Dover (DOV, Financial) has increased its dividend for 60 consecutive years, trades at a dividend yield of 3% and has a relatively low payout ratio of 30%. The stock also trades for just 14x forward earnings guidance. Why is this high quality industrial business looking so cheap? Energy markets.
Dover generated over 30% of its earnings from its Energy segment in 2014, with most of its exposure coming from drilling and production operations in North America (one of the most vulnerable spaces in the energy sector right now).
Energy headwinds are starting to create a compelling valuation case to add Dover to our Top 20 Dividend Stocks portfolio, but they could persist for much longer than investors expect.
Let’s take a closer look at Dover’s business.
Business overview
Dover was incorporated in 1947 and is one of the largest diversified manufacturers in the world with over $7 billion in annual revenue. The company delivers a wide range of equipment and components, specialty systems and support services that are sold to thousands of customers across virtually every end market.
By geography, 60% of Dover’s 2014 revenue came from the U.S., 16% from Europe, 10% from Other Americas, 9% from Asia and 5% from the Rest of the World.
Segments
Energy (26% of 2014 revenue, 34% of earnings): products include artificial lifts, pumps, sensors and monitoring solutions for customers in the drilling and production markets. Dover helps customers extract oil and gas more efficiently and safely.
Engineered Systems (31% of revenue, 39% of earnings): Dover helps drive efficiencies for customers in printing, identification, vehicle service and waste-handling equipment. Products in this segment include automation components, printing systems, hydraulic components, electronic components, 3D printing tools and more.
Fluids (18% of revenue, 19% of earnings): products include strategically engineered specialized pumps, tubing, fueling, vehicle wash and dispensing systems. Dover’s components and equipment are used for fueling and vehicle wash and for transferring and dispensing critical materials in numerous end markets such as chemicals, food and pharmaceuticals.
Refrigeration & Food Equipment (25% of revenue, 18% of earnings): Dover’s products reduce customers’ total cost of ownership in refrigeration, electrical, heating and cooling systems and food and beverage packaging. Products include commercial refrigerator and glass doors, lighting systems, food processing and packaging solutions, cooking preparation equipment and more.
Business analysis
Dover’s business model shares many traits with Illinois Tool Works’ business model. Both of these companies built up their businesses through acquisitions over the course of many decades. They maintained decentralized organizational structures to stay nimble and entrepreneurial while implementing productivity measures across their businesses. For example, the Dover Excellence program is Dover’s continuous improvement initiative. This creates a culture filled with problem solvers and solution providers for customers, helping Dover maintain its strong market share positions and stay ahead on the innovation curve. It also helps the company generate substantial free cash flow and consistently improve its profitability.
Dover has also been able to build up a portfolio of mission-critical products that serve highly profitable market niches. The company has established a relationship for quality and excellent customer support, making it a top vendor that customers want to partner with to get their jobs done right.
Dover’s global operations also help it reliably serve multinational customers, thanks to its strong distribution network. For example, if an oil customer’s pump dies out, it needs a new one as soon as possible, or its project will lose money. Dover’s distribution network alleviates this risk.
Operating on a global basis, Dover’s scale helps it efficiently expand the breadth of its product offerings through innovation and acquisitions. From 2012 to 2014, Dover spent over $2.2 billion to acquire 24 businesses. The company’s acquisition targets enhance Dover’s existing businesses through their global reach and customers or by broadening their customer mix.
Finally, the management team has remained disciplined with capital allocation. The team is constantly trying to reduce Dover’s exposure to cyclical markets and focus on higher margin growth spaces. From 2012 through 2014, Dover sold two businesses for about $270 million and executed a spinoff of electronics component manufacturer Knowles. These efforts help Dover maintain a strong return on invested capital and avoid growing too far beyond its core strengths.
Key risks
While the company is diversified by product and end market, Dover is sensitive to the broader economy. The business currently faces challenging market conditions that caused it to lower 2015 guidance in December.
More specifically, Dover is being impacted by deterioration in oil- and gas-related end markets (34% of earnings), sluggishness in China and the strong U.S. dollar (international sales are 41% of total revenue). The company expects fiscal year 2016 organic sales growth will range from 0% to down 3%, driven by an 8% to 11% fall in its Energy segment.
With oil supply showing no signs of slowing down, your guess is as good as ours regarding when this headwind will abate. Dover appears to be exposed to one of the most challenging parts of the energy market (mostly North American, focused on drilling and production). Since this is the company’s most profitable business, it could take at least several quarters or even one to two years for the Energy segment to find a trough.
Part of the requirement to own Dover is to have a stomach for the inevitable cycles many of its end markets go through.
Other than unpredictable macro trends, there doesn’t seem to be much that threatens Dover’s long-term prospects. The company is well diversified by product, end market and customer. Most of its markets evolve at a very slow pace, and it’s hard to imagine many of the company’s products becoming obsolete.
If anything, Dover’s biggest risk is probably itself. The company likes to acquire other businesses, which adds some risk to its strategy. Furthermore, although Dover has become less decentralized over the years, additional acquisitions could cause the company to reach a point where it needs to reorganize its segments or risk them becoming inefficient.
Overall, Dover has proven to be an extremely well-managed company. Macro trends in the energy market are the biggest challenge facing the business over the next few years, and the bottom could still be further away than many investors expect.
Dividend analysis
We analyze 25-plus years of dividend data and 10-plus years of fundamental data to understand the safety and growth prospects of a dividend.
Dividend Safety Score
Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends and more. Scores of 50 are average, 75 or higher is good, and 25 or lower is considered weak.
Dover’s dividend is extremely safe with an excellent dividend Safety Score of 87.
Over the last four quarters, Dover’s dividend has consumed 30% of its earnings and 28% of its free cash flow. As seen below, the company’s payout ratios have remained fairly steady at about 30% over the last decade, which means that Dover’s dividend grew along with its earnings.
Source: Simply Safe Dividends
Source: Simply Safe Dividends
You might have noticed above that Dover’s payout ratios spiked up during the last recession in 2009. This means that the company’s earnings dropped significantly compared to the dividend and is a sign that the company’s business is cyclical.
Looking at Dover’s historical sales growth, we can see that this is true. The company’s sales fell by 29% in 2009, and its reported earnings fell by nearly 40%. Many of Dover’s industrial customers pulled back on their spending, so it’s especially important that the company maintain a conservative payout ratio. Even if earnings fell by 50% today, the company’s payout ratio would likely remain below 70%.
Source: Simply Safe Dividends
Looking at Dover’s return on invested capital metric over the last decade, we can see that the company earned a double-digit return most years.
Source: Simply Safe Dividends
Dover’s business generates consistent free cash flow and targets a 10% free cash flow margin as part of its strategy. Such predictable cash flows allow Dover to comfortably pay a growing dividend while continuing to be opportunistic with acquisitions and share repurchases.
Source: Simply Safe Dividends
Since Dover is cyclical, it’s especially important to be aware of its balance sheet. Cyclical companies with high debt loads could run into periods of unexpectedly weak demand. If their cash flow dries up and capital markets are inaccessible, they might have to make tough decisions – such as cutting the dividend to keep funding their operations or repay some of their debt as it matures.
Dover’s balance sheet looks pretty healthy. As seen below, its net debt / EBIT ratio is 1.6. This means that the company could retire all of its debt with cash on hand and 1.6 years of earnings before interest and taxes (EBIT) – pretty reasonable. Dover also has an “A” credit rating from S&P and Fitch.
Source: Simply Safe Dividends
While Dover’s business is sensitive to the economy, its dividend payment is safe. The company has conservative payout ratios, generates excellent free cash flow and maintains a healthy balance sheet.
Dividend Growth Score
Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is good, and 25 or lower is considered weak.
Dover’s dividend growth potential is somewhat above average with a dividend Growth Score of 62. Dover increased its dividend by 5% in 2015 for its 60th consecutive dividend raise. Dover has one of the three longest records of consecutive annual dividend increases of all listed companies, a remarkable accomplishment.
Not surprisingly, the company is a member of the S&P Dividend Aristocrats Index and the exclusive list of dividend kings, companies that have raised their dividend for at least 50 straight years.
Over the last five fiscal years, Dover has increased its dividend at a 9% annualized rate. While depressed energy markets could keep dividend growth in the mid-single digits over the next one to two years, we expect the company’s long-term dividend growth to be between 6% and 9%.
Valuation
Dover trades at about 14x its forward earnings guidance and has a dividend yield of 3%, which is significantly higher than its five-year average dividend yield of 1.9%. The stock looks cheap because investors are very concerned with the company’s high exposure to energy markets, which could cause earnings to fall even further in 2016 and 2017.
With 34% of segment earnings exposed to energy, it’s hard to say what impact depressed U.S. energy markets could have on Dover’s long-term earnings growth rate. If oil never recovers beyond $60 per barrel, some of Dover’s business might never come back.
However, Dover’s other markets are all growing at around the rate of global GDP, and the company has the financial capacity to take on acquisitions. We would be surprised if Dover doesn’t find a way to grow earnings by at least 5% to 8% over the long term. When combined with the stock’s current dividend yield, Dover appears to offer total return potential of 8% to 11% per year. If the stock’s multiple ever improves, that would offer further upside as well.
For dividend growth investors willing to wait out energy market weakness, Dover is certainly interesting from quality and value perspectives. However, be aware that current market conditions could persist for quite some time and potentially shave off a few percentage points from Dover’s long-term earnings growth rate.
Conclusion
Dover is certainly a blue-chip dividend stock. However, it is a cyclical business that will experience its fair share of ups and downs. Energy market headwinds seem likely to continue pressuring Dover’s earnings growth for at least the next year, but they also seem to be creating an opportunity for patient dividend growth investors. Either way, Dover’s dividend is extremely safe and still appears to offer above-average growth potential going forward.
Disclosure:Ă‚ The author has no position in Dover.
