Dividend Aristocrats: Time to Buy Emerson Electric?

Emerson Electric is a Dividend Aristocrat, one of a select band of companies that have increased their payouts annually for at least 25 years. Income-seeking investors love such stocks, but they also love shares that appreciate over time. With that said, what are the prospects for Emerson Electric to remain a Dividend Aristocrat, and is it time for dividend-seeking investors to buy this company?

A mature dividend play
Emerson Electric is a mature company, providing manufacturing and technology for a number of markets, with a relatively high dividend of roughly 2.8%.

Naturally, the stock will attract income seekers, given a yield almost 0.5% above that of the U.S. 10-year Treasury note. However, its relatively high payout ratio -- about 37% of last year's earnings were paid out to shareholders in dividends -- means that its ability to grow its dividend aggressively in future years is somewhat constrained.

To explain this idea quantitatively, it's a good idea to use the Dividend Discount Model, also known as the Gordon Growth Model. In a nutshell, the model attempts to quantify the rate at which a company can grow its dividend, g, whereby:

g = ROE x (1 - D/E)

ROE: Return on equity, or the net income a company generates from shareholders' equity

D: Dividend per share

E: Earnings per share

Clearly, generating strong ROE is a key factor in increasing dividends, and the good news is that Emerson Electric has a strong record of doing just that:

Data source: Morningstar. Chart: author's analysis.

A ROE figure of 21.96% is very good, but because Emerson Electric pays out a large part of its earnings in dividends already, it can only grow its future payouts at a significantly lower rate. The following table works out the figure for you. (The trailing-12-month dividend and earnings numbers have been used.)

Source: Google Finance, author's analysis.

According to the model, the company can grow its dividend at a rate of 11.35%. Although this is at a lower rate than its ROE, it's still pretty impressive. Furthermore, if it does grow its dividend at this annual rate for the next 10 years, then in a decade it will be paying a dividend of about $5 a share -- equating to roughly 8% of the current share price. Again, investors need to consider whether they might prefer this scenario or a 10-year Treasury yielding just 2.35% at present.

Free cash flow and dividend history
Unfortunately, investing is rarely as simple as following the model above. Dividend seekers need to appreciate that the economy has historically been cyclical and that Emerson Electric's revenue depends a lot on global infrastructure spending, such as for oil and gas processing plants. If a company can't generate free cash flow (the money left over after capital expenditures are taken out of operating cash flow), then it can't pay a dividend without borrowing money.

But Emerson has a strong record of converting earnings into free cash flow, and its dividend per share is usually well covered by both. Indeed, even in the recession-hit year of 2009, Emerson Electric still generated good free cash flow.

Source: Morningstar.

In the last decade, the company has grown its dividend by 8.3% per year -- not bad for a relatively mature company.

Quality of earnings?
All of this quantitative analysis is a moot point if Emerson Electric can't grow its earnings in the future. For that, it will need growth in the global economy, and in particular a willingness among countries and large utilities to engage in sizable infrastructure spending projects. (I've done into more detailed analysis on the prospects for Emerson Electric's stock in a four-article series on the company.) One potential cause of concern could be its reliance on emerging-market infrastructure spending. For example, the company only generates 57% of its revenue from North America and Europe in its key process management segment -- a segment that generated 42.5% of sales in 2013.

Is Emerson Electric a worthy dividend candidate?
All told, the company's history and financial record suggest it can grow its future dividend at a healthy clip, and with its current yield notably above the benchmark 10-year Treasury yield, the stock is a strong candidate for long-term dividend investors.

One potential issue could be if emerging-market performance falls off a cliff. In such a scenario, these countries would slow infrastructure spending, and energy prices (oil and gas is a key end market for Emerson Electric) could also fall. However, if you think such an outcome is unlikely, the company is an excellent stock for income-seeking investors.