Recap from August’s Picks

On a price return basis, the Safest Dividend Yields Model Portfolio (-10.0%) underperformed the S&P 500 (-8.0%) by 2.0% from August 19, 2022 through September 19, 2022. On a total return basis, the Model Portfolio (-9.5%) underperformed the S&P 500 (-7.6%) by 1.9% over the same time. The best performing large cap stock and the best performing small cap stock were each up 1%. Overall, nine out of the 20 Safest Dividend Yield stocks outperformed their respective benchmarks (S&P 500 and Russell 2000) from August 19, 2022 through September 19, 2022.

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 September: Seagate Technology
STX

Seagate Technology Holdings PLC (STX) is the featured stock in September’s Safest Dividend Yields Model Portfolio.

Seagate Technology has grown revenue by 2% compounded annually and net operating profit after-tax (NOPAT) by 10% compounded annually over the past five years. The company’s NOPAT margin rose from 11% in fiscal 2017 (fiscal year end was 6/30/17) to 16% in fiscal 2022, while invested capital turns rose from 1.6 to 1.7 over the same time. Rising NOPAT margins and invested capital turns drive Seagate Technology’s return on invested capital (ROIC) from 17% in fiscal 2017 to 27% in fiscal 2022.

Figure 1: Seagate Technology’s Revenue & NOPAT Since Fiscal 2017

Free Cash Flow Easily Supports Regular Dividend Payments

Seagate Technology has increased its regular dividend from $2.52/share in fiscal 2017 to $2.77/share in fiscal 2022. The current quarterly dividend, when annualized, provides a 5.1% dividend yield.

Seagate Technology’s free cash flow (FCF) easily exceeds its regular dividend payments. From fiscal 2018 to 2022, Seagate Technology generated $7.3 billion (44% of current enterprise value) in FCF while paying $3.4 billion in dividends. See Figure 2.

Figure 2: Seagate Technology’s FCF vs. Regular Dividends Since Fiscal 2018

Companies with strong FCF provide higher quality dividend yields because the firm has the cash to support its dividend. Dividends from companies with low or negative FCF cannot be trusted as much because the company may not be able to sustain paying dividends.

STX Is Undervalued

At its current price of $54/share, Seagate Technology has a price-to-economic book value (PEBV) ratio of 0.4. This ratio means the market expects Seagate Technology’s NOPAT to permanently decline by 60%. This expectation seems overly pessimistic given that Seagate Technology grew NOPAT by 10% compounded annually over the past five years and 7% compounded annually over the past 15 years.

Even if Seagate Technology’s NOPAT margin falls to 13% (ten-year average vs. 16% over the TTM) and the company’s NOPAT falls by 4% compounded annually over the next decade, the stock would be worth $90+/share today – a 67% upside. See the math behind this reverse DCF scenario. Should the company’s NOPAT grow 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 Seagate Technology’s 10-Ks and 10-Qs:

Income Statement: I made $298 million in adjustments with a net effect of removing $269 million in non-operating expenses (2% of revenue).

Balance Sheet: I made $4.7 billion in adjustments to calculate invested capital with a net increase of $1.6 billion. The most notable adjustment was $2.6 billion (48% of reported net assets) in asset write-downs.

Valuation: I made $5.4 billion in adjustments with a net effect of decreasing shareholder value by $5.2 billion. Apart from total debt, one of the most notable adjustments to shareholder value was $120 million in excess cash. This adjustment represents 1% of Seagate Technology’s market value.

Disclosure: David Trainer, Kyle Guske II, Matt Shuler, and Brian Pellegrini receive no compensation to write about any specific stock, style, or theme.