Recap from June’s Picks
On a price return basis, the Dividend Growth Stocks Model Portfolio (+5.1%) outperformed the S&P 500 (+4.0%) by 1.1% from June 29, 2023 through July 25, 2023. On a total return basis, the Model Portfolio (+5.2%) outperformed the S&P 500 (+4.0%) by 1.2% over the same time. The best performing stock was up 21%. Overall, 16 out of 28 Dividend Growth stocks outperformed their respective benchmarks (S&P 500 and Russell 2000) from June 29, 2023 through July 25, 2023.
The methodology for this model portfolio mimics an “All Cap Blend” style with a focus on dividend growth. Selected stocks earn an attractive or very attractive rating, generate positive free cash flow (FCF) and economic earnings, offer a current dividend yield >1%, and have a 5+ year track record of consecutive dividend growth. This model portfolio is designed for investors who are more focused on long-term capital appreciation than current income, but still appreciate the power of dividends, especially growing dividends.
Featured Stock for July: Williams-Sonoma Inc.
Williams-Sonoma Inc. (WSM) is the featured stock in July’s Dividend Growth Stocks Model Portfolio. I first made Williams-Sonoma a Long Idea in September 2016, and the stock has outperformed the S&P 500 by 84% since then.
Williams-Sonoma has grown revenue by 10% compounded annually and net operating profit after tax (NOPAT) by a whopping 22% compounded annually from fiscal 2018 through the trailing-twelve-months (TTM). The company’s NOPAT margin increased from 8% in fiscal 2018 to 13% over the TTM, while invested capital turns rose from 1.8 to 2.3 over the same time. Higher invested capital turns and NOPAT margins drive return on invested capital (ROIC) from 13% in fiscal 2018 to 31% in TTM.
Figure 1: Williams-Sonoma’s Revenue & NOPAT Since Fiscal 2014
Free Cash Flow Supports Regular Dividend Payments
Williams-Sonoma has increased its regular dividend from $0.39/share in 1Q18 to $0.90/share in 3Q23. The current quarterly dividend, when annualized, equals $3.60/share and provides a 2.6% dividend yield.
More importantly, Williams-Sonoma’s free cash flow (FCF) easily exceeds its regular dividend payments. From fiscal 2018 through fiscal 1Q24, Williams-Sonoma generated $3.8 billion (34% of current enterprise value) in FCF while paying $912 million in dividends. See Figure 2.
Figure 2: Williams-Sonoma’s FCF vs. Regular Dividends Since Fiscal 2019
Companies with FCF well above dividend payments provide higher-quality dividend growth opportunities. On the other hand, dividends that exceed FCF cannot be trusted to grow or even be maintained.
WSM Is Undervalued
At its current price of $139/share, Williams-Sonoma has a price-to-economic book value (PEBV) ratio of 0.8. This ratio means the market expects Williams-Sonoma’s NOPAT to permanently fall 20% from current levels. This expectation seems overly pessimistic given that Williams-Sonoma has grown NOPAT by 22% compounded annually since fiscal 2018 and 15% compounded annually over the past decade.
Even if Williams-Sonoma’s NOPAT margin falls to 10% (compared to 13% in the TTM), and it grows revenue by just 3% compounded annually (below 8% compounded annually since fiscal 2013) over the next decade, the stock would be worth $168/share today – a 21% upside. See the math behind this reverse DCF scenario. In this scenario, Williams-Sonoma’s NOPAT would decline <1% compounded annually through 2032. Should the company’s NOPAT grow more in line with historical growth rates, the stock has even more upside.
Add in Williams-Sonoma’s 2.6% dividend yield and a history of dividend growth, and it’s clear why this stock is in July’s Dividend Growth Stocks Model Portfolio.
Critical Details Found in Financial Filings by My Firm’s Robo-Analyst Technology
Below are specifics on the adjustments I make based on Robo-Analyst findings in Williams-Sonoma’s 10-K and 10-Qs:
Income Statement: I made $121 million in adjustments with a net effect of removing $90 million in non-operating expenses (1% of revenue).
Balance Sheet: I made $1.4 billion in adjustments to calculate invested capital with a net increase of $367 million. The most notable adjustment was $680 million (22% of reported net assets) in operating leases.
Valuation: I made $2 billion in adjustments, with a net decrease in shareholder value of $2 billion. The most notable adjustment to shareholder value was $2.0 billion in total debt. This adjustment represents 22% of Williams-Sonoma’s market value.
Disclosure: David Trainer, Kyle Guske II, Italo Mendonça, and Hakan Salt receive no compensation to write about any specific stock, style, or theme.
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