Undervalued Dividend Growth Stock of the Week: Omnicom Group Inc. (OMC)

If you want to live like everyone else, simply think and act like everyone else.

But my guess (based on the fact that you’re reading this article) is that you don’t want to live like everyone else.

I used to live like everyone else.

Wake up too early. Drive through too much traffic in order to go to a job I dislike too much. Work too many hours.

Drive back through too much traffic. End up back at home too tired.

Rinse and repeat. 

To each their own, but I decided I couldn’t live like everyone else for the rest of my life.

That led to doing something about it, back in mid-2009.

That something involved reshaping my lifestyle so that I could live well below my means and invest my excess capital (the difference between my income and expenses) into high-quality dividend growth stocks.

Dividend growth investing offers a lot to like, as I’ve written about extensively, but a key element to the strategy is the reliable and growing dividend income that one could use to pay real-life bills.

This is a big part of what makes dividend growth investing so appealing.

If you can generate enough passive income to live off of, you can “opt out” of living like everyone else.

I opted out a few years ago, reaching financial independence at just 33 years old.

Financial independence arrived for me when the passive dividend income my real-money and real-life personal stock portfolio generates on my behalf was enough to cover my bills.

I’m expecting to earn more than $12,000 in dividend income over the course of 2018.

The crazy thing about it is, it wasn’t all that hard to put myself in this situation.

After all, it only took me approximately six years (2010-2016) to go from broke to financially independent.

But I spent much less than most people.

And I invested much more than most people.

However, I didn’t blindly invest.

I invested in some of the best businesses in the world. And it just so happens that many of the best businesses in the world directly share their growing profit with their shareholders, via growing dividend payments. 

If you peruse David Fish’s Dividend Champions, Contenders, and Challengers list, you’ll see more than 800 stocks that have paid out increasing dividends for at least the last five consecutive years.

But you’ll also see many of the best businesses in the world.

That’s because it takes a special kind of business to be able to write ever-larger dividend checks to shareholders for years – or even decades – on end.

And so that which can afford one financial independence (growing dividend income) is also that which serves as a great litmus test for business quality. 

That all said, one shouldn’t go out and buy dividend growth stocks randomly.

It’s important to make sure a business is within your circle of competence, first. It doesn’t make much sense to invest in a company if you have no idea what it is the company does or how it makes money.

You then want to perform a thorough analysis on a company, inspecting fundamentals, looking at prospective competitive advantages, and identifying key risks.

And then, of course, you want to value the business, as the price paid at the time of investment can have major implications in terms of investment performance, especially over the short term.

Price is what a stock costs, but value is what a stock is worth.

Being able to pay a price that’s much lower than the intrinsic value of a stock (i.e., buying a stock when it’s undervalued) can be massively beneficial to the long-term investor.

An undervalued dividend growth stock should present a higher yield, greater long-term total return potential, and less risk. 

This is relative to what the same stock might otherwise offer if it were fairly valued or overvalued.

That’s because, first, price and yield are inversely correlated; all else equal, a lower price will result in a higher yield.

Higher yield can and should mean more income in an investor’s pocket, both now and for the long haul.

But it’s not just more income.

Total return is comprised of income (via dividends or distributions) and capital gain.

We can already see how the first component is positively impacted.

But capital gain is also positively impacted when undervaluation is present, as there’s “upside” between price and value when the former is much lower than the latter.

This two-phase attack (via both the income and capital gain components) can lead to much greater long-term total return potential.

While the stock market isn’t necessarily very good at matching the two up over the short term, price and value tend to more closely correlate over the long run.

Short-term volatility can often create a long-term opportunity, as that short-term “mismatch” between price and value can lead to a “springboard” for extra capital gain if/when the mismatch favorably corrects itself.

The potential for extra income and capital gain aside, undervaluation can also serve to reduce one’s risk.

That’s because there’s usually a margin of safety in place when undervaluation and all of the accompanying dynamics are in place.

It should be fairly clear that paying $50 for a stock deemed to be worth $75 is a lot less risky than paying $75 or more.

As great as these benefits are, and as beneficial as undervaluation can be, it might be surprising to learn that estimating a stock’s intrinsic value is actually not a terribly difficult venture.

In fact, fellow contributor Dave Van Knapp sought to simplify this process for you readers via his “lesson” on dividend growth stock valuation, which discusses a valuation methodology that can be used for just about any dividend growth stock out there.

But I won’t leave you readers with just that.

I’m going to highlight a high-quality dividend growth stock that appears to be undervalued right now, meaning it may currently offer all of these aforementioned benefits to the long-term investor…

Omnicom Group Inc. (OMC) is an advertising, marketing, and corporate communications company.

The second-largest company (by revenue) of its kind in the world, Omnicom has built up an incredible amount of diversification, scale, breadth, and depth across its various businesses.

They provide services to over 5,000 clients in over 100 countries.

Breaking things down a bit, Omnicom’s fiscal year 2016 revenue was spread out across the following fundamental business disciplines: Advertising, 54%; Customer Relationship Management, 31%; Public Relations, 9%; Specialty Communications, 7%.

So while one might think at first glance that it’s an advertising agency, I actually think of Omnicom as a one-stop corporate communications company. They provide holistic solutions via their collection of complementary businesses.

And with companies as eager as ever to properly reach and communicate with a global audience, the expertise of a company like Omnicom has never been more important or necessary.

The nature of these partnerships – once Omnicom has partnered with a business – tends to be quite sticky, as campaigns take time to unfold, with long-term data becoming more valuable over time. Omnicom’s reputation across its agencies is excellent, and the deep integration between Omnicom and its clients’ marketing departments creates introduces switching costs.

The company is diversified across the world, with North America representing approximately 60% of FY 2016 revenue. There’s also heavy exposure to Europe and Asia.

Breadth and depth looks like this: the company’s largest client made up 3% of FY 2016 revenue, with the top 100 clients representing just over 52% of revenue. No one industry exceeded 14% of revenue, and the company is servicing almost every industry possible.

This company exposes you to most of the world’s best companies through one single investment, which is pretty incredible. Investing in this company is almost like investing in a diversified fund.

Due to the way the company is set up, the growth is almost completely secular.

This bodes well for the company’s ability to pay a growing dividend, which is music to a dividend growth investor’s ear.

The company has paid out an increasing dividend for nine consecutive years.

These aren’t small increases, either: the five-year dividend growth rate is sitting at 17.2%.

That’s well in excess of inflation, improving shareholders’ purchasing power with each passing year.

While recent increases have slowed down a touch, the most recent increase (announced about a month ago) came in at almost 10%.

This is great stuff.

And with a payout ratio of 47.8%, the stock has a well-covered dividend that is poised for more high-single-digit growth for the foreseeable future.

Meanwhile, the stock offers a market-beating yield of 3.41%, which just so happens to also be more than 80 basis points higher than the stock’s own five-year average yield.

The dividend metrics are right in my sweet spot, across the board.

You’ve got a 3.4%+ yield, dividend growth near double digits, a modest payout ratio, and almost a decade of annual raises.

I built my portfolio on the back of stocks that check these boxes.

Of course, we invest in where a company is going, not where it’s been.

And future dividend growth potential will largely be determined by future business growth.

So it’s critical that we attempt to estimate Omnicom’s future business growth, which will then tell us a lot about what to expect in terms of future dividend growth. It will also greatly aid us when it comes time to value the business and its stock.

To that end, we’ll take a look at Omnicom’s 10-year top-line and bottom-line growth, which tells us a lot about what the company has done over the long haul (using a decade as a proxy for the long term).

We’ll then compare that to a near-term professional expectation for the company’s EPS growth.

Blending the past and possible future like this should give us an idea as to what Omnicom may do moving forward.

The company increased its revenue from $12.694 billion to $15.417 billion between FY 2007 and 2016. That’s a compound annual growth rate of 2.18%.

I would usually expect a bit more than this, but it’s not a terrible number.

The bottom line, however, grew at a much faster rate thanks to systematic buybacks that reduced the outstanding share count by ~27% over the last decade.

Earnings per share grew from $2.95 to $4.78 over this same period, which is a more salient compound annual growth rate of 5.51%.

Not outstanding numbers here, but I think Omnicom makes up for some of this via the secular nature of its growth. Other than a relative (considering the nature of the financial crisis) bump in the road in FY 2009, EPS has move higher in every FY over the last decade.

Looking forward, CFRA is calling for Omnicom to compound its EPS at an annual rate of 8% over the next three years, citing a strong global economic backdrop and easing currency headwinds.

I don’t think Omnicom has to post 8% bottom-line growth in order to be an appealing investment here, all considered. But something closer to that mark would allow for like dividend growth, especially considering the moderate payout ratio.

For perspective, the company’s Q3 2017 report showed YOY diluted EPS growth of almost 7%.

The company’s balance sheet is quite strong, showing a prudent capital structure.

While the long-term debt equity ratio seems high – it’s at 2.28 here – the interest coverage ratio, which is over 9.

There’s no issue with debt here. Moreover, cash and cash equivalents add up to almost 60% of long-term debt.

Profitability is robust.

The company has averaged annual net margin of 7.09% over the last five years, while ROE has averaged 36.16% over that period.

Both numbers have shown a steady uptick in recent years, although ROE is impacted by low shareholders’ equity.

Omnicom has a rare combination of diversification, scale, breadth, depth, expertise, and experience across such a complementary collection of businesses.

And it’s a free cash flow machine, as capital expenditures end up eating very little into operating cash flow. This allows the company to pay out a big and increasing dividend, all while buying back prodigious amount of its own stock.

Indeed, the company routinely returns ~100% of its net income back to shareholders via dividends and buybacks.

Of course, any kind of global economic slowdown will negatively impact the company.

But it held up rather well during the financial crisis, which is an event that seems unlikely to repeat anytime soon.

And with the stock trading at a very reasonable valuation here, it looks quite compelling when comparing the opportunities against the risks…

The stock is trading hands for a P/E ratio of 14.02, which is substantially below where the broader market is at. Furthermore, that favorably compares to the stock’s own five-year average P/E ratio of 17.1.

The company’s sales are also valued a bit lower, compared to the five-year average.

And the yield, as described earlier, is materially higher than its own recent historical average.

So the stock does appear to be discounted here, but by how much? What might an estimate of its intrinsic value look like? 

I valued shares using a dividend discount model analysis.

I factored in a 10% discount rate and a long-term dividend growth rate of 7%.

That DGR is well below the long-term and short-term averages. It’s also lower than the near-term forecast for EPS growth, which will ultimately drive dividend growth. And the most recent dividend increase was almost 10%.

However, I’m balancing a lower 10-year EPS compound annual rate against a moderate payout ratio (which allows for some expansion).

The DDM analysis gives me a fair value of $85.60.

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.

That looks like enough undervaluation on a quality business to warrant a good look, in my view. That’s especially true in this market. But don’t take just my word for it. We’ll see how my valuation compares to what two select professional analyst firms concluded.

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.

Morningstar rates OMC as a 4-star stock, with a fair value estimate of $85.00.

CFRA 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.

CFRA rates OMC as a 3-star “HOLD”, with a fair value calculation of $76.46.

I came out within pennies of where Morningstar landed, which shows some consistency in thought here. Averaging the three numbers out gives us a final valuation of $82.35, which indicates the stock could potentially be 17% undervalued here.

Bottom line: Omnicom Group Inc. (OMC) is a high-quality global firm that gives its shareholders exposure to just about every industry in the world, all while doing so in a way that blends diversification, scale, breadth, depth, expertise, and experience across a wonderful collection of complementary businesses. With the possibility that shares are 17% undervalued, a well-covered and market-beating dividend that’s growing in the high single digits, strong fundamentals, and recent improvement across the company, this is one of my top 10 stock ideas for 2018.

— Jason Fieber

Note from DTA: How safe is Omnicom‘s (OMCdividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 88. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, OMC’s dividend appears very safe with an extremely unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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