Fed Chair Powell’s Debut, Retail Earnings Roundup, and the Dividend Cushion!

The 10-year Treasury yield continues to outpace that of the average dividend yield of an S&P 500 stock, and portfolio managers continue to evaluate long-term allocations as a result. We evaluate the initial testimony from new Fed chairman Jay Powell, report on developments in the crude oil markets, and survey the retail landscape to offer incremental insight into the health of the consumer. The Dividend Cushion ratio continues to prove its worth.

By Kris Rosemann and Brian Nelson, CFA

The month of February was a wild ride for investors, and it wasn’t pleasant. The stock market experienced incredible swings, both to the upside and to the downside, like no other time in recent memory as the very real risk of rising interest rates (TLT, TBT) came to the fore. We maintain our view that rising interest rates may put a damper on the attractiveness of dividend paying stocks, but we also note that dividend paying stocks have a growth element to them, which may mitigate any direct impact from rising rates, even if they are still felt. It should be widely-known that the 10-year Treasury yield has now surpassed that of the average yield on an S&P 500 dividend paying stock, and portfolio managers continue to evaluate how such a tradeoff may impact long-term equity/fixed-income allocations.

New Fed Chairman Jay Powell made his initial Congressional testimony on the morning of February 27, largely staying in line with recent commentary from the Fed. He noted that the FOMC continues to believe further gradual increases in the federal funds rate best promote the realization of its two primary objectives, maximizing employment and stable prices. As the Fed works to return inflation to its target of 2% on a sustained basis, some recent headwinds to the US economy have transitioned to tailwinds, including more stimulating fiscal policy and a more firm trajectory of foreign demand for US exports. However, we’ll be watching to see if the US’ lofty debt levels and increased deficits continue to propel increased sovereign credit risk (and higher interest rates). As evidence that rate hikes are coming no matter what, Powell expressed little concern over the recent volatility in the financial markets, stating his belief that “financial conditions remain accommodative,” and such developments should not have a material impact on the US economic outlook, labor market, or inflation.

The International Energy Agency (IEA) continues to highlight the tremendous growth of US oil production (USO, OIL) in recent years as it suggests that the country could become the world’s top oil producer in 2018, but such a development will take place “definitely next year” if not in 2018. Top producer Russia currently pumps just under 11 million barrels per day, a rate the US Energy Information Administration (EIA) expects the US to achieve by late 2018. The IEA does not expect US oil production to hit a peak before 2020, and it continues to warn of the implications of such strong production growth on the effectiveness of OPEC-led production cap agreements taking place elsewhere around the globe. US oil exports to Asia have been impacting OPEC and Russian market share, and US net imports of crude oil, which has been an important market for OPEC in decades-past, fell to the lowest level since the EIA began tracking the measure in 2001. We include the Energy Sector SPDR (XLE) in the simulated Dividend Growth Newsletter portfolio.

Let’s move on to developments in the land of retail. Department stores received a boost after Macy’s (M) and Dillard’s (DDS) turned in solid fiscal fourth quarter earnings reports before the open February 27 as consumer spending in the US remains robust, another positive trend pointed out by the new Fed Chairman. Dillard’s reported 3% comparable store sales growth in the quarter on a year-over-year basis, and gross margin improved nearly 50 basis points from the year-ago period. However, cash flow from operations felt meaningful pressure in the full fiscal year, falling to ~$274 million from $517 million in fiscal 2016, and free cash experienced an even greater drop as capital spending grew to ~$131 million in the year from $105 million in the prior fiscal year.

Macy’s turned in slightly less impressive top-line growth as comparable sales on an owned-plus-licensed-basis grew 1.4% in its fiscal fourth quarter from the year-ago period, but the improving trajectory of its brick-and-mortar business was augmented by its 34th consecutive quarter of double digit growth in its digital business. Operating margin expanded tremendously in the quarter on a year-over-year basis, but the gain was largely due to book gains related to the sale of the Union Square Men’s building. Nevertheless, we were encouraged by management’s self-reported discipline with respect to its promotional cadence. Though the firm continues to evaluate its real estate portfolio for potentially value-creating asset sales, this is not a sustainable source of bottom-line growth over the long haul.

Macy’s free cash flow generation improved nicely in fiscal 2017, growing to ~$1.2 billion from less than $890 million in fiscal 2016 thanks in part to reduced capital spending, and we like management’s decision to use free cash flow and asset dispositions ($411 million in fiscal 2017) to repay more than $950 million in debt (cash dividends paid in the year came in just above $460 million). Looking ahead to fiscal 2018, management expects comparable sales both on an owned and owned-plus-licensed basis to be flat to up 1%, and adjusted earnings per diluted share (excluding anticipated settlement charges related to define benefit plans) guidance has been issued in a range of $3.55-$3.75, significantly higher than consensus estimates of $3.04. It is worth noting that this guidance includes projected asset sale gains of $300-$325 million in the fiscal year, down from $544 million in fiscal 2017.

Shares of off-price retailer TJX Cos (TJX) leapt following its fiscal 2018 fourth quarter report, period ended February 3, results released before the open February 28. The quarter was marked by 4% growth in consolidated comparable store sales on a year-over-year basis, and it capped off the 22nd consecutive year of consolidated comparable store sales growth of at least 2%. Fourth quarter adjusted diluted earnings per share advanced 16% over the year-ago period to $1.19, but operating cash flow faced pressure in the full fiscal year as a result of an increase in inventory and accounts receivable and other assets.

Nevertheless, TJX’s fiscal 2018 free cash flow of nearly $2 billion was more-than-sufficient in covering cash dividends paid in the year of $764 million. The company plans to raise its dividend by 25% in the second quarter of fiscal 2019, marking its 22nd consecutive year of an increase in the annual dividend, which will have grown at a 23% CAGR over those 22 years. Other expectations for fiscal 2019 include consolidate comparable store sales growth of 1%-2%, and adjusted diluted earnings per share of $4.00-$4.08; wage increases are expected to provide a ~2% drag on adjusted EPS growth.

Home improvement retailer Lowe’s (LOW) was punished by the market, however, following its fiscal fourth quarter report, period ended February 2, results released before the open February 28. Comparable store sales grew 4.1% in the quarter on a year-over-year basis, but margin contraction was enough to cause diluted earnings per common share to fall to $0.67 from $0.74 in comparable period of fiscal 2016. Gross margin was squeezed by nearly 70 basis points, and operating margin fell by almost a full percentage point. Management did not offer much commentary on the margin compression, but it did note the need for acceleration of strategic investments due to a rapidly evolving competitive landscape.

Lowe’s will be working to improve gross margin and inventory management in fiscal 2018, but the company expects operating margin to decline by roughly 30 basis points in the year along with expectations for comparable sales to grow ~3.5% and diluted earnings per share guidance of $5.40-$5.50. Free cash flow dipped to ~$3.9 billion in full year fiscal 2017 from $4.45 billion a year earlier, but it was still more than three times annual cash dividend payments in the year. We’d like to see a reduction in share repurchases, which came in at nearly $3.2 billion in fiscal 2017, given the company’s debt load–net debt rose to ~$16.3 billion at the end of fiscal 2017 from $15 billion a year earlier, fueled in part by share repurchases and dividend payments exceeding free cash flow–and the fact that shares are trading in the upper half of our fair value range even after the post-earnings drawback.

Discovery Communications (DISCA) turned in a solid fourth-quarter earnings report before the open February 27 as each of its segments reported double-digit revenue gains on a year-over-year basis. The company’s ‘International Networks’ segment was a source of relative strength in the quarter thanks to higher contractual rates in Europe and Latin America and higher volume and pricing in advertising across key European markets. Adjusted OIBDA grew 10% from the year ago period, and full-year free cash flow grew 16% to ~$1.5 billion. However, perhaps most importantly, the company received clearance from the US Department of Justice in its pending acquisition for Scripps Networks (SNI). Discovery still expects to close the deal before the end of the first quarter of 2018, but the deal has yet to be cleared by Irish regulators.

The power of the Dividend Cushion ratio continues to become increasingly evident, too. Frontier Communications (FTR), which had a Dividend Cushion ratio that was significantly negative, suspended its dividend February 27 as it targets an accelerated pace of deleveraging. The suspension of the payout is expected to make an additional $250 million available for deleveraging on an annual basis. Though not under coverage, the risk of the dividend cut at Macquarie Infrastructure (MIC) could have been assessed as considerable, in light of the entity’s massive net debt position and insufficient free cash flow generation relative to cash dividends paid. We believe access to the Dividend Cushion ratio alone is worth the price of a membership as it continues to warn investors of tremendous risks to the income stream.

Related: SDY