Lowe's (NYSE:LOW) recently announced another increase in its quarterly dividend, up 17% to $0.41 per share. The dividend raise marks the 54th consecutive year in which management has given shareholders a raise, landing it high up on the list of Dividend Aristocrats. Still, the stock price has climbed quickly over the last five years or so as more people buy houses and fix them up. As a result, the shares only yield about 2%.
But the value of Lowe's dividend isn't in its current yield. It's in the potential yield on an investment today. After 54 years of dividend increases, it's a good bet management will do what it can to keep the increases coming. The question for investors is how much can they expect the dividend to climb?
Management's commitment to increasing the dividend
The first key ingredient to seeing meaningful increases in a company's dividend is that management must be committed to returning capital to shareholders.
To that end, management has its priorities straight. At its analyst conference in December, CFO Bob Hull expressed the company is first deploying capital in strategic investments, holding back some in case an excellent opportunity arises. But after that, it's dedicated to the dividend, with share repurchases coming after that.
"We expect to pay approximately $4 billion in dividends over the next three years, growing the per-share dividend by 15% to 20% annually as we target a 35% payout ratio," Hull said at the conference. "We've also modeled share repurchases of approximately $10 billion for 2017 to 2019."
With management's outlook for $4.64 in earnings per share in 2017, the company expects to pay out about 33% of earnings as dividends. That's in line with Lowe's historical payout ratio since 2011 and gives some wiggle room in Hull's target if Lowe's should miss its earnings expectations. Management also executed $1.2 billion of repurchases in the first quarter. The total buyback allocation of $10 billion represents around 15% of Lowe's $68 billion market cap.
Dividends come from earnings. Will they grow?
Lowe's should be able to grow its top line in the mid-single digits over the long term.
That breaks down into somewhat modest 2.5% to 3.5% same-store sales growth and an additional 1.5% to 2.5% increase from acquisitions and opening 15 to 20 new stores per year across North America. (Lowe's operates 2129 stores as of the end of fiscal 2016.) That results in an aggregated total of 4% to 6% sales growth per year.
At its analyst day in December management said it expects comparable sales to improve 3% to 3.5% through 2019. But it also set its long-term sales growth outlook relatively low at just 4%.
Earnings, importantly, has the potential to grow much faster. At the analyst day, management said it expects operating margins to expand 150 basis points over the next three years to reach 11.2%. Lowe's increasing scale through its acquisitions of Rona, Central Wholesalers, and Maintenance Supply coupled with increased demand from a strong housing market, should help it leverage SG&A expenses. For reference, Home Depot's (NYSE:HD) SG&A expenses as a percentage of revenue were just 18% last year compared to 23% for Lowe's.
On top of that, Lowe's huge buyback should help produce meaningful growth in earnings per share. With the company set to buy back about 5% of the shares outstanding per year in each of the next three years. Combined with a 0.5% increase from margin improvement and a 4% to 6% increase in revenue, investors can expect 10% to 12% earnings-per-share growth long term. That may be a conservative estimate as the analyst consensus is for 14.5% earnings-per-share growth over the next five years.
So, how much can the dividend grow?
We already know management plans to grow the dividend 15% to 20% in 2018 and 2019. But with the payout ratio already hovering close to the 35% target set by Hull, Lowe's doesn't have much wiggle room considering earnings aren't expected to grow quite that fast.
The good news is that since Lowe's has a lot of depreciation expense due to its 2000-plus storefronts, its free cash flow significantly exceeds its earnings, which would enable it to pay out much more than 35% of earnings as a dividend.
In fact, considering Lowe's can only realistically grow organic revenue about 5% per year, and it's producing a return on equity of around 50% (although it's become highly leveraged), it could manage to grow at the same rate while retaining just 10% of earnings to reinvest in the company. Granted, that would be a very precarious situation for management. The point is, there's room to increase the payout ratio beyond 35% of earnings. The Home Depot, for example, pays out closer to 50% of earnings as a dividend.
As such, it's reasonable to expect dividend increases to continue outpacing earnings-per-share growth, if only slightly. So, an 11% to 13% average annual dividend increase over the long term seems well within reach for Lowe's with a higher growth rate in the next few years per Hull's comments. While the days of 20%-plus growth in the dividend are over, there's still a lot of room left for Lowe's dividend to climb.