Although it's one of the lesser-known Dividend Aristocrats, Genuine Parts Company's (GPC -0.45%) remarkable track record of 63 years of consecutive payout increases deserves respect.
So naturally, income investors may want to consider the stock as an option for their retirement portfolios -- but they'll first want to take a closer look at the auto parts, industrial parts, and office products distributor to gauge whether it will be able to continue its great run.
Image source: Getty Images.
The bullish case
The glass-half-full viewpoint on Genuine Parts highlights its history of dividend increases and its strong ongoing return on equity (RoE). RoE is simply net income divided by shareholders' equity, and measures how much profit is being generated from the money invested in existing assets. Higher numbers are better, and demonstrate a company's ability to grow its earnings.
GPC Return on Equity (TTM) data by YCharts
Once we know the RoE, the payout ratio and divided yield we can use the Gordon Growth Model to calculate how much it can grow its dividend on an annual basis.
If Genuine Parts can continue to generate a 20% RoE, then -- given that its dividend currently consumes around 54% of its earnings -- it has the potential to grow its payout by around 9% annually over the long term. And with a yield that's now close to 3%, that's an attractive proposition.
Moreover, the business appears to be well balanced, with 56% of sales going to the automotive parts market -- traditionally a recession-resistant industry -- while the industrial parts business (34% of total sales) has the potential to do well in cyclical upturns. The remaining 10% of its sales come from business products -- an area where it's subject to fierce competition from Amazon.com (AMZN -1.65%).
The bearish case
Viewed from a more negative perspective, it's clear that the company's RoE has been boosted in a way that might not prove sustainable.
It's certainly true that Genuine Parts Company is generating good RoE, but it's important to look at how and why. Ultimately, a company's RoE is determined by multiplying the following metrics:
- Profit margin (income/revenue)
- The revenue it generates from its assets (revenue/assets).
- Financial leverage, or the ratio of assets to shareholder equity. (assets/shareholder equity).
In case you want to check this, it can immediately be seen that multiplying these factors together leaves you with RoE (income/shareholder equity).
The higher the number for each factor, the better -- because that increases the value of the final figure. However, investors need to keep an eye on those financial leverage figures. A company can boost those by taking on debt to buy assets, which juices its RoE to offset the impact of falling profit margins and asset turnover.
Unfortunately, that's exactly what Genuine Parts appears to be doing.
Genuine Parts' return on equity
To be clear, there's nothing wrong in a company taking on debt -- especially in a low-interest rate environment -- if it leads to the promised land of rising profit margins and better revenue generation from assets.
However, as you can see below, this company's profit margin has been on a downtrend, whether in favorable or unfavorable end-market conditions. Moreover, asset turnover keeps falling. This means that the company has seen falling margins as it adds assets, and that its new assets haven't been generating as much revenue as the old assets did.
The question, then, is just how sustainable its rising financial leverage is, and whether there are structural problems with Genuine Parts that are causing ongoing deteriorations in performance?
Data source: Genuine Parts Company presentations
A look at some commonly used metrics confirms the company's debt position has deteriorated, although it's worth noting that its current debt-to-EBITDA ratio is still at a level generally deemed acceptable for investment-grade debt.
GPC Net Total Long Term Debt (Annual) data by YCharts. EBITDA = earnings before interest, tax, depreciation, and amortization.
A structurally challenged business?
It's no secret that Amazon and other e-commerce companies have muscled in on the office supplies market -- Genuine Parts Company names Amazon as a competitor in its business products segment. It's no surprise to see margins challenged in that segment. However, Amazon's ambitions may present a long-term threat to auto parts retailers' margin prospects.
In addition, there's evidence to suggest that industrial supply companies also face margin challenges from Amazon and other online competitors. To be fair, Genuine Parts has improved its margin in its industrial parts business over the last few years, but its automotive parts segment margin remains challenged, and so does its total company margin.
Data source: Genuine Parts Company presentations
Genuine Parts Company is one to avoid
All told, if you are going to buy a stock for its dividend and then park it into a retirement portfolio, you probably ought to feel confident that the business isn't going to be structurally challenged over the long term. In this case, the current trends don't look great.
Moreover, the decade-long trend in the underlying components of the company's RoE generation needs improvement. Genuine Parts Company will have to start generating some margin expansion and revenue from assets in the future, but until then, it's probably a Dividend Aristocrat worth avoiding.
