Undervalued Dividend Growth Stock of the Week: Suncor Energy (SU)

yield-stockphotoThe stock market has been awfully rocky lately, hasn’t it?

One day the sky is falling and everyone is selling, meaning stock prices go down.

The next day everyone is cheery, the sky is suddenly bluer, and stock prices go back up again.

Enough to give you a stomachache, right?

That’s why I don’t worry too much about the broader stock market.

I focus on the dividends my personal holdings pay me.

No matter what’s going on in the market my dividend income is only moving in one direction – up.

The stocks I concentrate on are those that can be found on David Fish’s excellent Dividend Champions, Contenders, and Challengers list.

This fantastic resource has already compiled all the stocks out there that have increased their dividends for at least the last five consecutive years.

I’m obviously a fan of these stocks, as I’m betting my early retirement on a collection of high-quality companies that pay and grow dividend payouts to shareholders. After all, who doesn’t like a pay raise?

However, I can tell you what I love more than a pay raise.

A deal.

I love dividend growth stocks. I have invested my entire worldly wealth in them. However, I love a cheap dividend growth stock even more.

When’s the last time you scored a great deal on something? Didn’t it just make you feel good?

It’s great to know that the price you’re paying for something is less than what that particular item is worth. Which brings me to my point. Price and value are not one and the same, and stocks often have a disconnect between price and value.

Just like we saw recently with the whipsaw action in the stock market, stocks go up and down in price all the time. However, value doesn’t change that quickly.

Buying a cheap stock helps in more ways than one. First, you lock in a higher yield. After all, yield and price are inversely related. The cheaper the stock, the higher the yield. That means you’re able to buy more dividends for the same dollar.

Second, it provides an extra margin of safety against unforeseen risk.

Third, it bakes in the potential for extra return potential. If a stock is undervalued by 20% and the market recognizes that, it’s likely that the stock will be priced correctly at some point. That means a 20% return right there.

I definitely recommend doing some further reading on valuing stocks if you’re unfamiliar or uncomfortable with stock valuation. And David Van Knapp’s guide is an excellent place to start.

So I routinely hunt for cheap stocks. And I believe I found one. Even better, I’m going to share it with you readers.

Suncor Energy Inc. (SU) is a Canadian integrated energy company, focused on Alberta’s Athabasca oil sands. They explore for, acquire, develop, and market crude oil and natural gas.

They operate in four segments: Refining and Marketing (66% of fiscal year 2013 operating revenues net of royalties); Oil Sands (31%); Exploration and Production (14%); and Energy Trading & Eliminations (-11%).

SU doesn’t have as lengthy a dividend growth streak as some of the other oil companies out there, specifically US-based supermajors. However, they’re no slouch either.

The company has increased its dividend for the last eight consecutive years, and over the last five has raised the dividend by an annual rate of 30.3%. Wow! Few stocks I track have a growth rate that high, so this is very impressive stuff here.

The stock currently yields 2.96%, which isn’t bad against the broader market. It’s a bit lower than what you might find with other major integrated energy companies, but much higher than what could have been had just in the recent past due to incredible dividend raises.

statsMeanwhile, the payout ratio stands at 43.4%.

I typically like to see a payout ratio below 50% and SU definitely qualifies here.

There’s still room to moderately increase this payout ratio which means the company could actually grow dividends at a slightly faster rate than underlying earnings for the near term.

So the dividend track record is fantastic. But what about the rest of the company? Is it growing? We need to find out where it’s been to have any idea where it’s going. Furthermore, we can’t value a company without knowing how much cash it can possibly return to shareholders. So let’s take a look at revenue and EPS growth over the last 10 years. Their fiscal year ends December 31.

Revenue increased from $6.631 billion in FY 2004 to $39.128 billion at the end of FY 2013. That’s a compound annual growth rate of 21.8%. Extremely strong; however, the company merged with Petro-Canada in 2009, and this merger boosted revenue substantially.

Let’s take a look at how the company was able to increase profitability. This will give us a clearer picture of the overall business. Earnings per share grew from $0.98 to $2.53 during this period, which is a CAGR of 11.11%. That’s still might strong and certainly goes a long way toward that rather robust dividend growth record.

S&P Capital IQ expects EPS to grow at a compound annual rate of 7% over the next three years, citing takeaway issues and the potential for lower demand thanks to rising production in the US.

Now, the company’s results can be quite lumpy from year to year due to commodity pricing being so erratic and unpredictable; however, the long-term picture looks healthy thanks to the likelihood of increasing energy demand across the globe.

Let’s also take a look at the company’s balance sheet. After all, every dollar in interest a company is paying out is one less dollar that can be paid out to shareholders. Leverage can be used to amplify returns, but over doing it can create problems.

SU sports a long-term debt/equity ratio of 0.25. That’s fairly conservative, and in line with other major integrated oil companies. The interest coverage ratio is 18. These are very healthy numbers here.

Profitability metrics appear sound. Net margin has averaged 8.03% over the last five years, and that’s in line with many other competitors. Return on equity has averaged 8.18% over this period, which is a bit low.

One interesting note on this stock is that Berkshire Hathaway Inc. (BRK.B) has this stock in its venerable portfolio. So you have the Buffett thumbs up on this one. That’s a vote of confidence not to be taken lightly, in my view.

So what is the company worth?

We know what the growth looks like, and it’s solid. But how does that translate into what we should pay?

Shares in SU trade hands for a price-to-earnings ratio of 15.09 right now. That’s a discount to the broader market, and far below SU’s own five-year P/E ratio average. Furthermore, I like to use a P/E ratio of 15 as a rough guide to fair value. This of course varies by industry, but it’s a good rule of thumb.

But we need more than just a guess. Let’s put a number on it.

I valued shares using a dividend discount model analysis with a 10% discount rate and a 7.5% long-term growth rate. This rate is well below what SU has been able to deliver in regards to earnings and dividends over the last 10 years, and is also more or less in line with the forecast for earnings growth for the foreseeable future. The DDM analysis gives me a fair value of $43.00 on this stock right now.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide. The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth. It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today. I find it to be a fairly accurate way to value dividend growth stocks.

Seems like this is a good deal, but maybe you want to see what others think. Well, I’ll show you.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system. 1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value. These stars are meant to coincide with predicted returns, as a stock that is substantially overvalued will likely lead to subpar returns.

Morningstar rates SU as a 4-star stock, with a fair value estimate of $46.00.

S&P Capital is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line. They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

S&P Capital IQ rates SU as a 4-star “buy”, with a fair value calculation of $35.90.

Averaging all three of these numbers gives us a fair value of $41.63. That means this stock looks to be about 20% undervalued here, which provides for the potential of additional upside on top of any share price appreciation that would otherwise occur over the long haul. Furthermore, you have that healthy dividend and generous dividend raises to look forward to.

scBottom line: Suncor Energy Inc. (SU) is one of the largest integrated energy companies in Canada, and its operational results over the last decade are impressive. They have been sharing the wealth with shareholders in the form of very generous annual dividend raises, and I don’t see why this will discontinue anytime soon. Furthermore, the stock appears to be fairly cheap here. Perhaps Warren Buffett is on to something?

— Jason Fieber, Dividend Mantra

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