Squeezing Dividends out of the Tube

11/01/2010 12:00 pm EST

Focus: STOCKS

Josh Peters

Editor, Morningstar DividendInvestor

Josh Peters, editor of Morningstar DividendInvestor, and analyst Lauren DeSanto like consumer products giant Colgate-Palmolive, which has been paying dividends for more than a century.

Colgate-Palmolive (NYSE: CL) has long been one of the most focused consumer product companies on the planet, dominating the oral-care category with a worldwide toothpaste market share of almost 45%.

Colgate has a long record of operating in markets around the world and has deftly navigated crises from currency devaluations to cost inflation. Consumers worldwide want safe, trusted, effective products when it comes to oral care, so the firm has been able to build brand loyalty while keeping private-label threats at bay.

The firm’s expertise extends beyond toothpaste. Its core Colgate Business Planning tool gives management the ability to measure the impact of promotional investments on volume and profits and reallocate spending to better effect. As Colgate grows and tests new markets and promotions, the data and capability of this tool will only improve.

Product innovation at Colgate is more likely to take the form of incremental improvements rather than blockbuster new-product introductions. With competitors like Procter & Gamble (NYSE: PG) stepping up their competitive activity, Colgate may struggle to defend its market share, particularly if its product line up fails to hold consumers’ attention. Local brands could prove to be more of a threat in overseas markets as the firm grapples with wide foreign-currency swings.

And with such a narrowly focused product assortment, at some point Colgate could see diminishing returns as it reaches a ceiling on its market share potential. Over the longer term, Colgate’s deep knowledge of its categories and experience in its markets will serve it well, but the near term may be quite choppy.

A Morningstar credit rating of AA reflects very strong financial health. Net debt of $2.8 billion at June 30th represented less than one year’s worth of operating cash flow. Colgate’s dividend—continuously paid for 115 years now—is running at about 44% of earnings. Given a well-demonstrated stability in profits and cash flow, we see no threats to the current payout.

Colgate has a long history of putting up low-double-digit annual increases in its dividend; an unusually generous 20.5% hike was announced earlier this year. Though we don’t believe such impressive results can go on indefinitely, we still see the potential for 7%–9% yearly advances.

Colgate’s ability to generate cash is a key advantage: Over the past ten years, more than 90% of earnings were converted into free cash flow (even after acquisition spending), but the business certainly didn’t suffer from a lack of investment.

If purchased at our $77 Dividend Buy price, Colgate would provide a current yield of 2.75% while offering a long-run total return profile of 10%–12% a year. An impressive business, to be sure—but I would feel more comfortable considering the stock with a yield in excess of 3% (implying a price below $70). (The stock closed at around $77 Friday—Editor.)

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