.

The question, though, is whether Realty Income is trading at an attractive valuation. Assuming a constant valuation and dividend payout ratio, long-term returns are approximately equal to sum of dividend yield and dividend growth. For Realty Income, that sum is about 8%.

So, based on the Dividend Discount Model, investors looking for an 8% long-term rate of return, can pay up to $49 for shares of Realty Income, assuming that a 4% dividend growth rate occurs. If only a 3.5% long-term dividend growth rate is expected, this fair value drops to $43 instead.

If investors are looking for 9% annual returns over the long-term, and are expecting 4% dividend growth per year, then the fair value drops to $39.

Therefore, at $52/share, Realty Income is set to deliver shareholders a rate of return in the high 7% range, which is lower than the historical market rate of return, but comparatively solid for those seeking current income. Because the REIT is trading at a historically high valuation with a correspondingly low dividend yield, caution is advised.

Full Disclosure: As of this writing, I have no position in O.
You can see my dividend portfolio here.

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-Seven Year Revenue Growth Rate: 6.0%
-Seven Year EPS Growth Rate: 11.3%
-Seven Year Dividend Growth Rate: 11.9%
-Current Dividend Yield: 2.25%
-Balance Sheet Strength: Strong

Colgate’s strong product appeal and unusually wide global reach (even among American blue-chips) give investors a lot to like, but the fairly high stock valuation of the company keeps the dividend yield on the lower side and reduces or eliminates any margin of safety.

Overview

Colgate was founded in 1806 in New York as a soap and candle company. Colgate-Palmolive is now a multinational corporation selling oral hygiene products, soaps, and pet nutrition products. The company currently has a market capitalization of over $56 billion.

Business Segments and Divisions

Colgate-Palmolive consists of four business segments: Oral Care, Personal Care, Home Care, and Pet Nutrition.

Oral Care
Oral Care represents 44% of total company sales, which includes their flagship Colgate brand as well as Tom’s of Maine. According to a recent investor presentation, the company has #1 market share in 146 countries, which makes it the world’s leading oral care brand.

Personal Care
The company’s second largest segment is their personal care segment, which accounts for 22% of sales. This segment includes the leading Palmolive soap brand, as well as other brands such as Irish Spring and Speed Stick deodorants. The company claims the #1 market share spot worldwide for liquid hand soap and the #2 spot for bar soaps.

Home Care
The home care segment accounts for 21% of sales, and includes Palmolive dish soap and a set of small and medium brands. The company claims the #1 global spot for dish soap and the #2 spot for fabric conditioners and household cleaners.

Pet Nutrition
Approximately 13% of sales come from the Pet Nutrition segment. Their two big brands here are Science Diet and Prescription Diet, and while they are not the top brands overall, they do claim #1 market share in vet clinics worldwide. The products are sold primarily through veterinarians and specialty pet food stores, and the products are available in 90+ countries.

The company can also be understood as consisting of five geographic business divisions (or, more accurately, four geographic divisions plus Pet Nutrition)

North America
The North American division represents 18% of total company sales.

Latin America
The Latin America division represents 29% of sales.

Europe/South Pacific
The Europe/South Pacific division represents 20% of sales.

Greater Asia/Africa
The Asia/Africa division represents 20% of sales.

Hills Pet Nutrition
The Hills Pet Nutrition segment represents 13% of sales, as previously described. This segment is always grouped separately from their geographic segments.

Ratios

Price to Earnings: 25
Price to Free Cash Flow: 21
Price to Book: 32
Return on Equity: 115%

Revenue

(Chart Source: DividendMonk.com)

Revenue grew at a very solid 6% per year on average over this period. This revenue growth is what appears to be driving the stock’s high valuation.

Earnings and Dividends

(Chart Source: DividendMonk.com)

The EPS growth rate over this period averaged 11.3% per year, which for a blue-chip stock is quite substantial.

The dividend has increased each year consecutively for decades and currently has a payout ratio of approximately 50%. The rather high valuation of the stock has pushed the yield to a fairly low 2.25%. The dividend growth rate over the last seven years has averaged 11.9% per year.

Approximate historical dividend yield at beginning of each year:

Colgate Palmolve’s yield is in line with where it has been over the last several years. Despite being rather highly valued, it is not out of line of where it has historically been valued. The stock has offered solid returns over this period because the stock price has at most times been supported by fundamental outperformance.

How Does Colgate Palmolive Company Spend Its Cash?
Over the last three years, the company reported a sum of approximately $7.6 billion in free cash flow. Over the same period, $3.6 billion was spent on dividends, $5.8 billion was spent on share buybacks, and about $1 billion was spent on net acquisitions. The buybacks have resulted in a continuously shrinking outstanding share count, but the consistently premium stock valuation has minimized the overall value of these buybacks. Over the last seven years, the company has reduced its share count by about 13%.

Balance Sheet

The company has a total debt/equity ratio of approximately 300%, which is rather high. Furthermore, the amount of goodwill on the balance sheet exceeds the shareholder equity. At first glance, this appears to be a heavily leveraged balance sheet.

The total debt/income ratio, however, is only about 220%, which is rather low. The interest coverage ratio is nearly 50x, which is extremely high, and indicative of an unusually strong balance sheet. The company has very high credit ratings.

The reason for the high debt/equity ratio (and along with it the unusually high price/book value and unusually high ROE), is not that the company has a lot of debt, but rather that the company has a comparatively small asset base compared to the revenue and other figures. Colgate Palmolive has only approximately half as much value in non-current assets as their annual revenue, whereas Procter and Gamble, for example, has significantly more reported value in their non-current assets than their annual revenue.

This small reported asset base keeps the company’s shareholder equity very low, which skews the book value, ROE, and debt/equity metrics upwards. Overall, Colgate-Palmolive has a very strong balance sheet.

Investment Thesis

Colgate-Palmolive is in a very strong position compared to its peers. The company’s early move into developing markets has paid dividends, literally and figuratively, because strong performance in those areas is what is driving the company’s substantial revenue growth.

Even among American blue-chip companies, which tend to have significant international exposure, Colgate-Palmolive is an atypically geographically expanded company. Three-quarters of the revenue is generated outside of North America.

In particular, the Latin America and Asia/Africa regions are enjoying rapid expansion. Their sales growth in Latin America has averaged over 12% per year over the last seven years, and their Asia/Africa region has grown at nearly 10% per year over the same period.

The company complements its traditional mass-marketing branding with brands that focus on natural or sustainable aspects to appeal to certain customers. The acquisition of Tom’s of Maine, for example, gives the company a portfolio of products that attempt to be better for the environment and use more natural ingredients.

Oral care products typically carry high profit margins and customer loyalty. The relatively high price per ounce of branded toothpaste, combined with the rather infrequent need to purchase it (and therefore less of a need to compare prices or buy primarily based on price) as well as the unique taste or characteristics of toothpaste that results in frequent repurchase of the same type, gives the Colgate brand quite a bit of strength compared to other product categories of comparable consumer companies.

Risks

Like any company, CL has risks. Their business is fairly recession-resistant, offering high quality basic products, but they face continual risk from foreign exchange rates, commodity costs, and cheaper product alternatives, as well as strong competition from other top brands including from Procter and Gamble, a larger company. The company spends nearly $2 billion per year on advertising to allow them to maintain or grow their market share.

No single customer represents 10% or more of total sales, and no single supplier or packaging material represents a large percentage of total material requirements of the company.

The place where risks for this kind of company would typically manifest themselves are in the profit margins. Increasing advertising costs and increasing commodity costs can squeeze profit margins and reduce income growth.

Conclusion and Valuation

Overall, I view Colgate-Palmolive as a particularly strong dividend-grower, with high and increasing profit margins, solid revenue growth, wide international reach, and reasonable product diversification.

The question, then, is whether the fairly high price is justified. In order to achieve a 9% rate of return over the long-term based on the Dividend Discount Model, the company would have to grow the dividend by an average of nearly 7% per year for the foreseeable future. If a 10% rate of return is desired, the dividend growth rate would have to be closer to 8%. Colgate-Palmolive has maintained this level of EPS and dividend growth historically, but as it grows larger and saturates its core areas, it may be unable to continue that level of growth.

A reasonable scenario for the company is 2-3% core growth, 2-3% inflation (resulting in 4-6% revenue growth), stable profit margins (resulting in 4-6% net income growth to match revenue), 2-4% worth of the market cap being repurchased annually (resulting in 6-10% EPS growth), and a stable dividend payout ratio (resulting in 6-10% dividend growth) puts it in line with the required sustainable dividend growth rates to justify the current price.

There is not a substantial margin of safety built into the stock price, nor is the current yield particularly desirable. I believe total long-term returns should be reasonable for the foreseeable future, but there are likely superior combinations of income and growth available.

Full Disclosure: As of this writing, I have no position in CL.
You can see my dividend portfolio here.

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-Seven Year EPS Growth Rate: 4.1%
-Seven Year Dividend Growth Rate: 12.6%
-Current Dividend Yield: 2.80%
-Balance Sheet Strength: Investment Grade

Overview

I published a stock report last week on Oneok Partners LP (NYSE: OKS), which is a relatively large natural gas and NGL master limited partnership. In the article, I stated that quantitatively and qualitatively, it appears to be a strong investment with a great combination of yield and growth.

Another way to invest in the assets of that partnership is to invest in Oneok Inc. (NYSE: OKE), which owns the General Partner, 100% Incentive Distribution Rights, and 41.4% of the Limited Partner units, of Oneok Partners LP. Unlike OKS which trades as an MLP, Oneok Inc. trades as a regular dividend stock. This article finishes the Oneok series by taking a look at this general partner.

Business Areas

Oneok Inc. is divided into three main areas: Distribution, Energy Services, and Oneok Partners.

Distribution
Oneok Inc. also owns three natural gas distribution companies that serve customers in Oklahoma, Kansas, and Texas. Oneok has been in business as an intrastate natural gas distributor in Oklahoma for over 100 years, and now serves three states with over 2 million customers. Oneok’s businesses in Oklahoma and Kansas are the largest in those states, while their Texas distributor is the third largest distributor in Texas.

Energy Services
Oneok makes contracts for supply, transportation, and storage of natural gas to customers across the U.S. This includes leases for storage and transport.

Oneok Partners
Oneok Partners is responsible for most of the growth of Oneok Inc. This MLP is described in more detail here, and primarily deals with natural gas pipelines and NGLs.

Earnings and Dividends

(Chart Source: DividendMonk.com)

For MLPs, earnings per share is not the most accurate way to express profitability of the business due to the very asset-heavy nature of the business. Oneok Inc.’s income statement includes the Oneok Partners income items and then accounts for non-controlling interests. As such, depreciation reductions are substantial for the business and result in a lower net income. A more important chart for profitability appears below in the Thesis section.

For dividends, the company currently pays a 2.8% yield and has an average five-year dividend growth rate of 12.6% per year. The company also buys back a small portion of its shares each year to reduce the outstanding share count ($150 million worth in 2012), and in 2012 purchased additional limited partner units of Oneok Partners LP to increase their total holding.

Approximate historical dividend yield at beginning of each year:

Balance Sheet

Oneok’s credit rating is BBB/Baa2. As the bulk of the assets for the business are in the MLP, this constitutes a fine credit rating and overall balance sheet strength. As very asset-heavy businesses, energy partnerships utilize substantial leverage in order to get solid returns on capital.

Investment Thesis

Oneok was a run-of-the-mill utility until the years between 2004 and 2006 when it purchased the general partner of Northern Border Partners and renamed it under the Oneok brand. Since then, the company has grown like wildfire because it has been able to use limited partner capital to produce an enormous internal rate of return thanks to the Incentive Distribution Rights (IDRs). The company is vertically integrated now, as the interstate pipeline assets that it acquired overlap geographically with their intrastate distribution assets.

Much like Kinder Morgan Inc. and Energy Transfer Equity, Oneok Inc. is a publicly traded general partner of another publicly traded partnership (Oneok Partners LP), and the overall benefits are similar.

Put frankly, a general partner holding of a well-run MLP can be one of the highest-returning investment structures there is, because the whole structure is based on allowing the general partner to get a share of the limited partners’ investment capital, while being given a good incentive to pay the limited partners ever-growing distributions.

The structure of an MLP is that there exists a general partner and limited partners. In the beginning, the general partner gets 2% of the distributions while the limited partners get the other 98%. But as the partnership hits higher per-unit distribution thresholds, the general partner gets a larger share of the distributions, which are called Incentive Distribution Rights (IDRs). So the general partner is given a strong incentive to raise the distribution for the limited partners, and over time if they are able to do so, their own rewards are even better, because they get a larger share of the total.

For Oneok, the distribution thresholds are as follows:
-Once OKS hits $0.3025 in distributions per unit per quarter, the general partner gets 15% of amounts distributed above that.
-Once OKS hits $0.3575 in distributions per unit per quarter, the general partner gets 25% of the amounts distributed above that.
-Once OKS hits $0.4675 in distributions per unit per quarter, the general partner gets 50% of the amounts distributed above that.

OKS is currently paying $0.715 in distributions per unit per quarter, so it’s well over the top threshold. As it continues to raise the distribution, the general partner (held by Oneok Inc., OKE) will continue to get this top tier chunk of the cash flows.

This is in addition to the fact that Oneok Inc. holds 41.4% of the limited partner units of OKS, so they also get those limited partner distributions.

Here’s the chart that shows the distributions that Oneok Inc. (OKE) is receiving from Oneok Partners LP (OKS). The period is for 2007-2012, and shows the total broken down into the general partner share and the limited partner share.

(Chart Source: DividendMonk.com)

As can be seen, the general partner portion has grown much more quickly than the limited partner portion. The 2013 estimate for total distributions from Oneok Partners to Oneok Inc. by company management is expected to be another 25% higher than 2012.

In 2007 Oneok Inc. received $145.1 million in limited partner distributions from OKS, which increased to $235.4 million in 2012. This represents an annualized growth rate in limited partner distributions of 10.1%

In comparison, in 2007 Oneok Inc. received $58.5 million in general partner distributions from OKS, which increased to $201.3 million in 2012. This represents an annualized growth rate in general partner distributions of 28%.

The total annual growth rate for distributions received from OKS (meaning both limited and general partner distributions) was around 16.6% per year for this period. This growing stream of incoming cash flow to Oneok Inc. is what fuels the continued dividend growth to their shareholders.

The reason the general partner does so well, if properly managed, is that they get an ever-increasing percentage of the total cash pie, and the overall size of the cash pie grows. So they get a larger share of a larger total, which compounds into a very large internal growth rate. The growth of the total cash pie is fueled by issuing more limited partner units, and if that money is invested well, it can increase the revenue for the overall partnership and increase distributions for all limited partner units. For the 2007-2012 period, OKS increased its outstanding unit count by about 4.5% per year on average, although OKE was itself a major purchaser of these units.

In 2007, Oneok Partners LP paid around $385 million in total distributions. Of this, around 15%, or $58.5 million, went to the general partner share, and the rest went to the limited partners (of which Oneok owns a substantial portion as well).

By 2012, Oneok Partners LP grew as a whole, and paid $761 million in total distributions. Of this, around 26%, or $201.3 million, went to the general partner share, and the rest went to the limited partners (of which Oneok still owned over 40%). During this five year period, the total distributions from the partnership, nearly doubled from around $385 million to around $761 million, the percentage that went to the general partner increased from 15% or so to over 26%, and therefore the distributions to the general partner increased dramatically from $58.5 million to $201.3 million; an almost 3.5x increase.

Even as Oneok Inc. slowly reduces its share count, OKS will likely continue to increase its unit count, which brings in more capital, grows the total cash pie, most likely grows the distributions per unit, and therefore continues to significantly grow the general partner distributions to Oneok Inc.

Risks

The performance of Oneok Inc. is heavily reliant on Oneok Partners LP. While Oneok Inc. does hold its own distribution and energy services segments, the real growth engine for the company over the last 5-6 years has been the LP. If Oneok Partners LP cuts its distribution at any point, not only will Oneok Inc. have its 41.4% limited partner share cut, but they’ll also have their general partner share cut even more dramatically due to the IDR agreement and the aforementioned target distribution thresholds.

More risks are discussed in the OKS analysis.

Conclusion and Valuation

Oneok Partners LP (OKS) is currently in a very strong position of growth with several years of planned investments. Oneok Inc. (OKE) has an even better structural advantage as far as the investment is concerned, because in addition to having exposure to the growing distributions to the limited partners, they enjoy the disproportionate growth of the distributions paid to their solely owned general partner, and they also hold separate assets.

Even a great business, however, can make for a lousy investment if the price isn’t right. As described in the OKS analysis, I believe OKS is at an undervalued price. OKE, however, continues to hit new high water marks of price as it’s fueled by this strong general partner growth.

OKS grew its per-unit limited partner distribution at a 5.5% annual growth rate over the last five years. OKE enjoyed this annual limited partner distribution growth, but also increased its number of limited partner units and enjoyed strong general partner growth. OKE’s total distribution growth from OKS has averaged 16.6% over the last five years. The 2011-2012 growth was over 30%, and management’s predicted 2013-2012 growth is around 25%. Meanwhile, OKE’s stable natural gas distribution income, and their slightly diminishing share count due to repurchases, help per-share growth for OKE investors.

Using a two-stage Dividend Discount Model, if Oneok Inc. grows its dividend by 10% per year on average over the next 10 years followed by 6% thereafter, then with a 10% discount rate (a reasonable target rate of return), the intrinsic fair price will be slightly over $50. This is about a buck less than the current share price, but with this high dividend growth rate, the estimate has a significant margin of error.

Overall, I believe OKE to be approximately fairly valued. It’s not a cheap stock in terms of valuation, but the expected growth does appear to justify the current price.

Generally speaking, I prefer to own publicly traded general partners such as ETE and KMI if given the opportunity. However, if the stock valuations favor the publicly traded limited partnership instead, and if the limited partnership continues to grow its distribution well (as OKS is expected to do, based on its growth plans), then the limited partnership can sometimes be the preferable investment. It’s certainly the preferable investment if you’re after a high current yield. I currently believe OKS is moderately undervalued, while OKE is fairly valued. But OKE as the general partner is in a position to achieve a better rate of return, which may approximately balance out the total returns for investors. I expect that both investments will do well over the long term.

It’s worth pointing out, as usually is the case for publicly traded general and limited partners, that insiders own a much larger portion of Oneok Inc. than Oneok Partners LP. CEO and Chairman John Gibson is reported to own over $30 million worth of Oneok Inc., but under $3 million of Oneok Partners LP.

-Oneok Partners LP appears to be a good choice at an attractive price for a combination of a high distribution yield and moderate distribution growth. As an MLP, investors are responsible for the greater tax complexity during tax season.

-Oneok Inc. appears to be a reasonable choice at a fair valuation, despite the ever-increasing stock price, for a combination of moderate dividend yield and high dividend growth. As a regular stock, investors have a simpler time during tax season.

Full Disclosure: As of this writing, I have no position in OKS or OKE, but they’re on my watch list. I am long ETE and KMI.
You can see my dividend portfolio here.

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-Distribution Yield: 5.10%
-Seven Year Distribution Growth Rate: 7.1%
-Credit Rating: BBB, Stable Investment Grade

Overall, I view OKS as one of the better income investments on the market currently, with an appealing combination of yield and growth at a reasonable valuation.

Overview

Oneok Partners LP (NYSE: OKS) is a $12 billion vertically integrated master limited partnership that focuses on natural gas and natural gas liquids.

As an MLP, it offers a substantial distribution yield, significant distribution growth, and a tax-advantaged investment. MLPs are flow-through entities, and therefore they avoid the double taxation of the corporate/dividend tax duo.

MLPs like Oneok generally increase their number of outstanding units over time (rather than decrease them as blue chip corporations tend to do), because as a flow-through entity they can generally get a good enough rate of return on their newly issued units in order to grow the distributions on all units, if managed well. This has allowed MLPs to dramatically outperform many standard utility companies (a stronghold of dividend investors) over the last decade, and there isn’t a structural reason why this general outperformance should not continue.

The limited partners benefit when distributions increase, and the general partner benefits both when the distributions increase and when the number of units and overall partnership size increases.

The disadvantage to this tax-advantaged structure is that individual investors are responsible for an additional tax form during tax season.

Distribution Growth

(Chart Source: DividendMonk.com)

The current distribution yield for Oneok is 5.10%.

Over the seven year period ending in 2012, Oneok increased its distribution by an average rate of approximately 7.1% per year. Distribution growth was rather consistent over this period, with an increase each year. In particular, the distribution increased almost every quarter, with an exception in 2009 at the most uncertain point in the recession when the distribution was held flat for a few quarters.

The distribution for the first quarter of 2013 is 16.4% higher than the distribution for the first quarter of 2012. According to the most recent annual report, management expects to increase the distribution by 8-12% per year through 2015.

Approximate historical distribution yield at beginning of each year:

Particularly for shares/units with a consistent and large dividend/distribution, tracking the yield over time for the units is a relevant valuation method. As can be seen, the price dip in 2009 presented investors with an attractive opportunity to pick up very high yielding healthy units. Apart from that, the yield has fluctuated between 4% and over 6%. The current 5.1% yield offers a better value than this time last year, because the unit price has remained flat while the distribution and partnership assets have continued to grow, and indeed actually accelerate in growth.

Balance Sheet

Oneok Partners has a BBB/Baa2 investment grade credit rating, and an interest coverage ratio that is comfortably over 4.

The partnership compares fairly to its peers in terms of balance sheet strength.

Investment Thesis

Oneok Partners LP is an option if you want to diversify into a bit more energy assets outside of Texas. Many MLPs like Energy Transfer Partners (ETP) and Kinder Morgan Energy Partners (KMP) have a substantial asset density on the Texas Gulf Coast, and while Oneok does have Texan assets, the bulk of their assets are further north.

The central hub of Oneok assets is Oklahoma, and the partnership has natural gas and NGL pipelines in the central United States. In particular, the partnership has exposure to the Bakken Shale and Williston Basin in North Dakota, and the Niobrara Shale and Piceance Basin in the central U.S.

The company has $5 billion in growth projects underway or planned for the 2011-2015 period. This is significantly greater than the 2006-2010 period, and the partnership also claims a $2 billion backlog of unannounced natural gas and NGL infrastructure growth prospects with EBITDA multiples of 5-7. Half of the $5 billion is being invested into infrastructure related to the major Bakkin Shale and Williston Basin. The other half is going towards infrastructure projects in the central United States and the Gulf Coast.

The partnership has invested heavily into Natural Gas Liquids, which are expected according to partnership guidance to account for 61% of partnership operating income in 2013. The rest comes from Natural Gas gathering, processing, and pipelines.

The holder of the general partner, including the Incentive Distribution Rights (IDRs) of Oneok Partners LP (NYSE: OKS) is publicly traded as Oneok, Inc. (NYSE: OKE). OKE offers a substantially lower dividend yield, but faster dividend growth, and the investor can avoid the special tax aspects of MLPs by investing in OKE instead. OKE does have a premium valuation, however, because expected growth is substantial due to their general partner holding of OKS. This is similar to how Kinder Morgan Inc. (KMI) is the publicly traded general partner of Kinder Morgan Energy Partners (KMP). OKE, however, offers a moderately lower current dividend yield than KMI by about 1 yield percentage point.

Risks

The bulk of Oneok’s revenues are generated with stable fees, but there are areas of risk.

There is commodity price risk in the natural gas gathering and processing operations, which the partnership hedges against. There is also volume risk in the NGL operations, including from ethane rejection.

As an asset-heavy business that necessarily uses substantial debt, Oneok is vulnerable to substantial increases in interest rates.

Since Oneok is at a high level of distributions per unit, a considerably high percentage of their cash flow goes to the general partner (over 24% for 2012), which can eventually limit distribution growth to limited partners. Some partnerships can maintain distribution growth for very long stretches of time (Kinder Morgan, as an example), while others run into issues and have to halt distribution growth due to hefty IDR payments (Energy Transfer Partners, for example, had to have several IDR rights temporarily waived by the general partner for acquisitions to work).

Conclusion and Valuation

In conclusion, Oneok is a $12 billion diverse collection of natural gas and NGL assets throughout the central United States that offers investors a good combination of distribution yield and growth.

Using a 10% discount rate as the target rate of return for a two stage Dividend Discount Model estimation, the units have an estimated fair price of $66 if the partnership can grow the distribution at an average rate of just 7% over the next decade (which is conservative) and only 5% thereafter. Considering that management expects 8-12% distribution growth over the next three years, there is potentially a higher upside than that. Compared to the current price of approximately $56, I consider there to be an attractive margin of safety, and I view OKS to be one of the rarer attractively valued income investments in a market that otherwise seems to offer a limited number of attractively priced stocks for dividend growth investors.

Full Disclosure: As of this writing, I have no position in OKS, though it is on my watch list. I am long ETE and KMI.
You can see my dividend portfolio here.

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Despite that, there have been some blue-chip stocks that have missed out on part of this increase. Here are five of them at that trade at valuations that are lower than the rest of the market.

Chevron Corporation (CVX)

Chevron’s stock performance over the past four years has been admirable, but most of the increase in price occurred in in the 2009-2011 period. The stock has been fairly flat and choppy since then, and currently offers a dividend yield of 3.14%, a five-year dividend growth rate of approximately 9%, and a dividend payout ratio of under 40%. The dividend is likely to increase this quarter.

Cost over-runs at the enormous $50+ billion Australian Gorgon LNG gas project, as well as continued litigation risk from their ceased Ecuadorian operations seem to be keeping the stock valuation in check.

Chevron has a pristine balance sheet, and gas output in 2015 from the Gorgon project should be a driver for growth.

Intel Corporation (INTC)

Intel’s #1 problem is that they have the dominant position in the softening PC market. As the world’s largest semiconductor producer, they use their immense capital resources to keep ahead of AMD with the tick-tock method, but ARM has strongly outperformed Intel in the proliferating market of mobile computing devices. This leaves Intel holding the bag in the PC market, but fortunately they do have strong positioning in the growing server market.

Another strike against the company is that their billions spent on acquisitions over the last several years doesn’t seem to be having a material benefit. I pointed out in my 2010 analysis of the company that their McAfee acquisition, at 40 times earnings, doesn’t seem particularly justifiable unless several bullish assumptions all take place.

The company offers a hefty dividend yield of 4.1%, the most recent increase was over 7% (which I believe is a more practical measure of dividend growth at this point compared to their much larger five-year dividend growth rate), and so with a P/E of only 10, the company doesn’t require almost any core growth to offer investors a shot at double-digit returns. The company likely isn’t looking at a whole lot of growth, but since most of their cash goes to investors in the form of dividends and share buybacks (which fuels EPS/dividend growth), Intel stock is still in a reasonably appealing position.

Oneok Partners LP (OKS)

NGL prices haven’t been helping Oneok, but over the long term, their $5 billion in projects seem to present a clear path to growth over the next several years. I was a bit wary of this MLP back in 2011 when the unit price was soaring, but after a flat unit price of 2012 and 2013 along with continued distribution growth, OKS is looking a bit more attractive compared to the market these days.

With a 5.21% distribution yield and 6% annualized distribution growth over the last five years, the partnership is a strong income producer. Pipelines represent consistent, wide-moat infrastructure investments that are perfect for dividend investors.

For those interested in MLPs, two other partnerships that I’m bullish on (and own) for yield and growth, are Kinder Morgan Inc. (KMI) (full analysis) and Energy Transfer Equity LP (ETE) (recent analysis).

Air Products and Chemicals (APD)

With 30 years of consecutive dividend growth, APD has had some consistency. This company is the largest supplier of hydrogen to companies in the world, and generally signs long-term contracts with customers. The focus recently has been on cost-cutting and selling of non-core business units, and so their revenue for 2012 wasn’t as strong as 2011.

The dividend yield is a decent 3.31%, the dividend growth rate over the last 5 years has averaged more than 10% per year, and the balance sheet is quite strong with an interest coverage ratio of 10.

BHP Billiton ADR (BBL, BHP)

BHP Billiton, headquartered in Australia, is the largest mining company in the world. Two ADRs (with equal economic and voting rights) trade on the NYSE: BBL and BHP. BBL trades at a discount to BHP and therefore offers a higher dividend yield.

The market has boomed in 2013 while the stock price of BHP Billiton has fallen. On April 17th alone, BBL fell over 4.5%. The reason is, commodity prices have fallen compared to 2011, and institutional investors have pulled back a bit. That leaves BBL ADR shares with a 4.2% dividend yield. The 2007-2012 period saw annualized dividend growth of nearly 19% per year in USD, although the 2012-2013 dividend change has so far been 3.6% in USD.

Looking at this from a long-term view rather than a short-term one, BHP Billiton offers a strong combination of yield and growth, has highly diversified mining operations, and it will continue to offer materials that the world needs. At a P/E ratio of 15, the company is on sale compared to the market.

A Snapshot of the Market

The Shiller P/E of the market is currently in the range of 22-23, which places it well above its historical average of under 17, but lower than it was prior to the latest recession. Using the Shiller P/E as the metric of choice, the market’s overall valuation has been fairly flat over the last three years as both earnings and stock prices have risen.

While these five investments don’t necessarily represent recommended picks, they may be good places to look. The most recent issue of the dividend newsletter included three other stock picks that seem to be trading at reasonable valuations. Even in this moderately highly valued market, values can still be found.

Good Dividend Growth Candidates Often Have:
-A sum of dividend yield and expected future EPS growth that sums to 10 or higher. Assuming a constant stock valuation over time, the sum of yield and EPS growth is the best estimate for long-term returns, which can be quantitatively demonstrated with methods like the Dividend Discount Model.

-A sturdy balance sheet with an interest coverage ratio of 8 or higher. A company with a balance sheet that’s stronger than its peers has flexibility to make opportunistic investments, to take advantage of low interest rates to temporarily increase their debt and buy back shares, and to weather major economic downturns. Of course, for asset-heavy businesses like utilities or MLPs, a much lower interest coverage ratio is allowed and expected, and the credit rating becomes a more relevant assessment.

-A specific plan for the future. Rather than operating quarter by quarter, successful companies plan years ahead. Look for companies that proudly explain their plans over the next five years or so, including specific projects or specific growth targets and explanations of how they’ll meet those targets. Blue-chip stocks that have mild to moderate growth and that spend much of their money on dividends and buybacks are often consistent enough for investors and managers to make fairly accurate predictions about EPS and dividend growth over a business cycle.

Full Disclosure: As of this writing, I am long CVX, ETE, and KMI.
You can see my dividend portfolio here.

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

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Over the last two years, the Energy Transfer set of investments has exploded in complexity. I currently view both ETE and ETP as investments that remain appealing purchases in this rather highly valued market, but until consolidation occurs an accurate valuation is difficult to come by. Therefore this report is being published as an “update” rather than an “analysis”, as the primary focus will be on a qualitative overview rather than a quantitative assessment.

Overview

The Energy Transfer set of investments is currently among the most complex investments traded on the public market, and management’s current focus is primarily on simplifying the organizational structure.

The set of investments exists as a combination of master limited partnerships and corporations.

I previously analyzed ETE about 20 months ago in 2011 with a 3,500 word analysis that can be found here. That analysis is currently quantitatively outdated but includes a lengthy description on the risks and benefits of owning a general partner like ETE, and in that article I proposed that the price at the time of under $37/unit was a very attractive purchase. It has since then gone up to just under $60/unit while paying also paying a fairly high yield.

At the time of that article, the ownership structure was reasonably complex but fairly straightforward to value, with ETE owning the general partner, 100% Incentive Distribution Rights (IDRs), and a portion of the limited partnership units, of both Energy Transfer Partners (ETP) and Regency Energy Partners (RGP). Now in April of 2013, after a series of mergers and acquisitions, the investment structure has enormously grown in complexity.

The history of the events can be summarized as:
-ETE acquired Southern Union which held attractive pipeline assets in Florida, and then dropped down the most important assets to ETP.
-ETP acquired Sunoco Inc., including their retail gas assets and their holding of Sunoco Logistics Partners (SXL).
-ETE and ETP formed Holdco to consolidate some of these assets. ETE shifted their Southern Union assets to Holdco, and ETP shifted their Sunoco Inc. assets to Holdco but held onto the SXL ownership (the GP, IDRs, and a portion of the LPs) directly. ETE owned 60% of Holdco while ETP owned 40%.
-Some non-core Southern Union assets were sold to an outside entity.
-Southern Union Gas Company was sold to Regency Energy Partners (RGP).
-ETE and ETP reached an agreement to sell ETE’s stake of Holdco to ETP for $2.35 billion in ETP units and $1.4 billion in cash. This is a the key part of consolidation into a simpler structure.

The current situation remains complex, and is a three-tier publicly traded structure. As this Holdco sale finalizes, the structure will be as follows:

-ETE as a publicly traded entity will continue to own the GP, 100% IDRs, and a portion of the LP units of both ETP and RGP.
-ETP as a publicly traded entity will own its core assets as well as Sunoco Inc. (gas retail), the remaining Southern Union Assets, and the GP, 100% IDRs, and a portion of the LP units, of Sunoco Logistics Partnership (SXL).
-RGP as a publicly traded entity will continue to operate as a fairly independent partnership with its GP owned directly be ETE.
-SXL as a publicly traded entity will continue to operate as a fairly independent partnership with its GP owned directly by ETP (and partially and indirectly by ETE due to ETE’s ownership of ETP’s GP).

ETE Distributions

(Chart Source: DividendMonk.com)

The chart value for 2013 extrapolates the current quarterly distribution of $0.635 (up from $0.625 from last quarter) throughout the year, and therefore is best understood as an estimated minimum distribution for the year.

Distribution growth stalled for several quarters during this period of mergers and acquisitions. The primary reason was that for these sales to work, ETE had to temporarily waive its share of the IDRs of the assets it was selling to ETP. ETE began resuming its distribution in 2013 and appears to be set for decent distribution growth as the structure simplifies and as they eventually get access to their full IDRs on these various assets.

The current distribution yield is 4.28%.

ETP Distributions

(Chart Source: DividendMonk.com)

ETP has held its distribution steady without growth since mid 2008.

Like the last chart, this chart value for 2013 extrapolates the current quarterly distribution throughout the year, and therefore is best understood as an estimated minimum distribution for 2013.

Distributions have remained flat for a frustrating period of time for ETP investors. As ETP has acquired these assets and grew considerably, they have issued units to fund these purchases, and have been able to maintain but not grow their distribution payments. I do expect ETP to boost its distribution before 2014, and according to recent presentations, it’s a large focus of ETP management to resume increasing its distribution as it cuts costs and finds synergies in its consolidating set of new assets.

The current distribution yield is 7.41%.

Between ETE and ETP, ETE as the general partner is expected to have a lower distribution yield and higher distribution growth, while ETP is expected to maintain a higher distribution yield while having lower distribution growth.

Balance Sheet

ETP currently has a Baa3 credit rating while ETE has a Ba2 credit rating from Moody’s. This puts ETP on the low side of investment grade, and ETE into the non-investment grade category.

Each partnership holds debt, and then ETE holds stakes in those partnerships while also having its own parent debt, which is why ETE is more leveraged than any other entity in this structure.

Investment Thesis

Predicting where this investment is going to go involves two primary areas of focus. The first is to focus on potential areas of growth for this set of investments, and the second is to focus on the changing structure of the set of investments.

Growth Opportunities
Over the last decade, Energy Transfer expanded from a small set of assets in Texas to one of the largest energy companies in the country. They now own pipelines, terminals, storage, and other facilities throughout all of Texas, Louisiana, and Florida, as well as in the mid-western states and northeastern states. Sunoco gas stations are now part of the portfolio as well.

The partnership continues to expand in the Eagle Ford Shale of Texas, as well as with the Godley Plant Expansion, the SUGS Red Bluff Project, the SUGS Mi Vida Project, and the Mont Belvieu Fractionators.

A longer-term project is the Trunkline Crude Oil Conversion Project, which is expected to be in service in 2014. Then there’s the much longer-term LNG Export Project expected to be in service for 2018-2020.

ETP (and indirectly, ETE) is positioned to benefit from increasing SXL distributions. Now that SXL is hitting its top distribution tier, 50% of cash above this level goes to ETP in the form of IDRs. So for example, a 24% increase in SXL limited partner distributions results in a 45% increase for distributions to ETP. A 48% increase for SXL limited partners instead results in an 89% increase for ETP. ETP also benefits when SXL issues more units for growth, as they get a share of a larger total cash pie. As the general partner holder, ETP benefits from this arrangement in much the same way that ETE benefits from ETP.

Business Structure
The structure has exploded in complexity in the last year, but is now showing signs of consolidation as ETE sells its portion of Holdco to ETP. I expected ETE to eventually drop down all of its acquired Southern Union assets to ETP, but the acquisition of Sunoco by ETP complicated the structure, and so that final drop down has been delayed until now.

I envision one of two most probable paths here.

It could be a shift towards ETE once again being a holding entity for other partnerships. In that case, ETP may sell the GP of SXL to ETE, which would result in a simplified structure of ETE holding the GP, IDRs, and a portion of the LP units of the three MLPs: ETP, RGP, and SXL. In that case, ETP, RGP, and SXL would be able to operate fairly independently and offer high current yields while ETE would reap the rewards of the IDRs and offer a great sum of distribution yield and distribution growth.

Another way this could evolve is for the structure to fold itself entirely into ETP. There has been a history on the market of general partners being bought out by the MLP to reduce the drag on distribution growth, with Enterprise Products Partners being the largest example. ETP is the largest compared to SXL and RGP. Like the previous scenario, ETP could sell the SXL GP to ETE. RGP and SXL could merge with ETP, and then ETP could acquire all of ETE so that the structure would then exist as a partnership that can send all cash towards ETP LP distributions.

Regardless of the precise outcome, I expect in the moderate term that we’ll see continued consolidation, some areas of growth, a return to ETP increasing its distribution from a long plateau, and an acceleration of ETE’s distribution growth.

Risks

The largest risks here are the complexity and leverage. Sorting through the financial details of this set of investments takes time and reduces the ability of retail investors to thoroughly invest in the partnership. Each partnership holds debt (currently rated Baa3/BBB- by the major rating agencies), and then ETE also holds parent debt and is rated only Ba2/BB. This leverage has reduced the flexibility of the partnerships, and has played a role in keeping the distribution growth from occurring.

The partnership primarily deals with the transportation of gases and liquids but does have some exposure to commodity pricing. They’re dependent on the health of the U.S. economy and their leverage increases their dependence.

Like other publicly traded partnerships, an additional form is required to be filed during tax season. This generally delays the date in which taxes can be filed by an investor.

Conclusion and Valuation

ETE and ETP are not the kind of investments that can be purchased and ignored. Much has changed in the last two years, and consolidation should simplify analysis of this structure for next year.

ETP is currently paying a high yield of 7.41% and management has expressed commitment to resuming growth of that distribution. For long-term rates of return to be 9% or 10%, the distribution only has to grow by 1.5-2.5% per year, respectively. It’s the better investment if a high current yield is desired, and I expect ETP’s operations and their SXL holding in particular to allow them to modestly increase their distribution over time.

ETE is paying a more modest yield of 4.28%, but I continue to believe that ETE is in a position to produce higher total returns as this investment consolidates and as the IDRs come back into focus. To produce a 9-10% long-term rate of return, 5-6% distribution growth is required. If SXL continues to increase its distribution, if ETP resumes its distribution increases, and if the partnership continues to consolidate focus on organic growth projects, ETE is in a position to strongly benefit.

It’s useful to recognize the inside ownership in this case. Kelcy Warren, the CEO of the partnership, holds over $350 million of his wealth in ETE and only a small fraction of that in ETP. The same can be said for COO Marshall Mccrea. In addition, Kelcy Warren made multi-million dollar purchases of ETE units in both 2011 and 2012.

Overall, while the market as a whole is highly valued, I observe ETE and to some extent ETP to be reasonably attractive purchases at the current valuations based on their current yields and expectations of mild to moderate distribution growth from consolidation and organic growth.

For further quantitative articles on the partnership, I point readers to these great recent resources:
ETP Turning The Corner Albeit Slowly- Ray Merola
Energy Transfer Fulfilling Its Promise to Simplify- Ray Merola
Further Thoughts on Energy Transfer Holdco Transaction- Ron Hiram

Full Disclosure: As of this writing, I continue to own units of ETE.
You can see my dividend portfolio here.

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-Seven Year Revenue Growth Rate: 1.2%
-Seven Year EPS Growth Rate: N/A
-Seven Year Dividend Growth Rate: 4.2%
-Current Dividend Yield: 3.41%
-Balance Sheet Strength: Fairly Strong

Personally, while there are a number of good things that can be said about the company, I’d stay away from buying CINF shares at the current price after this recent bull market. The combination of yield and growth is not currently appealing.

Overview

Cincinnati Financial Corporation (CINF) was formed in 1968, though its primary subsidiary, Cincinnati Insurance Company, was founded in 1950. CINF has 4,057 associates and operates in 39 states as of the end of 2012. CINF currently owns 100% of three subsidiaries: Cincinnati Insurance Company, CSU Producer Resources, Inc., and CFC Investment Company. They also own their headquarters property and a large investment portfolio.

The company sells its insurance products exclusively through independent insurance agents.

The premise behind an insurance company is that they spread risk out over a wide number of people and businesses. They collect premiums (payments) from clients and in return those clients are covered in case of a serious loss. From an insurance business standpoint, it’s ideal to collect more in premiums than you pay out for losses. This is not the primary form of earnings, though. An insurance business, after collecting all of the premiums, holds a great deal of assets that, over time, are paid out for client losses. An insurance company constantly receives premiums and pays out for losses, so as long as they are prudent with their business, they get to constantly keep this large sum of stored-up assets.

As any investor reading this knows, a great sum of money can be used to generate income from investments, and that’s how an insurance company really makes money. CINF invests its stored up collection of assets (a $12+ billion portfolio) in stocks and bonds. For example, in 2012, the company brought in $566 million in pre-tax corporate income, which includes the investment income of $531 million. As is typical, the insurance business barely broke even while the investment income represented the real profit of the corporation.

Commercial Lines Property Casualty Insurance Segment
Total net earned premiums for 2012: $2.383 billion
Change compared to 2011: +8%

This segment includes casualty insurance, property insurance, commercial vehicle insurance, worker’s compensation, executive risk, machinery and equipment, and specialty insurance. A total of $181 million in pre-tax income came from this segment in 2012.

Personal Lines Property Casualty Insurance Segment
Total net earned premiums for 2012: $868 million
Change compared to 2011: +14%

This segment includes homeowner insurance, auto insurance, and other insurance (marine, umbrella, etc). The company aims to insure customers that own both a house and a car. A loss of $43 million came from this segment in 2012.

Life Insurance Segment
Total net earned premiums for 2012: $178 million
Change compared to 2011: +8%

This segment provides a variety of life insurance products. A loss of $3 million came from this segment in 2012.

Excess and Surplus Lines Property Casualty Insurance Segment
Total net earned premiums for 2012: $93 million
Change compared to 2011: +33%

This segment includes commercial casualty and commercial property insurance for businesses that have unique risk profiles. A loss of $1 million came from this segment in 2012.

Investments Segment
CINF has a $12.466 billion portfolio which consists of 51.7% taxable fixed maturities, 26.0% tax-exempt fixed maturities, 21.4% common equities (including MLPs), and 0.9% preferred equities.

For the fixed maturities, about two-thirds of the portfolio is rated A or better, while the other third is rated BBB. A very small portion is rated below BBB.

The equity portfolio is sector-weighted similarly to, but not identical to, the S&P 500. There is a bit more emphasis on dividend stocks and MLPs.

$531 million in investment income was generated by the company in 2012, which is where the bulk of the profit comes from.

Ratios

Price to Earnings: 18.4
Price to Book: 1.4

Revenue

(Chart Source: DividendMonk.com)

Revenue grew at a rate of a little over 1% per year over this period, and the premium portion of that revenue grew by over 2% per year. This has been a common trend among property and casualty insurers, and CINF held up fairly well with regards to premium growth compared to its peers. The years of 2006-2010 included realized capital gains that were larger than normal years, especially 2006 and 2007. Those capital gains are the reason for the bulge in revenue for that period.

Earnings and Dividends

(Chart Source: DividendMonk.com)

EPS growth was negative over this period, but the core company performance isn’t as disastrous as the chart may imply. The high EPS figures in 2006 and 2007 were due to the aforementioned realized capital gains, and so the large reduction in earnings after those years are not due to actual profit deterioration. The 2008-2010 years also had substantial capital gains which were not present in 2011 and 2012. The year 2011 was particularly rough due to an increase in claims/benefits, and this improved for 2012.

Cincinnati Financial Corporation’s dividend has a streak of annual dividend growth that stretches back over 50 years. The company has, as far as I’m aware, the tenth longest streak of dividend growth out of any company in the United States. It also has one of the higher yields out of the 50+ dividend increase year group.

Unfortunately, while the average dividend growth over this seven year period is a respectable 4.2% (especially considering the 5+% yield the stock had for several years there), the dividend growth has slowed substantially starting in 2008. During the bottom of the recession in 2008-2009, the company held the dividend static for 6 straight quarters but raised it in time so that the calendar year 2009 dividend was higher than the 2008 dividend. Since then, the company has been increasing the dividend on schedule every 4 quarters, but only at a rate of around 1% per year.

Currently, the reasonable payout ratio over a business cycle leads to the dividend appearing fairly safe. Without more growth, the dividend income is not going to keep up with inflation.

Approximate historical dividend yield at beginning of each year:

 
During 2005-2008, the dividend yield was modest but the dividend growth rate was decent. During 2009-2012, the dividend growth slowed down to next to nothing, but the yield was decent at 5-6%. Now, in 2013 after this strong bull market, the yield has been pushed back down to modest levels at 3.41% while the dividend growth rate is still tiny.

Balance Sheet

CINF maintains a solid balance sheet. The company aims to maintain the debt-to-total-capital level at under 20% and they’re currently comfortably below that figure. The portfolio has more volatility than other insurers due to the equity exposure, but I consider this a positive thing and it is discussed below in the thesis.

Investment Thesis

The principle problem of an insurance company is that insurance is largely a commodity. Besides operating an all-round well-run business, the number of things that an insurance company can do to distinguish itself is small in number. That works the other way as well though; insurance companies don’t face problems from competitors that offer better technical products or have big brand mark-ups, which is the case in other industries.

That being said, there are a few things that CINF does focus on to make itself unique in certain ways.

1) Independent Agent Focus
The first thing is their focus on independent agencies, which is the core of their business model. CINF attempts to make it as worthwhile as possible for agents to recommend CINF insurance to their clients, even at the cost of reduced underwriting profitability. The strategy certainly pays off in terms of agency loyalty, according to the 2012 annual report. For agencies that have represented CINF for less than 1 year, only 1.2% of the insurance purchased through that agency is from CINF. But for agencies that have represented CINF for 2-5 years, this share jumps to 4.3%, and for agencies that have represented CINF for 6-10 years, it increases to 8.5%. Finally, the average for agencies that have represented CINF for more than 10 years give CINF an average of 17.7% share of the insurance that they write.

For agents that have represent CINF for 5+ years, CINF is generally the #1 or #2 insurer that they write premiums for in terms of volume. As can be seen in the overview section, some of CINF’s segments aren’t even profitable. That’s because premium growth is a focus for them, and making sure they offer diversified and competitive insurance products for agents is critical.

2) Equity Portfolio
Most insurance companies don’t have an equity portfolio, and instead invest entirely in fixed maturities. They do this because they money has to be conservatively invested. Historically, a stock/bond portfolio outperforms a bond portfolio, and this statement of comparable outperformance has been true over the long term for as long as the public market has existed. But, a stock/bond portfolio is more volatile.

Overall, CINF’s portfolio looks like what some financial advisers state that a retiree’s portfolio should look like, with a heavy emphasis on fixed maturities and a small segment of equities. For CINF at the end of 2012, equities made up less than 25% of the total portfolio but after the bull market should have risen a bit. Specifically, CINF’s equity portfolio looks much like what a typical dividend investor’s portfolio would look like, except on much larger scale. They hold stock in most of the well-known blue-chips, they have a bit of a slant towards dividend-paying companies, and they include preferred shares and MLPs in their portfolio.

This willingness to invest in stocks opens CINF up to some additional portfolio risk compared to its peers, but if managed decently is statistically expected to produce better returns.

Risks

Insurers have practically no moat. Some of the biggest and best may be able to have a narrow moat, but in general as mentioned in the investment thesis section, it’s mostly a commodity business and they compete on price.

CINF’s geographic area of focus is the Midwestern United States region including their home state of Ohio, and this region is among the most economically disadvantaged regions of the country. Their risks from this region include insurable catastrophes as well as general economic weakness.

Their portfolio will be more volatile than their peers. While I consider it a good move for them to invest a portion of their portfolio in equities, it does mean the portfolio is more volatile. Plus, there’s greater risk for financial mismanagement. Prior to the financial crisis, over 50% of the equity portion of the portfolio was in financial stocks, which proved to be an unwise allocation. Now the portfolio is more diversified and similar to the S&P 500, but this is an area that investors in the company should occasionally observe.

I’m a bit concerned about the management of the book value of the company over time. Between 2005 and 2012, the book value per share went from $34.84 to $33.45, which is a small reduction over a substantially long seven year period. In comparison, Chubb Corporation (CB), which actually had revenue reduction over this same period, doubled their book value from $31.03 to $60.46 per share. For a slow growth company, it’s important that every dollar maximizes shareholder value in as close to an optimal manner as possible. This management of shareholder money is why I featured Chubb as an example in the Dividend Toolkit, and CINF represents somewhat of a contrast to that ideal.

Conclusion and Valuation

Cincinnati Financial does have an impressive streak of over 50 years of consecutive dividend growth, and I believe their portfolio strategy of using equities is a strong move compared to their peers, but the desired ratio of dividend yield to dividend/earnings growth just doesn’t get over the hurdle.

Over the long term, earnings and dividend growth drive the share price. If the valuation is constant and dividends are reinvested, then the sum of dividend yield and earnings/dividend growth is the expected rate of return. With a yield of 3.41% and current dividend growth of 1.2% per year, we’re looking at numbers that should result in a rate of return of below 5% per year if that dividend growth rate keeps constant. Then if we remove the assumption that valuation is constant, the results may be worse, because after this bull market the P/E is over 18 and the Shiller P/E of the market is currently above average, so we may be primed for a mid-term reduction in valuation. Obviously, a value investor would prefer to purchase undervalued stocks.

With the Dividend Discount Model (DDM), a typical 9% discount rate (target rate of return) and a 2% dividend growth rate (which is higher than their 2009-2013 dividend growth rate) results in a fair value of only around $24, or half of the current market value.

Looking at it another way, a long-term dividend growth rate of at least 5.3% is required for the DDM to produce a fair value estimate assuming a 9% discount rate (target rate of return) that is equal to the current stock price of over $47. CINF would have to begin growing the dividend at a decent rate again in order to produce these favorable yield/growth characteristics.

Given the fact that the market and this stock have had a major run to a fairly high valuation, I’d want to see the company producing better dividend growth before investing in the company, rather than making expectations about a return to better dividend growth. I believe there are better stocks on the market currently, and CINF may be a stock to revisit in the future.

Full Disclosure: As of this writing, I have no position in CINF and am long CB.
You can see my dividend portfolio here.

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Three of the companies on the short list of companies that have 50+ years of dividend increases without a miss are engineering companies, and they’re included below. The other two on this list are in the 40+ year range.

3M Company (MMM)

3M, the largest company on this list in terms of revenue, is the business behind the well-known Scotch Tape brand, but the bulk of their 55,000+ products are marketed towards other businesses rather than consumers. This includes abrasives, adhesives, films for LCD screens, toll booth technology, and safety products. The dividend yield is a bit low at 2.39% but comes with the momentum of five decades of consecutive annual dividend growth.

This business is strong and I believe shareholders will do fine over the long run, but as I described in the latest 3M analysis, the sum of EPS growth and dividend yield is a bit on the lower side which can impact long-term returns.

Emerson Electric (EMR)

Emerson Electric is positioned behind the growing fields of data centers and telecommunications. The world is becoming increasingly connected with more telecommunications infrastructure and more bandwidth, and cloud computing means a larger emphasis on servers rather than client machines, and these industries have the need for reliable power and cooling systems, reliable physical infrastructure to hold and connect the parts, etc. Emerson provides these things, and also is a global player in the industrial automation market.

With one of the more generous payout ratios on this list, Emerson currently offers investors a yield of just shy of 3% with more than five decades of consecutive dividend growth. The full Emerson analysis is here, and personally I’d wait for a pullback allowing a 3+% yield before making a buy here.

Dover Corporation (DOV)

Dover unfortunately offers the lowest yield on this list at slightly under 2% (all of these yields have been pushed lower due to the 2013 year-to-date strong bull market), but also has the longest dividend streak on this list, and as far as I’m aware has the third-longest annual dividend growth streak out of any company in the world.

The five operating segments of the company are Energy, Refrigeration and Food Equipment, Communication Components, Product Identification, and Fluids. The full analysis from a few months ago is available here.

Leggett and Platt (LEG)

LEG is the smallest company on this list but has the largest dividend yield of 3.50% and four decades of dividend growth without fail. The payout ratio appears high at first glance, but as detailed in the full analysis report, the company generates much more free cash flow than reported net income, so they’re able to pay the dividend and then pay just as much towards share buybacks or acquisitions.

The company has had quite the transformation over the last decade as they have divested considerable portions of their business to focus on their strong areas of furniture components, steel wire, shelving, and specialized engineering, and refocused themselves towards the specific and admirable goal of offering total shareholder returns in the top third of the S&P 500. Their business segments are operated like a portfolio, and listed as “grow”, “core”, “fix”, and “divest” to determine how much capital they’re allocated.

Illinois Tool Works (ITW)

Illinois Tool Works now has a similar business model of LEG, where they manage their business units like a portfolio, are divesting non-core units rather than focusing purely on growth, and are focusing on balanced total shareholder returns (core organic growth, acquisitions, dividends, and buybacks). As described in the full ITW stock report, the company is well-known for its focus on the 80/20 rule, where they’d rather limit their number of products and customers to maximize profitability than grow customers and products simply for the sake of growth.

The yield is currently 2.49%, and unlike many other businesses, their stock valuation has not soared in 2013 so they might be a good candidate to look into for dividend investors. I consider their current price to be fairly valued.

Three Notes About Engineering Companies

1) They tend to do well with acquisitions. In general, acquisitions have a reputation for being great for the acquired company but an often expensive and overpriced mistake for the acquirer. It’s sometimes referred to as “Empire Building” when a business seeks to grow itself simply for the sake of growth rather than for maximizing shareholder returns. Engineering companies, on the other hand, tend to make smart and consistent acquisitions at good prices as part of their regular growth policy. Occasionally they do a bit of streamlining and divest non-core operations and return the cash to shareholders.

2) With the exception of LEG and to some extent EMR, engineering companies tend to keep dividend payout ratios a bit on the low side. This is because as a group, they’re slightly more volatile than consumer businesses. They primarily sell their products to other businesses, so their earnings tend to be a bit more erratic during periods of economic weakness.

3) The positive aspect of their volatility is that this is one of the better industries to write puts or sell covered calls with. In many cases, you can lower your cost basis or make an annual return in the range of 8-15% by writing long-term puts or selling calls on companies in this industry. These tools are particularly useful for value investors when stock valuations are a bit on the high side.

Full Disclosure: As of this writing, I am long EMR and LEG.
You can see my dividend portfolio here.

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