Recap from June’s Picks
On a price return basis, the Safest Dividend Yields Model Portfolio (-1.7%) underperformed the S&P 500 (+2.0%) by 3.7% from June 23, 2021 through July 20, 2021. On a total return basis, the Model Portfolio (-1.6%) underperformed the S&P 500 (+2.0%) by 3.6% over the same time. The best performing large cap stock was up 6% and the best performing small cap stock was up 7%. Overall, nine out of the 19 Safest Dividend Yield stocks outperformed their respective benchmarks (S&P 500 and Russell 2000) from June 23, 2021 through July 20, 2021.
This Model Portfolio only includes stocks that earn an attractive or very attractive rating, have positive free cash flow and economic earnings, and offer a dividend yield greater than 3%. Companies with strong free cash flow provide higher quality and safer dividend yields because I know they have the cash to support the dividend. I think this portfolio provides a uniquely well-screened group of stocks that can help clients outperform.
Featured Stock for July: H&R Block Inc.
H&R Block Inc. (HRB) is the featured stock in July’s Safest Dividend Yields Model Portfolio.
H&R Block has grown revenue by 2% compounded annually and net operating profit after-tax (NOPAT) by 7% compounded annually over the past five years. H&R Block’s NOPAT margin increased from 15% in 2016 to 18% over the trailing-twelve-months (TTM) while its return on invested capital (ROIC) rose from 14% to 21% over the same time.
The firm’s economic earnings, or the true cash flows of the business, increased from $288 million in 2016 to $498 million over the TTM.
Figure 1: H&R Block’s Revenue & NOPAT Since 2016
Free Cash Flow Supports Dividend Payments
H&R Block has paid a quarterly dividend since 1995, and its dividend in fiscal 2021 was $1.04/share. The current quarterly dividend, when annualized provides a 4.4% dividend yield.
Since 2016, H&R Block’s cumulative free cash flow (FCF) easily covers its annual dividend payments. Over the past five years, H&R Block generated $2.8 billion (64% of current market cap) in FCF while paying $1.0 billion in dividends, per Figure 2. The firm was hit hard by the pandemic, which caused negative FCF in fiscal 2020.
Figure 2: H&R Block’s FCF vs. Dividends Since 2016
Companies with strong FCF provide higher quality dividend yields because I know the firm has the cash to support its dividend. On the other hand, dividends from companies with low or negative FCF cannot be trusted as much because the company may not be able to sustain paying dividends.
HRB Is Undervalued
At its current price of $24/share, HRB has a price-to-economic book value (PEBV) ratio of 0.3. This ratio means the market expects H&R Block’s NOPAT to permanently decline by 70%. This expectation seems overly pessimistic given that H&R Block has grown NOPAT by 4% compounded annually over the past decade and 2% compounded annually over the past two decades.
Even if H&R Block’s NOPAT margin falls to 10% (10-year low excluding the pandemic vs. 18% TTM) and the firm’s NOPAT declines by 3% compounded annually over the next decade, the stock is worth $48/share today – a 100% upside. See the math behind this reverse DCF scenario. Should the firm grow NOPAT more in line with historical growth rates, the stock has even more upside.
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 H&R Block’s 10-K and 10-Q:
Income Statement: I made $244 million in adjustments with a net effect of removing $43 million in non-operating expenses (1% of revenue). See all adjustments made to H&R Block’s income statement here.
Balance Sheet: I made $1.7 billion in adjustments to calculate invested capital with a net increase of $244 million. The most notable adjustment was $735 billion (30% of reported net assets) in asset write-downs. See all adjustments to H&R Block’s balance sheet here.
Valuation: I made $2.8 billion in adjustments with a net effect of decreasing shareholder value by $1.3 billion. Apart from total debt, one of the most notable adjustments to shareholder value was $763 million in excess cash. This adjustment represents 17% of H&R Block’s market value. See all adjustments to H&R Block’s valuation here.
Disclosure: David Trainer, Kyle Guske II, Alex Sword, and Matt Shuler receive no compensation to write about any specific stock, style, or theme.