Note from Daily Trade Alert: As long-time readers are aware, Dave Van Knapp is a highly-respected authority in the dividend growth investing (DGI) space. He wrote our Dividend Growth Investing Lessons. Since 2008 Dave has maintained and made public a real-money Dividend Growth Portfolio. It demonstrates the results available from a sound dividend growth strategy. In the following article Dave reveals another stock featured in his special eBook, Top 40 Dividend Growth Stocks for 2014.
This is the third in a series of four articles about stocks in the new edition of my eBook, Top 40 Dividend Growth Stocks for 2014.
In the first two articles, I described a couple of iconic stocks that have made it into the Top 40 all seven years that I have been writing the eBook. These stocks are Coca-Cola (KO) (click here for the article) and Procter and Gamble (PG) (click here for the article).
Now I want to continue the series by turning to two stocks that are less well known, but which in my opinion are also very good dividend growth stocks.
The first is Sunoco Logistics Partners (SXL). Even though SXL is a much smaller company than the first two, it also has been in my Top 40 all seven years that I have published my eBook. My wife and I have owned SXL in our retirement portfolio since 2011.
SXL is a Master Limited Partnership (MLP), which makes it a little different from many stocks that investors would normally think of as dividend growth stocks. But it fulfills all of the requirements:
- It has a decent yield (currently 2.9%)
- It grows its dividend every year (its streak is 13 years)
- It has one of the best business models known to mankind – the tollbooth model
- It has sustainable competitive advantages
- It is well run
Let’s go through these elements one at a time. For each factor, I will draw comparisons between Sunoco Logistics and the two previous companies, Coca-Cola and Procter & Gamble.
Yield
As you can see, SXL’s dividend yield is 2.9%, making it comparable to KO’s and PG’s yields, which are just above it at 3.0% and 3.1% respectively.
[ad#Google Adsense 336×280-IA]Obviously, SXL’s yield has been declining for the past 5 years.
Why is that?
It is not because the company has been cutting ist dividend.
Indeed, SXL has increased its dividend for 13 consecutive years, most recently in February of this year.
The answer is its price: Sunoco Logistics’ price has climbed steeply in the past several years.
Since yield and price are inversely related, SXL’s price increase has caused its current yield to decline even as the company has been relentlessly increasing its dividend.
The dividend increases and price increases are vividly shown on this graph.
With dividend growth stocks, it is common to see price and dividends (in dollars-and-cents, not in percentage yield) grow at roughly the same rate.
That has not been SXL’s story. Its price has climbed much faster than its dividend. On the chart, the dividend has aproximately doubled in five years, but the price is almost 5 times higher. That’s why the yield has declined even as the dividend has been increasing rapidly.
Dividend Growth
Well, we mostly just covered SXL’s dividend growth, didn’t we? But I want to show you a chart that compares SXL to Coke and P&G on dividend growth.
As you can see, both KO and PG increase their dividends once per year. Their dividend rates look like staircases. They increase their dividend, pay the new rate 4 times (quarterly for one complete year), then raise it again the following year and pay 4 times at that new rate.
Sunoco Logistics, for at least the past 5 years, has increased its dividend every quarter. It also pays 4 times per year, but every payment is more than the last payment. That’s why the blue line in the chart above has no level sections and does not look like a staircase either. Every point plotted is higher than the one before it, which smooths the line out.
Business Model
Like most MLPs, Sunoco Logistics is a pipeline company. It was formed in 2002 as a spinoff from Sunoco, the oil giant, primarily to connect Sunoco’s refineries to its retail distribution system. In 2012, it became a unit of Energy Transfer Partners (ETP).
SXL’s pipeline system includes a diverse mix of crude oil and refined products pipelines, terminalling and storage facilities, and crude oil acquisition and marketing facilities. Its assets include 7500 miles of crude oil and refined product pipelines, primarily in Oklahoma and Texas, but also stretching up into the Northeast. It owns about 200 crude oil trucks, 120 truck unloading facilities, and 41 refined products terminals with 42 million barrels of storage capacity.
On this map, red lines represent SXL’s crude oil pipelines, while blue lines are refined product pipelines.
I stated earlier that SXL has a great business model, namely the tollbooth model. To be more specific, the company’s revenues come from tariffs for transporting refined products and crude oil through pipelines; fees for storing refined products, crude oil, and other hydrocarbons in terminals; and purchasing domestic crude oil and selling it to Sunoco and other customers.
In other words, SXL runs a toll “highway” system – its pipelines. Other companies pay SXL tolls to move products through those pipelines. SXL’s first-class pipeline and storage assets constitute a cash flow machine,
There seems to be plenty of growth available to SXL, especially in light of the resurgence of U.S. oil and gas production. Crude oil and natural gas liquids production in shale plays provide the company with opportunities to extend its pipeline network and collect more attractive fee-based cash flows. The company is actively building out new pipeline capacity.
SXL does have a crude oil acquisition and marketing business that follows a diffferent business model and is low-margin. However, the company has indicated that it does not rely on marketing cash flows for determining distribution policy.
Here is a direct link to SXL’s website: Click here.
Sustainable Competitive Advantages
The building of pipelines is regulated. Thus, the existing pipelines of any company are in effect protected from ordinary competition by those regulations.
In addition, the tolls SXL charges are not dependent on the prices of the products moving through its pipelines. We all know that oil prices rise and fall, and often the profits of energy companies are dependent on the price of oil. But it does not matter to SXL whether the products moving through its pipelines are costly or cheap. They still charge the same tariffs and fees based on volume.
That is not to say that profits are guaranteed. In a recession, demand for gas and oil drops. That means that a company like SXL may suffer a decline in its own business, as there may be less demand for moving oil and refined products around.
Well Run Business
This is Sunoco Logistics’ strategy as stated on its website:
Our goal is to generate growing cash flows, increase distributions and provide attractive returns to investors. Strategies for growth include increasing pipeline and terminal throughput, utilizing our crude oil distribution and marketing expertise to address regional crude oil supply and demand imbalances, and pursuing organic growth opportunities as well as strategic acquisitions that are synergistic with existing assets. Strong cash flows have allowed us to consistently increase our distributions.
In my scoring of SXL’s “Story,” I gave it 11 points, the same score that I gave Procter & Gamble. Its overall score for Company Quality was 70, which ranked it second in the Top 40. (Coca-Cola scored an overall 66, while Procter & Gamble scored 57.)
Comparison on Important Metrics
Now that we have looked at 3 good dividend growth companies, let’s compare them on several metrics that are important to dividend growth investors.
Here is how SXL’s dividend record looks on the Dividend Champions document:
Valuation
As I explained in the other two articles, valuation is an important step in deciding whether to purchase a company. I use two sources for valuation – Morningstar and FASTGraphs. Let’s look at them.
Morningstar thinks Sunoco Logistics Partners is overvalued right now.
The two stars on a five-star system indicate that SXL is trading higher than Morningstar thinks that it is worth.
At first glance, FASTGraphs appears to indicate the opposite:
The black line beneath the orange “fair value” line would, at a glance, suggest that SXL is undervalued right now. But as with Coke and Procter & Gamble, we should check SXL’s normal valuation ratio. That shows as the blue line in this graph.
As you can see, the blue line shows us that SXL is “always” undervalued. The blue line is constantly beneath the orange line.
We see this “always undervalued” situation frequently with companies in the energy industry. I’m not sure exactly why that is, but I think it is related to the fact that the price of oil changes so much. I think that leads investors to believe that the earnings power of many energy companies is unreliable. Therefore they are less willing to pay as much for those companies. You may recall that we saw the exact opposite with Coca-Cola and P&G, which seem to be always overvalued.
Here is my interpretation: SXL, right now, would not be a “buy” for me. Averaging out the valuation factors, and observing that its price line has moved above its blue normal valuation line, it is hard to avoid the conclusion that SXL is overvalued at the moment. That is not surprising, given its strong price run-up over the past few years. I would wait for its price to drop before buying shares,
That would have at least two benefits. (1) It would make it more likely that future price moves are up instead of down. (2) It would provide a higher yield for SXL, because price and yield are inversely related. For example, if SXL’s price were to drop 10%, from about $90 to about $81, its yield would improve by 10%, from 2.9% to 3.2%. That would still be historically low for the company, but it would be more attractive than the 2.9% available now. A 15% price decline would be even better.
It may strike you as odd that an investor might be rooting for a price decrease in a stock. Doesn’t everyone want stock prices to go higher? Well, lower prices are the springboard for successful value investing. Warren Buffett did not become rich by over-paying for assets. Maybe we’ll kick that subject around in a future Lesson.
It may also strike you as odd that I covered a top-notch stock that I would not suggest that you buy at this time. That’s part of investing sometimes: waiting. This would be a stock for your watch list.
Postcripts
Funds From Operations
In using FASTGraphs, I departed from the usual method of drawing the valuation line. I used an option called FFO, which stands for Funds from Operations. (You can see in the graphs that the data points along the orange lines are marked by little circles rather than the familiar triangles.) I made the selection off to the left side of the graph, like this:
The reason is that with MLPs (and Real Estate Investment Trusts), FFO gives a more accurate reading of the company’s valuation. Without going into detail, it revolves around the high capital investments that MLPs and REITs make. Those continual capital investments, which are depreciated over many years after each investment is made, distorts their regular earnings. FFO is a better metric to look at.
Taxation
When you buy shares in a limited partnership such as SXL, you become a limited partner in the enterprise. Among other things, this means that taxation of distributions is different from that of C Corps (that is, “regular” corporations). The distributions technically are not even called dividends.
Distributions from MLPs are not “qualified” under the Internal Revenue Code for special tax treatment. The company sends you a special form, known as a K-1. The distributions technically are not dividends taken from earnings, but rather they are return of capital. You are getting your own money back.
That means it is not taxable at all (because it is not income), until you have received back the entire amount originally invested, which will take years. After that, distributions are treated as ordinary income and taxed at your ordinary rate.
If you sell your shares, your cost basis is considered to have been lowered by the distributions you received. That means that you will have more capital gain to pay taxes on.
Some investors do not like the complications of K-1’s and the different tax treatment of distributions. Personally, I consider MLPs to be just a different species of dividend growth stocks. We have an accountant that does our taxes, and she handles the K-1’s each year without problem or comment. I have read that people who use programs like Turbo-Tax to do their own taxes have no problems with them either; it’s just a matter of following the steps.
That said, some investors avoid MLPs entirely based on this issue. It’s a personal decision. Here is a little table that summarizes some of what we just discussed.
I am not a tax expert, so please consider this simply an overview for general understanding. Consult your own tax adviser for detailed information.
Portfolio Management
We saw that SXL is probably overvalued right now, and its yield is depressed when compared to historical levels. It is also lower than what is available right now from other MLPs.
For some investors, that would actually raise a question of whether they should sell it.
Obviously, ignoring taxes, my wife and I could sell a portion of our SXL right now and immediately turn around and invest that money in Coca-Cola or Procter & Gamble.
Since the latter two stocks are paying higher yields at the moment, that maneuver would immediately increase our overall dividend stream by a few bucks.
We won’t do that, but it brings up the whole topic of why or when you should think about selling a dividend growth stock. That is probably a subject that should be covered in a future Lesson or two. Stay tuned.
Dave Van Knapp
Author of Top 40 Dividend Growth Stocks
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