Undervalued Dividend Growth Stock of the Week: BHP Billiton (BBL)

yield-stockphotoThe stock market is such an exciting place.

It’s basically a store, where there are thousands of pieces of merchandise (stocks) that are for sale every day the market is open.

You have some expensive merchandise near the front of the store, where fancy stocks might drape themselves over mannequins.

But I tend to walk right past those expensive stocks, marching toward the clearance section in the back of the store.

See, I’m always looking for a deal.

That goes for everything in my life, from clothing to food to stocks.

And just like someone might be excited to find out their favorite pair of jeans are half off, I get equally excited when I’m able to find a stock selling for less than what it’s intrinsically worth.

Price and value are, after all, almost always not one and the same.

And it is possible to reasonably conclude what a stock might be worth, as you can see in this valuation piece written by David Van Knapp.

As a dividend growth investor who solely invests in stocks that have a penchant for regularly and reliably paying and increasing dividends, I’m always on the lookout for a high-quality dividend growth stock on sale.

The cheaper the stock, the higher the yield. And that’s because a stock’s price and its yield are inversely correlated. So by snapping up cheaper shares, I’m increasing my dividend income right out of the gate!

I was recently scanning David Fish’s Dividend Champions, Contenders, and Challengers list for a stock that’s on sale. The reason I like to use David Fish’s spreadsheet as a shopping list is because it’s an excellent resource, documenting all US-listed stocks that have increased their dividends for at least the last five consecutive years.

It appears that I might just have found such a stock – a high-quality company whose shares are selling below what they’re really worth. And I’m going to share that opportunity with you today.

BHP Billiton PLC (BBL) is the world’s largest diversified resources company. They’re engaged in the exploration, development, processing, and production of a number of minerals. They also have a substantial oil & gas business.

This company might not be a household name, but they’re the biggest and arguably the best at what they do.

It’s also not a stock you might think of when trying to build a growing source of dividend income, but BBL has increased its dividend to shareholders for the past 12 consecutive years. That actually puts it ahead of many more well-known companies out there.

The dividend raises, by the way, haven’t been token either: the five-year dividend growth rate stands at 10.6%.

That’s actually a really solid rate of dividend increases, especially when you consider the stock yields 4.94% right now. That’s approaching telecommunications territory, which is to say it’s a very attractive yield.

CaptureAnd while some stocks out there with a yield that high might offer a dividend that’s not sustainable, BBL’s payout ratio is only 47.9%.

So what we have here is a stock with a relatively high yield, sustainable payout, and growing dividend. Check, check, and check!

The dividend definitely looks solid, but what about the rest of the company?

If the business isn’t growing, the dividend will do the same at some point. So we need to know what kind of growth the company typically experiences over a long period of time to not only determine if the dividend will likely continue growing, but also to extrapolate that data out to try and value shares.

As such, let’s see what kind of growth BBL has been able to muster over the last decade.

Revenue increased from $29.587 billion in fiscal year 2005 to $68.730 billion at the end of FY 2014. That’s a compound annual growth rate of 9.82%. What’s impressive is that they managed that kind of growth in revenue even though we’re talking about really huge numbers here. Almost $70 billion in annual revenue is just massive.

Meanwhile, earnings per share grew from $2.08 to $5.18 during this time frame. That’s a CAGR of 10.67%, which is almost exactly the same as their more recent dividend growth rate. Not only is that a great rate of growth in profitability, but it means the dividend increases are obviously sustainable and not out of line.

S&P Capital IQ predicts EPS will grow at only a 3% compound annual rate over the next three years, due in part to a spin-off of certain assets.

BBL’s balance sheet is strong, particularly considering the size of the business and capital-intensive nature of mining for natural resources. The long-term debt/equity ratio is 0.38 as of the end of FY 2014 (which ended June 30), and the interest coverage ratio is 38.4.

What might be even more impressive is their profitability, which well exceeds any of their close peers. Net margin has averaged 23.43% over the last five years, while return on equity has averaged 27.22%. These numbers pretty much blow away any competition.

Just a lot to like here. You’ve got a very attractive yield supported by growing profitability. The balance sheet is in excellent condition and the company also sports some great profitability metrics.

So we clearly have a high-quality company. But even the best companies aren’t worth paying more than what they’re worth. That leads us to the question: What is BBL worth?

We can see shares are selling for a P/E ratio of 9.69 right now. Single-digit P/E ratios always grab my attention, but this is perhaps even more stunning when you keep in mind that BBL has traded hands for a P/E ratio of 14 over the last five years. So clearly there’s some kind of disconnect here.

I valued shares using a dividend discount model analysis with a 10% discount rate and just a 5.5% long-term growth rate. I’m being ultra conservative here to account for the potential of slowing growth over the near term, as well as the cyclical nature of their business. But 5.5% is well below what BBL has historically been able to deliver, so I believe there’s a margin of safety in that number. The DDM analysis gives me a fair value of $58.14 on shares.

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.

So my ultra conservative analysis spits out a price that’s about’s more than 10% higher than the $52.15 shares are trading at right now. Maybe I’m wrong and Mr. Market has it right? I don’t personally believe so, but let’s see what some of the prevailing valuation opinions on BBL are right now.

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 BBL as a 4-star stock, with a fair value estimate of $70.00.

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 BBL as a 4-star “buy”, with a 12-month target price of $59.00.

It appears that not only am I not alone on this one, but I’m actually the most conservative of all. Averaging these three numbers out gives us a fair value of $62.38. That would seem to indicate that shares in this world-class miner are 20% undervalued right now. That’s the kind of clearance rack special I’m talking about!

scBottom line: BHP Billiton PLC (BBL) is an absolute juggernaut in the natural resources industry. Shares have been weak lately, on concerns over Chinese demand for iron ore and a potential de-merger of certain assets. But price and value aren’t always one and the same, and it appears that there’s a serious disconnect between the two here. Shares yield almost 5%, and the dividend is growing at a healthy clip. You don’t run into shares that are potentially 20% undervalued every day of the week, which is what makes this such a potentially outstanding opportunity. If you’re ready to mine for big dividends at a discount, I’d consider BBL here.

— Jason Fieber, Dividend Mantra

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