Dividend-growth investing is a popular and largely successful approach to generating wealth over long periods of time.Investors typically do well focusing on companies with long streaks of dividend increases in part because of the positive qualities a business needs in order to be able to continually afford what is ultimately a cash layout to shareholders.However, many of the companies known as “dividend champions”– those with 25 consecutive years (or more) of dividend growth – are mature companies.By identifying strong companies earlier in their life cycle, we can benefit from strong total returns while these companies build their dividend growth reputation.We will be spotlighting numerous dividend up and comers to identify the best “dividend growth stocks of tomorrow.” Overview Avnet, Inc.( AVT ) is a company that distributes electronic components, as well as provides a host of services that help bring products to market.
These include supply chain, supply chain optimization, and design services.The company generates almost $20 billion in annual revenues between its two primary business segments: Electronic Components, and Premier Farnell.
The vast majority of the company’s sold products are semiconductors.As we look at the company’s revenue and EBITDA trends, it’s important to note that Avnet sold off its Technology Solutions business in 2016 for $2.6 billion.
This is partially why the company’s performance steeply dropped off.Source: YCharts Following this drop, revenues over the past three years have grown at a CAGR of 5.25%.EBITDA has grown at a CAGR of 4.93%.Fundamentals To gain a better understanding of the type of business that Avnet, Inc.is and the company’s strengths and weaknesses, we will review some key operating metrics.We review operating margins to make sure the company is consistently profitable.
We also want to invest in companies with strong cash flow streams, so we look at the conversion rate of revenue to free cash flow.Lastly, we want to see that management is effectively deploying the company’s financial resources, so we review the cash rate of return on invested capital (CROCI).We will do all of these using three benchmarks: Operating Margin – Consistent/expanding margins over time FCF Conversion – Convert at least 10% of sales into FCF CROCI – Generate at least 11-12% rate of return on invested capital Source: YCharts We are disappointed to see that Avnet performs below benchmark on all three metrics.The reason for this primarily involves the fact that Avnet’s business sells semiconductors as its primary product.Semiconductors are a commodity at heart, which makes the operating environment very competitive.
Avnet’s primary role as a distributor is also a tough position from a leverage standpoint – there is simply less of a “moat” to the business.The company faces many competitors, with the scale of Avnet’s operations being among its best competitive tools.The company’s Farnell segment somewhat breaks out of this mold, selling lower volume/high margin kits, and electronic components to end users (operating margin of 9.7%).Unfortunately, this is a much smaller slice of Avnet’s “revenue pie” at about $1.5 billion, so the company’s overall profitability is weighed down.Because the company relies on top-line growth to drive FCF higher, the balance sheet only becomes increasingly important.A strong balance sheet provides financial flexibility to either fund M&A, or to protect the business from an unexpected downturn.Source: YCharts While Avnet’s balance sheet shows leverage at 3.2X EBITDA (exceeding our cautionary threshold of 2.5X), the company possesses a strong cash balance of $546 million (putting debt to cash at approximately 3:1).
As a company that doesn’t generate strong cash flow streams without revenue growth, it’s more susceptible to a downturn in the business.The company’s strong cash balance provides some protection from that.However, if that cash hoard dries up, Avnet is left without a ton of room on the balance sheet to maneuver with.Dividends and Buybacks After ignoring its dividend for many years, Avnet has raised its dividend for each of the past seven years.The current payout totals an annual sum of $0.84 per share, and yields approximately 2.03%.The yield isn’t anything to write home about, but it does slightly edge 10-year US treasuries (offering 1.75%).Source: YCharts The dividend really ramped up when management began to raise the payout, so the five-year CAGR is quite high at 21.1%.
Over the past three years, however, it’s grown much more slowly at 5.7%.We don’t expect very rapid growth out of the dividend moving forward.The company’s payout ratio from a cash basis is low at 21.15%, but there are other ways that Avnet tends to spend its cash flow.Source: YCharts Avnet has aggressively bought back shares to help drive earnings per share growth over the years.The actual amount spent fluctuates, but common buybacks total in the $200-400 million per year range.This has lowered the float from about 150 million to 102 million over the past decade.Growth Opportunities and Risks As a distributor in the supply chain process, Avnet almost plays the role as a middle man or broker.
The company profits from bringing products to market to fill applications.While general economic trends can impact Avnet (both good and bad), the company can help growth by increasing its market share within its field.
There are some ways that Avnet is working on this.Source: Avnet, Inc.Avnet has a global sales presence with just 26% of revenues stemming from sales in North/South America.The company is taking action to grow its technological sales tools throughout all regions of the planet.
The company has advanced its CRM tool (customer relationship manager) in the Americas and Asia, but is still in the process of bringing it online in Europe.Additionally, the company has begun to implement automation into its marketing efforts.Leads are being shared more efficiently, which is helping the sales teams generate more activity – and ultimately, more orders.Additionally, the company can continue to diversify its product offerings.The Farnell business this year added 159,000 SKUs to the Farnell website which will only increase product exposure and drive more sales.All of these efforts focus on increasing penetration with customers.
That is because the actual industry is brutally competitive.Innovation in sales and marketing efforts is crucial to sustaining positive momentum.
This constant pricing pressure from competition will likely keep margins below ideal benchmarks, and remains the largest threat to Avnet.Investors need to focus on what the company is doing to drive top-line growth and cut costs on its side to maximize cash flow growth.Unfortunately, these efforts took a hit when it was announced recently that Avnet was losing its vendor relationship with semiconductor company Texas Instruments ( TXN ).Texas Instruments’ products accounted for a whopping 10% of revenues for all of Avnet in 2019, so it remains to be seen what Avnet will do to counter this.Valuation Shares of Avnet, Inc.have bounced around some this year, trading for between $33 and $49 per share.Today, the stock is in the midpoint of that range at $42.
Source: YCharts Based on analyst estimates , Avnet is looking at earning approximately $3.21 per share for the full fiscal year.This puts the stock at an earnings multiple of 13.04X, which is a 25% premium to the stock’s 10-year median P/E ratio of 10.44X.Despite such a premium on earnings, the stock’s FCF yield actually points in the opposite direction.If we look at valuation from a cash flow standpoint, the current yield of 8.89% is near a multi-year high.Source: YCharts While the FCF yield is strong, we remain cautious until we see how Avnet is able to fill the void that will be left by the departure of Texas Instruments.At minimum, we would want to see shares cross below their median P/E ratio.If shares crossed under 10X earnings ($32 per share) we would re-evaluate the landscape at Avnet, Inc.
Wrapping Up Avnet, Inc.is a great example of what companies have to fight through when they operate in a tough sector.
The immense pricing pressure that Avnet faces really ties its hands behind its back in terms of profitability.Avnet’s global presence and agenda to maximize its marketing/selling efforts is commendable, but the company’s fundamentals ultimately hold it back as an investment.This just makes it tougher for the company to sustain growth when a major disruption occurs such as a recession, or its loss of Texas Instruments.If you enjoyed this article and wish to receive updates on our latest research, click “Follow” next to my name at the top of this article.Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.I wrote this article myself, and it expresses my own opinions.I am not receiving compensation for it (other than from Seeking Alpha).I have no business relationship with any company whose stock is mentioned in this article.
Share this: .