Passive income is a marvelous thing.

It can set you free and allow you to pursue the life of your dreams.

“If you don’t find a way to make money while you sleep, you will work until you die.” – Warren Buffett

Trust me. You want your money working for you, instead of the other way around.

But not all passive income is created equal.

I hear the term “passive income” bandied about as if anything not totally related to a normal paycheck qualifies.

Well, there are definitely degrees of passiveness.

And I can’t think of anything more passive than dividends.

I say that from firsthand experience.

I earn five-figure and growing passive dividend income from my real-life stock portfolio, which I call the FIRE Fund.

Guess what I have to do to collect that income?

Nothing. Nada. Nil.

The money comes in rain or shine, regardless of what I do or do not do in my life. I wake up and get paid. It simply cannot get any more passive than that.

This is why I’ve used dividend growth investing as the basis for my early retirement.

I wanted to retire very early in life. But I also wanted to make sure I wouldn’t have to ever go back to the job.

Jason Fieber's Dividend Growth PortfolioThat’s why I needed an income source that was totally passive and highly secure.

Well, it’s worked out incredibly well.

As I detail in my Early Retirement Blueprint, I was able to retire in my early 30s!

I did that by investing my savings into high-quality dividend growth stocks like those you’ll find on the Dividend Champions, Contenders, and Challengers list.

However, I didn’t buy any stocks at any prices.

I always made sure to focus on great businesses.

And I did my best to buy those stocks when they were undervalued.

“Price is what you pay, value is what you get.” – Warren Buffett

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

That’s relative to what the same stock would otherwise offer if it were fairly valued or overvalued.

Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.

Since total return is simply investment income and capital gain, you’re looking at greater long-term total return potential right out of the gate.

Plus, there’s the possible “upside” that you could be looking at when a price is well below intrinsic value.

If price and value more closely correlate in the future, leading to a higher price, that’s capital gain.

And that’s on top of whatever capital gain would come about as a business grows its profit, becomes worth more, and increases in price.

This should all lead to reduced risk.

It’s naturally less risky to pay less (rather than more) for the same exact asset.

Furthermore, you introduce a margin of safety – a “buffer” – when there’s a favorable gap between price and value.

This protects your downside against unforeseen negative developments. Mismanagement, malfeasance, new competition, additional regulation, etc.

It’s clear that undervaluation is advantageous.

Fortunately, it’s not that difficult to value most dividend growth stocks and spot the better long-term opportunities.

Fellow contributor Dave Van Knapp even put together a template that can act as an excellent valuation tool.

It’s part of his overarching series of articles that are designed to teach the strategy of dividend growth investing.

Make sure to check that out via Lesson 11: Valuation.

With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…

Skyworks Solutions Inc. (SWKS)

Skyworks Solutions Inc. (SWKS) is a global semiconductor company that produces components to enable wireless connectivity across communication devices.

You don’t have to be a genius to see that wireless connectivity is increasingly important in our modern-day society.

That’s obvious to anyone. And that makes the investment thesis almost as obvious.

Skyworks is part of a group of global companies that produce the bulk of the technology that allows smartphones and related devices to work.

With the oncoming 5G revolution, companies like Skyworks have never been more important (or profitable).

While developed countries take access to smartphones and the Internet for granted, Skyworks estimates there are over 2 billion “unconnected” people worldwide. That’s a tremendous runway for growth.

This runway should pave the way for increased dividends.

Skyworks has increased its dividend for five consecutive years already.

Not a terribly long track record.

But they’re growing the dividend aggressively.

The three-year dividend growth rate is an astounding 50.8%.

And the most recent dividend increase was over 18%.

Of course, this is coming off of a 0% payout ratio – because the dividend was non-existent as recently as 2013.

But there’s plenty of room for more where that came from.

The payout ratio is still only 21.1% (using adjusted TTM EPS), which is extremely low.

Meanwhile, the stock offers a fairly appealing yield of 2.29%.

It’s not possible to compare this to a recent historical average because of the newness of the dividend.

However, it is higher than the broader market.

And that yield comes with what is obviously huge dividend growth. That’s in terms of both the existing track record and potential moving forward.

But in order to estimate that dividend growth moving forward, we need to estimate business growth moving forward.

So we’ll take a look at what this company has done in terms of top-line and bottom-line growth over the last decade (a proxy for the long term) first.

And then we’ll compare that to a professional near-term expectation for profit growth.

These numbers should tell us a lot about where Skyworks has been, as well as where it’s likely going.

The company grew its revenue from $803 million in FY 2009 to $3.868 billion in FY 2018. That’s a compound annual growth rate of 19.09%.

This is incredible.

But bottom-line growth was even more incredible over this stretch, which says a lot.

Earnings per share advanced from $0.56 to $7.22, which is a CAGR of 32.85%.

Obviously very impressive.

I used adjusted EPS for FY 2018 only because there was a large tax hit to Q1 2018 GAAP EPS (related to US tax reform). This doesn’t materially impact the company’s true earnings power.

The excess bottom-line growth over this period was driven by a significant margin expansion. Net margin expanded from below 12% a decade ago to now well over 20%.

Moving forward, CFRA is predicting that Skyworks will compound its EPS at an annual rate of 8% over the next three years.

This reflects the anticipation of lower unit volume from high-end smartphone manufacturers, along with slowing demand in China. There could be a temporary lull in sales until 5G starts to more broadly roll out.

But 5G is promising. 5G enabled devices will likely require more content per device (compared to 4G devices), especially on the RF side. Seeing as how Skyworks has built up expertise and leadership in RF tech, this bodes well for the company.

One key risk, in my view, is the trade tension between the US and China.

Notably, Huawei is one of their largest customers – making up 10% of FY 2017 revenue.

All that said, the long-term future looks amazingly bright.

And even if Skyworks is only able to manage 8% annual EPS growth over the next few years, that would still easily allow for double-digit dividend increases by virtue of the very low payout ratio.

One other area of the company that gives it further flexibility as it relates to capital returns to shareholders is the balance sheet.

Skyworks has a fortress balance sheet.

It’s one of the best balance sheets in all of tech. No doubt about it.

They have no long-term debt.

That’s against more than $1 billion in total cash, which is fairly significant for a company with a market cap of just over $12 billion.

Profitability is also pretty spectacular.

Over the last five years, the company has averaged annual net margin of 25.23% and annual return on equity of 25.31%.

Extremely robust numbers here, especially considering the lack of debt.

This is, overall, a very high-quality company.

Phenomenal growth, a secure and increasing dividend, a fortress balance sheet, and otherworldly profitability.

Of course, there are risks to keep in mind.

As noted earlier, the exposure to China could be an issue.

Related to that, Skyworks is concentrated across just a few customers. Foxconn, Samsung Electronics, and Huawei together accounted for 61% of FY 2017 revenue. Foxconn alone was ~40%, which is more or less a proxy for Apple.

So this is a cyclical business model that’s highly concentrated. That might not position them well when the next recession inevitably hits.

However, the stock has dropped from almost $116 back in March to below $67 now – a drop of over 40% in nine months!

And that correction has brought the valuation down to a compelling level…

The P/E ratio is sitting at just 9.19 (using adjusted FY 2018 EPS).

That’s less than half of the broader market’s earnings multiple. It’s also about half of the stock’s own five-year average P/E ratio of 18.8.

Every other basic valuation metric is also substantially below its recent respective historical average.

For example, the P/CF ratio of 9.6 compares quite favorably to the stock’s three-year average P/CF ratio of 15.6.

The stock clearly appears to be heavily discounted at first glance. But how cheap might it actually be? What would a rational estimate of 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 8%.

This DGR is on the upper end of what I allow for.

But I think this stock qualifies for it based on the extremely low payout ratio, flawless balance sheet, business growth, and demonstrated dividend raises thus far.

The China uncertainty is unwelcome, but I don’t see that as a long-term issue.

It’s a cyclical business model with a concentrated customer base, but this forward-looking DGR is also considerably lower than the dividend increases that have come thus far.

The DDM analysis gives me a fair value of $82.08.

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.

The stock might have been expensive at over $110/share, but it now looks downright cheap. This precipitous drop on the stock’s price demonstrates why valuation is so important.

My valuation implies attractiveness.

But we’ll now compare that valuation with where two professional stock analysis firms have come out at.

This adds balance, depth, and perspective to our conclusion.

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 SWKS as a 4-star stock, with a fair value estimate of $113.00.

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 SWKS as a 3-star “HOLD”, with a 12-month target price of $98.00.

I came out on the low end, but I believe I was being conservative. Averaging these three numbers out gives us a final valuation of $97.69. That would indicate the stock is 47% undervalued right now.

Bottom line: Skyworks Solutions Inc. (SWKS) is a high-quality technology company that sports phenomenal fundamentals. Double-digit growth, no debt, an above-market yield, an extremely low payout ratio, and the potential that shares are 47% undervalued means this dividend growth stock should absolutely be on your radar right now.

-Jason Fieber

Note from DTA: How safe is SWKS’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 74. 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, SWKS’s dividend appears very safe with an extremely unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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