It is close of five year now that I have been a long term buy and hold, and dividend growth focused investor. When I meet friends, acquaintances, or colleagues, on many occasions the discussion starts from what’s market doing today and steers towards trading/investing is nothing but a poker game. I get a sense that many of these folks think that buying (and selling) stocks is just a gamble of some kind. Irrespective of this, I believe both, trading and investing, have their own set of pros and cons depending upon what context an individual is looking at it. In the end, both trading and investing is done to make money. Some use approach of capital appreciation, some use dividend income, some do trades to generate income. The key is to have a plan and execute it with consistent results.

When it comes to dividend investing, many individuals think of high yields (perhaps Cramerica syndrome!). It shows lack of patience and tendency to read too much into the business media. They do not understand dividend growth and sustainability.

There are two very significant aspects that investors need to understand about dividend growth investing and sustainability. These are (a) quality of dividends; and (b) potential for capital appreciation.

• Quality of dividends is related to how and from where the company is paying dividends. Good quality of dividends from companies that consistently generates cash from selling products or services, manages dividend with payout ratio, prudent uses capital for growth, and remains focused on its core competency. It is ideal to have everything in a company, but ideal situations and scenarios are either in short supply or not practical. Occasionally, companies will have issues and stumble, but those should be short lived. As long as quality of dividends are good, I believe the dividends are sustainable. These dividends add to the total return.
• Potential of capital appreciation is related to individual’s cost basis and future growth in value. Buying a stock at fair value builds-in a level of safety margin. Furthermore, I believe as the company grows and expands, it will grow its earnings and hence the dividends will grow. This growth in the company is bound to result in value over a period of time (and hence capital appreciation).

Thus, the key is to invest in companies which can grow its operating cash flow with consistency and can sustain it. A company that consistently generates cash is likely have to less downside risk. Even if they do get affected by market downturns, such companies experience less downward pressure. In addition, the continued dividends keep adding to the total returns. Examples of such companies are Proctor and Gamble (PG), Johnson and Johnson (JNJ), Becton, Dickinson and Company (BDX), T. Rowe Price Group (TROW), Sysco Corporation (SYS), Emerson Electric Company (EMR), Dover Corporation (DOV), and Jonn Wiley Sons (JW.A).

Dividend investing does not mean focus on high yield only. It is about consistency and sustainability which inherently focuses on total returns.

Chart 1 shows the overall operating earnings of the S&P index companies. It shows the operating earnings were negative in last quarter of 2008. Since then, the operating earnings are slowing coming back and increasing quarter over quarter.

Chart 1: S&P500 Operating Earnings Growth

Chart 2 shows the summary plot of percentage of companies beating the estimated earnings. This chart also shows improving trends. 80% of the companies beat estimated earnings.

Chart 2: S&P Companies Beating Estimates

Now these two charts will make you believe that company results are turning positive and hence the rise in markets are justified. We all like to see some greens in our portfolio.

No matter how much I like to see positives, I am still skeptical about the stability and continued growth. Beating own estimates does not mean company is doing good. All it means is estimates were wrong. Estimates were out of whack. Earnings need to be compared with company’s past record, and not to S&P’s estimates. So many times these analysts have been wrong. Sometimes I wonder what was the author trying to communicate.

Furthermore, we would tend to believe that growth in operating earnings shows companies earnings are growing. However, if we take a look at S&Ps data on actual operating earnings, the message seems to be different. A total of 478 companies have reported their third quarter earnings which represent 96.3% of the market. The observations are as follows

• 137 companies show positive revenue growth, while 341 companies have negative revenue growth. Basically, most of them have reduced their revenue.
• 227 companies have had positive growth in operating earnings, while 251 companies have had negative growth in operating earnings.

Let us take a look at two examples:

• Sysco Corporation: Its revenue has been either flat or little reduction during 2009. It has had reduced earnings, but flat to increasing free cash flow. Overall, most of this is coming from reduced cost of goods, reduced payroll expenses, and lower incentive compensation, and other accounts of cost reduction. There is no growth in revenue, means it is not selling more to earn more.
• Proctor and Gamble: Through 2009, it has seen continued reduction in its revenue. However, on account of reduced working capital, reduced manufacturing cost, reduced commodity cost, etc the earnings and free cash flow are improving.

In essence, revenue is decreasing but operating earnings are increasing. In short, while companies are not selling more, they are continuing to earn more on per share basis. Intriguing! In my view, these growth in operating earnings are nothing but cost reduction initiatives. Companies are reducing their expenses by reduced head count, weeding out in-efficiencies, etc. By citing SYS and PG, I am these are in trouble or bad shape. I am only attempting to show how the earnings are growing.

Every company should try to weed out in-efficiency and make cost reduction efforts. In my viewpoint, that is the hallmark of the good company that they are trying to adapt according to business environment. However, in the end there is only so much one can do with reducing operating expenses. These performances are temporary, and real growth should come from selling more product or services. Charts like these do not communicate the real underlying scenarios.

Sysco Corporation (SYS), through its subsidiaries, markets and distributes a range of food and related products primarily for food service industry. It distributes frozen foods, non-food items, restaurant equipment and cleaning supplies. It serves restaurants, hospitals and nursing homes, schools and colleges, and hotels and motels.

SYS is a member of Broad Dividend Achievers and has been raising dividends for last 38 years. The most recent dividend increase was in December 2008. It remains to be seen if it will increase dividends later this year. I had reviewed this stock in February 2008 which at that time was a medium risk to dividend. My objective here is to analyze if SYY still continues to be a good dividend growth stock.

Trend Analysis
This section measures the trends for past 10 years of corporation’s revenue and profitability. The parameters should show consistent growth trends. The image below shows the trend chart.

• Revenue: Increasing trend in revenue with average growth of 9.4% (3.4% standard deviation). Immediate past five years show reducing trend of growth rates from low teens to high single digits. This is sign of slow down in growth rates.
• Cash Flow: The cash flow is remaining flat in 2008 to 2009 with minor reduction. Free cash flow is almost equal to net income. The good aspect is that it continues to generate operating cash flow.
• EPS from continuing operation: In general, the EPS also has an increasing tread (with a blip in 2006 and 2009) with average growth rate as 13.2% (11.1%).
• Dividend per share: Dividends per share are consistently growing for the last 10 years.

Risk Parameter Calculation
Here I use the corporation’s financial health to assign a risk number for measuring risk-to-dividends. The risk number for risk-to-dividends is 2.00. This is a medium risk category as per my 3-point risk scale. An increasing payout factor, historically high yield, negative EPS growth makes SYY dividend as a medium risk.

Quality of Dividends
This section measures the dividend growth rate, duration of growth, consistency over a period of past ten years.

• Dividend growth rate: The average dividend growth (17.9%) is higher than average EPS (13.2%) growth rate. The flexibility in payout factor and share buybacks allowed this difference. However, on a longer term basis this is not sustainable.
• Duration of dividend growth: Dividends have continuously grown for the last 37 years.
• 4 year rolling dividend growth rate for past ten years: Close to 10% on 4 year rolling basis.
• Payout factor: Historically, it has been less than 50%. However, the trend is showing that payout factor has been increasing from low 30% to now more than 50%.
• Dividend cash flow vs. income from MMA: Here, I analyze how the dividend cash flow stacks up against the income from FDIC insured money market account. The baseline assumption is (a) stock is yielding 3.9%; and (b) MMA yield is 3.4%. Considering historical average growth rate of 18.9%, the stocks dividend cash flow at the end of 10 years is 4.0 times MMA income. If we assume my average expected growth rate of 6.4%, then the dividend cash flow is 1.5 times MMA income.

Fair Value Calculation
This section determines what price I should pay to buy a given stock

• Net present value (NPV) price based on 20 year DCF: $18.21
• Average high yield price calculated based on past 10 years: $40.1
• Pricing based on past 10 year relative price-to-earnings ratio. $41.5
• Pricing based on price-to-earnings ratio of 12: $19.0
• Graham number: $15.10

The range of fair value is calculated as $20.3 to $26.8.

Qualitative Analysis
The strength of SYY is its well established distribution network and existing leadership position. In context of ongoing economic environment, it has opportunity to grow due to its pricing ability and leveraging existing distribution network.

• This quantitative analysis shows that, so far, SYS has been able to maintain its historically consistent profitability. It appears that in last few years, the dividend growth is coming from the combination of payout factor and growth in EPS.
• The flexibility in payout factor, stable profitability, and slow EPS growth provides room for maintaining the consistency is dividend.
• The revenues are likely to be under pressure. It’s largest customer base is restaurant industry which is expected to have a slow down.
• Meanwhile, SYS continues to adapt with new initiatives around its core competency.

Conclusion
SYS is an enviable position with largest market share in its market segment. A hallmark of a good company like SYS is that it is always evolving to remain competitive. With negative growth in 2009, it remains to be seen whether management will raise its dividends. The flexibility in payout factor should allow the increase in dividends. The stocks risk-to-dividend number is 2.00 (medium risk category). The stock’s price is within my buy range. I would continue to hold on to my existing position, and wait for dividend increase decision.

Full Disclosure: Long on SYS

This article was originally published on The DIV-Net on September 24, 2009.