Friday’s market drop has left us with a handful of financially strong, strategically competitive, undervalued stocks with nice dividend yields. I decided to screen my list of approximately 150 stocks identified to have a durable competitive advantage that are also in solid financial health for the highest and safest dividends. Highly levered companies and companies with inefficient inventory and cash conversion metrics have been excluded.
The stocks were subsequently filtered by:
· Five-year ROE greater than 18%
· Based on a 3-stage DCF model for intrinsic value calculation, a margin of safety of 30% was required
· Debt/equity ratio less than one
The output was as follows:
Transocean Ltd (RIG, Financial), Nucor Corp. (NUE, Financial), Paychex Inc. (PAYX, Financial), Exelon Corp. (EXC, Financial), Merck & Co. Inc. (MRK, Financial) and BHP Billiton Plc ADR (BBL, Financial).
The list includes six companies with a five-year average ROE in the range of 18.9%-35.5%, indicative of a durable competitive advantage. Note that Paychex (PAYX) has produced the highest five-year ROE on this list, likely due to its durable competitive advantage from charging high-switching costs for its services. I happen to think Paychex’s 4.7% dividend is safe but will not be writing about them today. Forward P/Es range from approximately 7.8-16.1, indicative of cheap valuation.
Let’s look a bit closer at these three companies to get a sense of whether these juicy dividends are safe and sustainable.
Transocean (RIG) Dividend Yield 6.6%
Transocean owns (or co-owns) and operates 136 mobile offshore drilling units, including 48 High-Specification rigs (Ultra-Deepwater, Deepwater and Harsh Environment), 25 Midwater Floaters, 9 High-Specification Jackups, and 51 Standard Jackups. Four High-Specification Jackups are also under construction. The NY Times estimated that the company owned almost half of all deepwater platforms in the world in 2010. Therein lies one of Transocean’s strengths: Its size and market share mean that whenever someone contracts a deepwater rig, there is about 50% chance that it will be from Transocean.
Size isn’t Transocean’s only competitive advantage. The company has a history of being “the first” in the offshore drilling business: it was the first to deploy jackup drilling rigs more than 50 years ago (these have legs that allow a rig to stand on the ocean floor); the first to drill year-round in the North Sea; the first to be able to drill under 10,000 feet of water (when the standard was 3,000 feet); and it was the first to announce being able to conduct two drilling operations from the same ship simultaneously. In September 2009, Transocean’s Deepwater Horizon rig set a record for the deepest offshore well at 35,050 feet. These achievements demonstrate Transocean’s innovation and technological leadership, which is extremely important, because as known oil and gas reserves run dry, exploration is going to move into increasingly hazardous environments with extreme conditions, with deep waters being the main target. Transocean is likely to be the prime candidate for providing equipment for such projects.
The explosion on Transocean’s Deepwater Horizon rig (also known as the Macondo incident) that left 11 people dead and caused a huge oil spill in the Gulf of Mexico in 2010 remains a risk to the company, but I believe that the market has overshot on this one to the downside. With a $23.6 billion business backlog, liability coverage, modest leverage, and debt comfortably spread out in relatively small portions across the next 27 years (the largest annual amount is $3.3 million due in 2037), I believe that this dividend is safe.
Nucor Corp. (NUE) Dividend Yield 4.6%
I wrote about Nucor in this month’s value contest here.
Nucor has a healthy balance sheet, with $2.3 billion in cash and short-term investments. It has $4.3 billion debt, most of which is long term with maturities in 2017 and beyond. Nucor’s has strong cash generation ability and the company has had to issue debt or stock only a few times in the past ten years, when investing needs could not be met with internal reserves. Nucor reports that it has been paying increasing dividends since 1973. Robust balance sheet and strong cash generation ability mean that the company should be able to continue paying dividends, as well as implement investments and seize acquisition opportunities without overstretching the balance sheet.
Merck & Co (MRK) Inc. Dividend Yield 4.6%
Recently launched first-in-class compounds Januvia for diabetes, Isentress for HIV, and the Gardasil vaccine against human papillomavirus are performing well and have a patent life ranging from 5-10 years. These products brought in revenues of $4.46 billion in 2010. Isentress achieved blockbuster status in 2010 with sales coming in at $1,090 million, up 44.9%. Victrelis (bocepravir) for hepatitis C, received unanimous support for approval by an advisory panel of the FDA in April 2011, was approved in May and will compete with Vertex’s compound telapravir in a Hepatitis C market that is expected to grow from ~$2 billion in 2008 to $7.7 billion in 2013. With the company's deep Phase III pipeline, the SGP acquisition provides strong replenishments to the current product line and will fill the gaps caused by upcoming patent expirations. In total, Merck reports 19 drugs in phase III development. The animal health and consumer care segments provide diversification of revenues streams and contributed approximately 10% to Merck’s 2010 sales and net profits. Merck’s Intervet/Schering-Plough reported sales of $2.9 billion in 2010 and, led by strong performance by key brands Dr. Scholl’s and Coppertone, the consumer health segment contributed $1.3 billion.
The company is on track to deliver on their stated a goal of $3.5 billion in annual cost savings by 2011 stemming from the acquisition. The company expects to reduce its workforce by 17% under the restructuring program. Operating costs fell more than 400 basis points from the prior-year period and, notably, improved margins come despite increased costs due to U.S. health-care reform. Merck is in a strong financial position despite $8.5 billion in debt needed for the Schering acquisition. Even with the acquisition, the current reported debt to equity ratio of 0.29 is in line with Merck’s historical average.
Operating cash flows of $11.2 billion in the latest quarter represent a 35% increase over the annualized averages over the last decade. A current ratio of 1.98 and a quick ratio of 1.34 are indicative of Merck’s liquidity. We expect the combined company will generate free cash flow of approximately $12 billion in 2011. Merck's current liquidity coupled with strong and stable cash flows should whittle away the debt relatively quickly and I believe that the dividend is quite safe.
These stocks are worth a look from income and value-oriented investors.
Disclosures: Long MRK, PAYX, and RIG
The stocks were subsequently filtered by:
· Five-year ROE greater than 18%
· Based on a 3-stage DCF model for intrinsic value calculation, a margin of safety of 30% was required
· Debt/equity ratio less than one
The output was as follows:
Transocean Ltd (RIG, Financial), Nucor Corp. (NUE, Financial), Paychex Inc. (PAYX, Financial), Exelon Corp. (EXC, Financial), Merck & Co. Inc. (MRK, Financial) and BHP Billiton Plc ADR (BBL, Financial).
The list includes six companies with a five-year average ROE in the range of 18.9%-35.5%, indicative of a durable competitive advantage. Note that Paychex (PAYX) has produced the highest five-year ROE on this list, likely due to its durable competitive advantage from charging high-switching costs for its services. I happen to think Paychex’s 4.7% dividend is safe but will not be writing about them today. Forward P/Es range from approximately 7.8-16.1, indicative of cheap valuation.
Let’s look a bit closer at these three companies to get a sense of whether these juicy dividends are safe and sustainable.
Transocean (RIG) Dividend Yield 6.6%
Transocean owns (or co-owns) and operates 136 mobile offshore drilling units, including 48 High-Specification rigs (Ultra-Deepwater, Deepwater and Harsh Environment), 25 Midwater Floaters, 9 High-Specification Jackups, and 51 Standard Jackups. Four High-Specification Jackups are also under construction. The NY Times estimated that the company owned almost half of all deepwater platforms in the world in 2010. Therein lies one of Transocean’s strengths: Its size and market share mean that whenever someone contracts a deepwater rig, there is about 50% chance that it will be from Transocean.
Size isn’t Transocean’s only competitive advantage. The company has a history of being “the first” in the offshore drilling business: it was the first to deploy jackup drilling rigs more than 50 years ago (these have legs that allow a rig to stand on the ocean floor); the first to drill year-round in the North Sea; the first to be able to drill under 10,000 feet of water (when the standard was 3,000 feet); and it was the first to announce being able to conduct two drilling operations from the same ship simultaneously. In September 2009, Transocean’s Deepwater Horizon rig set a record for the deepest offshore well at 35,050 feet. These achievements demonstrate Transocean’s innovation and technological leadership, which is extremely important, because as known oil and gas reserves run dry, exploration is going to move into increasingly hazardous environments with extreme conditions, with deep waters being the main target. Transocean is likely to be the prime candidate for providing equipment for such projects.
The explosion on Transocean’s Deepwater Horizon rig (also known as the Macondo incident) that left 11 people dead and caused a huge oil spill in the Gulf of Mexico in 2010 remains a risk to the company, but I believe that the market has overshot on this one to the downside. With a $23.6 billion business backlog, liability coverage, modest leverage, and debt comfortably spread out in relatively small portions across the next 27 years (the largest annual amount is $3.3 million due in 2037), I believe that this dividend is safe.
Nucor Corp. (NUE) Dividend Yield 4.6%
I wrote about Nucor in this month’s value contest here.
Nucor has a healthy balance sheet, with $2.3 billion in cash and short-term investments. It has $4.3 billion debt, most of which is long term with maturities in 2017 and beyond. Nucor’s has strong cash generation ability and the company has had to issue debt or stock only a few times in the past ten years, when investing needs could not be met with internal reserves. Nucor reports that it has been paying increasing dividends since 1973. Robust balance sheet and strong cash generation ability mean that the company should be able to continue paying dividends, as well as implement investments and seize acquisition opportunities without overstretching the balance sheet.
Merck & Co (MRK) Inc. Dividend Yield 4.6%
Recently launched first-in-class compounds Januvia for diabetes, Isentress for HIV, and the Gardasil vaccine against human papillomavirus are performing well and have a patent life ranging from 5-10 years. These products brought in revenues of $4.46 billion in 2010. Isentress achieved blockbuster status in 2010 with sales coming in at $1,090 million, up 44.9%. Victrelis (bocepravir) for hepatitis C, received unanimous support for approval by an advisory panel of the FDA in April 2011, was approved in May and will compete with Vertex’s compound telapravir in a Hepatitis C market that is expected to grow from ~$2 billion in 2008 to $7.7 billion in 2013. With the company's deep Phase III pipeline, the SGP acquisition provides strong replenishments to the current product line and will fill the gaps caused by upcoming patent expirations. In total, Merck reports 19 drugs in phase III development. The animal health and consumer care segments provide diversification of revenues streams and contributed approximately 10% to Merck’s 2010 sales and net profits. Merck’s Intervet/Schering-Plough reported sales of $2.9 billion in 2010 and, led by strong performance by key brands Dr. Scholl’s and Coppertone, the consumer health segment contributed $1.3 billion.
The company is on track to deliver on their stated a goal of $3.5 billion in annual cost savings by 2011 stemming from the acquisition. The company expects to reduce its workforce by 17% under the restructuring program. Operating costs fell more than 400 basis points from the prior-year period and, notably, improved margins come despite increased costs due to U.S. health-care reform. Merck is in a strong financial position despite $8.5 billion in debt needed for the Schering acquisition. Even with the acquisition, the current reported debt to equity ratio of 0.29 is in line with Merck’s historical average.
Operating cash flows of $11.2 billion in the latest quarter represent a 35% increase over the annualized averages over the last decade. A current ratio of 1.98 and a quick ratio of 1.34 are indicative of Merck’s liquidity. We expect the combined company will generate free cash flow of approximately $12 billion in 2011. Merck's current liquidity coupled with strong and stable cash flows should whittle away the debt relatively quickly and I believe that the dividend is quite safe.
These stocks are worth a look from income and value-oriented investors.
Disclosures: Long MRK, PAYX, and RIG
