Tuesday, August 28, 2012

Buy This 4% Yielder While It's Still a Bargain

As different as they are, stocks and bonds often share a key feature -- yield, the annual dividend or interest payment divided by the price of the security, expressed as a percentage. It's a simple concept, but it's one of most importance in investing.

This is because, as most investors quickly learn, yields fall when security prices rise. In other words, you're not getting as good a deal on the interest or dividend and could even be overpaying, depending on what the security's yield has been historically.

It's the type of thing I'm afraid might happen with an excellent small-cap stock I'd like to tell you about. The stock is yielding 4%, based on the current dividend of 66 cents a share, and recent stock price around $16.20, but this may not last long. The stock is set for quick growth in the price but not the dividend, so the yield could plummet -- soon.

The table below summarizes projected earnings, stock prices and yields for the next five years:

Earnings Table

I'm referring to Ingles Markets Inc. (Nasdaq: IMKTA), a leading food retailer that operates 203 large (65,000 - 80,000 square-foot) supermarkets in suburban and rural areas of the southeast United States. A big reason why I like Ingles is because it's one of those rare small-cap stocks (the market capitalization is only $393 million) that seems much bigger. It has been around for nearly five decades, has a great reputation and solid financial statements and pays a nice dividend. Additionally, the stock is typically 13% less volatile than the overall market.

The quick stock growth I'm predicting is related mainly to the company's ongoing effort to achieve outstanding customer service by providing modern, convenient, one-stop shops for everything from perishables, packaged foods and baked goods to pharmaceuticals and fueling stations. During the past five years, Ingles has plowed nearly $710 million into renovations, expansions and new store openings. Management plans to spend about $160 million more on upgrades during the next 12 months.

A large portion of future spending will be on enhancing warehousing/distribution, including upgrades to a centrally-located, 919,000 square-foot facility near Asheville, N.C. The facility, which typically stores about 40,000 pallets of products at any given time, enables the company-owned trailer truck fleet to efficiently resupply Ingles stores since it's within 250 miles of every location. What's more, another 830,000 square-foot warehouse and distribution facility is under construction nearby, and management expects operations there to be in full swing by early 2013.

Ingles also has small but substantial real estate holdings and milk production activities. For instance, it owns 71 shopping centers, 58 of which have an Ingles supermarket. The company also holds 13 parcels of undeveloped real estate suitable for new Ingles locations, and it owns and operates a milk processing and packaging plant that supplies the majority of the milk sold at Ingles stores. Most of the milk produced, however, -- about two-thirds -- is sold to other retailers, warehouses and food service distributors.

Of the $3.6 billion in sales the company is on track to generate in 2012, about $3.5 billion (96%) should be from the sale of food and nonfood grocery items. Milk production and sales will probably account for around $126 million (3.5%). Shopping center rental income should total about $18 million (0.5%).

Analysts project revenue will grow at a 5% rate to about $4.6 billion a year by mid-2017. During that time, they see earnings per share (EPS) rising at a 10% pace from $1.69 to $2.72. Both of these estimates look reasonable to me.

So do their expectations for no dividend growth during the next three to five years, since Ingles has $101 million of debt coming due during that time and plans to keep putting excess cash into upgrades and renovations for at least another year. But the price-to-earnings (P/E) ratio of 10 is a good value relative to the historic P/E ratio of 12 and the P/E ratio of 15 for the overall market.

Risks to Consider: While Ingles Markets is a defensive stock, due to the focus on selling groceries and other necessities, it is by no means immune to economic weakness. A significant downturn could easily make revenue and earnings growth estimates unobtainable and jeopardize the dividend.

Action to Take --> If you're interested in Ingles Markets for the dividend, then buy the stock now while shares are cheap and the yield is high. Since dividends probably won't grow for years, the yield could quickly erode because the stock is set to climb.

Indeed, if the P/E ratio keeps to the historic average of 12 and EPS climbs 10% to $1.86 in a year as projected, then the stock price could hit $22.32 at that point (12 x $1.86 = $22.32). The yield, in turn, would fall to 3% [[66 cents/$22.32) x 100 = 3%]. After another year of 10% EPS growth, the yield would shrink to 2.7% if the dividend remains the same. By 2017, it would be hovering around 2%, as you can see in the table above.

Of course, the table also illustrates the stock's growth potential, which is outstanding. Again, assuming the P/E ratio stayed at historic levels, the price would reach nearly $33 a share by 2017 (12 x projected EPS of $2.72 = $32.64), about double the current price.


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