There’s so much uncertainty right now.
The world is a bit of a mess.
War in Ukraine, midterm elections, sky-high inflation, and energy shortages in Europe are only a few examples.
But you know what?
There’s always uncertainty.
It’s just that you don’t always recognize it.
Every single day is uncertain.
Life itself is uncertain.
The key is to acknowledge constant uncertainty and position your investments in a way that sets you up to succeed, regardless of uncertainty.
One of the best ways to do this is through dividend growth investing.
This investment strategy advocates buying and holding shares in world-class enterprises that pay reliable, rising dividends to shareholders.
These companies are able to fund reliable, rising dividends by producing reliable, rising profits.
And reliable, rising profits come about by selling the products and/or services the world demands.
You can see what I mean by checking out the Dividend Champions, Contenders, and Challengers list.
This list contains invaluable information on hundreds of US-listed stocks that have raised dividends each year for at least the last five consecutive years.
These companies have been battle tested, proving their ability to deal with constant uncertainty.
I’ve been using the dividend growth investing strategy for more than a decade now, using it to build out my FIRE Fund.
That’s my real-money portfolio, which is chock-full of high-quality dividend growth stocks.
This portfolio produces enough five-figure passive dividend income for me to live off of.
I’ve actually been living off of dividends for years now.
I retired in my early 30s, choosing to live off of dividends rather than a paycheck from the day job.
And my Early Retirement Blueprint explains exactly how and why I was able to retire so early in life.
A lot of my success is owed to the dividend growth investing strategy, which kept me focused on the great businesses of the world that are built for uncertainty.
It’s not only about investing in the right businesses.
Valuation at the time of investment is also critical.
Price is what you pay, but it’s value that you get.
An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.
This is relative to what the same stock might otherwise provide 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.
That higher yield correlates to greater long-term total return potential.
This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.
Prospective investment income is boosted by the higher yield.
But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.
And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.
These dynamics should reduce risk.
Undervaluation introduces a margin of safety.
This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value.
It’s protection against the possible downside.
Buying high-quality dividend growth stocks when they’re undervalued positions you to succeed over the long run, regardless of the constant uncertainty that plagues our world.
Of course, doing this would require one to grasp the concept of valuation in the first place.
Well, this isn’t as difficult as it might seem.
My colleague Dave Van Knapp wrote Lesson 11: Valuation in order to make it even easier.
One of a series of “lessons” designed to teach dividend growth investing, it spells out valuation in an easy-to-understand way.
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…
Magna International Inc. (MGA) is a multinational mobility solutions and technology company for automakers that designs, develops, and manufactures automotive systems, assemblies, modules, and components.
Founded in 1957, Magna is now a $16 billion (by market cap) manufacturing goliath that employs over 160,000 people.
FY 2021 revenue can be broken down by product category: Body Exteriors & Structures, 40%; Power & Vision, 31%; Complete Vehicles & Other, 15%; and Seating Systems, 14%.
Based out of Canada, Magna is one of the world’s largest manufacturers of OEM components for various automakers.
Yes, it’s large.
But Magna is also broad.
Magna is so broad, in fact, that it could practically be its own carmaker.
Morningstar elaborates on this point: “Many suppliers focus on a particular area of the vehicle. In sharp contrast, Magna’s capabilities are so broad that the firm could nearly design, develop, supply, and assemble vehicles all on its own.”
We know two things about mobility.
It’s becoming more pervasive.
And it’s becoming more complex.
Companies left and right are getting into the mobility game through EV and self-driving efforts; simultaneously, vehicles are becoming increasingly reliant on technology.
All of this plays right into the hands of Magna.
Any company that’s trying to quickly scale up in mobility is naturally going to consider partnering with a capable manufacturer like Magna.
And the more complex a vehicle becomes (EVs are a prime example of this), the more imperative it is for the manufacturer to be technologically adept.
In a world that demands more mobility and more tech, Magna is up to the task.
And that bodes well for the company’s growth as it relates to revenue, profit, and the dividend.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Already, Magna has increased its dividend for 13 consecutive years.
The 10-year dividend growth rate is 12.7%.
That’s solid, and it easily beats inflation.
Plus, the stock yields a market-beating 3.2%.
That’s a heck of a combination of yield and growth.
By the way, this yield is 60 basis points higher than its own five-year average.
And since the payout ratio is 45.3%, based on TTM adjusted EPS, we have a well-covered dividend.
I like dividend growth stocks in what I call the “sweet spot” – a yield of between 2.5% and 3.5%, paired with a high-single-digit (or better) dividend growth rate.
The yield is on the high end of that range, and the dividend growth rate is well above what I’d look for.
Revenue and Earnings Growth
As sweet as these dividend metrics are, though, they’re largely looking backward.
But investors must face the prospect of risking today’s capital for tomorrow’s rewards.
This is exactly why I’ll now build out a forward-looking growth trajectory for the business, which will be of great assistance when it comes time later to estimate the stock’s intrinsic value.
I’ll first show you what the company has done over the last decade in terms of its top-line and bottom-line growth.
I’ll then unveil a professional prognostication for near-term profit growth.
Drawing a line from the proven past to a future forecast in this way should allow us to built a mental model about where the business might be going from here.
Magna has advanced its revenue from $30.8 billion in FY 2012 to $36.2 billion in FY 2021.
That’s a compound annual growth rate of 1.8%.
I usually look for a mid-single-digit top-line growth rate from a mature business like this.
Did Magna disappoint me on this front?
The business has been severely impacted by pandemic-related lockdowns and the corresponding kinks in the global supply chain.
Revenue is still not back to where it was in FY 2019.
Meantime, earnings per share grew from $3.04 to $5.00 over this time period, which is a CAGR of 5.7%.
But not great.
Again, the business has been directly and negatively impacted by the unfortunate events of the last two years.
If, for instance, we back things up and look at the five-year period from FY 2012 to FY 2016, EPS sported a CAGR of over 14%.
So it depends on when you’re looking at Magna’s results.
We are starting to move past the pandemic, so this impact from this temporary shock to the business will start to abate.
Over the next few years, Magna should recover with meaningful growth off of this artificially low base.
I will note that a lot of the excess bottom-line growth has been driven by share repurchases.
For perspective on that, the outstanding share count is down by 36% over this 10-year time frame.
Looking forward, CFRA believes that Magna will compound its EPS at an annual rate of 17% over the next three years.
I said that Magna should recover with meaningful growth.
Well, that would be very meaningful.
I would ordinarily be leery of this kind of forecast.
But I think it’s actually quite reasonable in this case.
That’s because I see the business as a coiled spring in some ways.
Magna has been forced to operate at a compressed, suboptimal level for more than two years.
As the kinks in the global supply chain become corrected, however, the coiled spring should explosively uncoil.
Record-low inventories for new autos are coming at a time when demand is at all-time highs, which has led to record-high prices.
Supply doesn’t have to just catch up to 2022’s demand but also make up for the pent-up demand that’s been building over the course of more than two years.
Simply put, there has not been enough supply to meet demand.
CFRA states it best here: “Sales would be stronger if not for the record-low inventory levels and parts shortages (particularly semiconductors) which have plagued the market in recent months.”
The need for supply to catch up to demand obviously bodes well for Magna.
CFRA adds this: “On the positive side, economic growth, low unemployment rates, and relatively low (but rising) interest rates should help support sales volumes. We think margins will benefit from a combination of record-high new vehicle price realizations (over $47,000 in the U.S. as of May 2022) and cost cuts implemented during the course of the Covid-19 pandemic.”
Magna does have certain idiosyncratic challenges, including impairments relating to Russian operations.
But the setup for the next few years is about as good as it can possibly get for Magna.
While dividend raises could be modest over the next year or two, due to so much uncertainty, I would expect a nice acceleration in dividend growth once the global economy gets on more sure footing.
This would allow for the payout ratio to remain healthy in an environment where lesser companies would have to cut the dividend.
Once we get past the next year or two, a return to double-digit dividend growth may be back on the menu.
And when you’re already starting off with a 3.2% yield, that’s a compelling package.
Moving over to the balance sheet, the company’s financial position is solid.
The long-term debt/equity ratio is 0.3, while the interest coverage ratio is 17.
The interest coverage ratio is already really good, but it should improve when EBIT rises as a result of operational normalization.
In addition, there’s almost enough cash on the balance sheet to offset all long-term debt.
Profitability is certainly adequate, but I think it can, and will, improve further.
Over the last five years, the firm has averaged annual net margin of 4.2% and annual return on equity of 15%.
Magna is a fine business that’s positioned to become even finer over the coming years.
And with economies of scale, barriers to entry, and switching costs, the company does benefit from durable competitive advantages.
Of course, there are risks to consider.
Competition, regulation, and litigation are omnipresent risks in every industry.
The company does have exposure to Russia, and the most recent quarter included a large impairment charge related to Russian plants.
Input costs are highly volatile.
Magna has customer concentration risk: Its six largest customers account for nearly 80% of annual sales.
There is direct exposure to economic cycles, and this risk is amplified by the capital-intensive business model.
The current kinks in the global supply chain could take longer than anticipated to resolve.
Constant technological changes in mobility introduce the risk of Magna being left behind.
These risks are valid and worth carefully thinking over, but the business still strikes me as appealing for long-term investment.
The 40% drop in price from the 52-week high, which has created a favorable valuation, makes it that much more appealing…
Stock Price Valuation
The P/E ratio is 13.7, based on TTM adjusted EPS.
To be fair, Magna typically gets a relatively low earnings multiple.
However, even by Magna’s standards, this is noticeably undemanding.
Its five-year average P/E ratio is 15.2.
We can see that the P/S ratio of 0.4 is slightly lower than its own five-year average of 0.5.
And the yield, as noted earlier, is significantly higher than its own recent historical average.
So the stock looks cheap when looking at basic valuation metrics. But how cheap might it 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 7%.
In my view, this is a balanced and appropriate long-term expectation of dividend growth.
This is quite a bit lower than the demonstrated dividend growth over the last decade.
But the truth of the matter is that EPS growth hasn’t kept pace.
On the other hand, CFRA’s near-term EPS growth forecast would allow for the dividend and EPS to come into better alignment.
With the payout ratio being so moderate, Magna could afford to hand out good-sized dividend raises over the foreseeable future, with room for further acceleration in dividend growth down the line.
The DDM analysis gives me a fair value of $64.20.
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.
I put together a reasoned valuation, yet the stock’s cheapness still shines through.
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 MGA as a 4-star stock, with a fair value estimate of $83.00.
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 MGA as a 3-star “HOLD”, with a 12-month target price of $60.00.
I came out closer to where CFRA is at, but we all see undervaluation here. Averaging the three numbers out gives us a final valuation of $69.07, which would indicate the stock is possibly 27% undervalued.
Bottom line: Magna International Inc. (MGA) is a leading manufacturer and supplier in mobility. Supply needs to catch up to demand, which means the business could be a coiled spring ready to explosively uncoil to the upside. With a market-beating yield, double-digit long-term dividend growth, a moderate payout ratio, more than 10 consecutive years of dividend increases, and the potential that shares are 27% undervalued, this could be a fantastic long-term opportunity for dividend growth investors.
P.S. If you’d like access to my entire six-figure dividend growth stock portfolio, as well as stock trades I make with my own money, I’ve made all of that available exclusively through Patreon.
Note from D&I: How safe is MGA’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 70. 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, MGA’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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Source: Dividends & Income