4 dividend stocks to win the war on your income€¦ · tax profits to pay investors 2.5% to 3% in...

4 Dividend Stocks to Win the War on Your Income

4 Dividend Stocks to Win

the War on Your Income

A Special Research Report from The Dividend Hunter


Introduction

By Tim Plaehn

In December 2008 the Federal Reserve Board lowered the Fed Funds Discount rate to a

target of 0% to 0.25%, basically a zero interest rate policy (ZIRP). The Fed Funds rate

controls short term interest rates and has a powerful effect on intermediate term rates.

The purpose of ZIRP was to stimulate economic growth, but now over six years later, the

economy remains sluggish, ZIRP is still in effect, and the Fed and government policies

continue to fail to help out the economy. In the meantime, investors and savers have

been saddled with very low interest rates on most types of "safe" investment products. I

am sure you are aware that earning 1% on your money and then paying taxes on that

interest does not leave much to either grow your account value or provide cash to pay

the bills.

To fight and win in the War on Your Income, we look to the stock market, but not at the

familiar corporations that pay billions in corporate income taxes, leaving enough after-

tax profits to pay investors 2.5% to 3% in taxable dividends. Instead, we go with

companies using alternative, but perfectly legal, business structures that reduce the tax

burden, leaving more money to be paid out as dividends to you. In these hidden corners

of the stock market, you can find 5% to 8% yields with a high degree of safety

concerning future dividend payments.

Our investment selection criteria include focusing on stocks that function under a

beneficial section of the tax code, have stable business models that allow them to

generate high levels of cash flow from which to pay dividends, and a past history plus

current focus on increasing dividend rates over times. One "secret" of dividend investing

is that a company that has increased its dividend in the last year is many times less likely

to reduce that dividend compared to a company with a history of level dividend

payments.

Here are four stock market investments that will put cash into your brokerage account

and provide a true return on investment in an economy where the rules are stacked

against you making and keeping money on your investments.


Ship Finance International Ltd (NYSE:SFL) Hamilton, Bermuda

www.shipfinance.bm

Last: $14.90

Dividend & Yield: $1.68 (11.25%)

Market Sector: Specialty Financial Services

Ship Finance International Ltd.

I first developed an interest in the shipping

industry and related stocks almost 10 years

ago. The period of 2005 through 2008 was

exciting for both shipping companies and

their investors. The record prices for

commodities like grains, crude oil and iron

ore made it very profitable to buy a new

crude tanker or dry bulk carrier vessel and lease them on the spot market at

tremendous profit margins.

Of course all of the ship buying happened with borrowed money and when the bottom

fell out of shipping rates, many of these high-flying shippers suddenly could not

generate enough revenue to cover operating costs and interest payments. As shipping

rates fell, so did the market value of vessels owned by these companies.

By 2009, the stocks of some of the biggest names in shipping had lost over 90% of their

values and banks were no longer interested in financing any of the ships these

companies had ordered during the glory years. While some companies that I covered

during this period went bankrupt, others still survive, but with share values 95% below

their heyday prices.

Back in 2006 and 2007, Ship Finance International Ltd. (NYSE: SFL) was the boring,

moderate yielding choice among the several dozen shipping stocks trading on the U.S.

exchanges. Ship Finance came into existence as a 2004 spin-off from Frontline Ltd.

(NYSE: FRO), the world's largest crude oil tanker company.


Ship Finance received 47 tankers from Frontline, which were leased back to FRO on long

term contracts. Splitting off Ship Finance allowed Frontline to increase its risk/reward

profile as tanker spot rates moved up or down. Ship Finance received steady lease

payments enhanced with a modest profit sharing agreement with Frontline. As a result,

Ship Finance was able to pay steady dividends with moderate distribution growth and

use the profit sharing payments to diversify away from a dependence on the crude

tanker market.

The Modern Ship Finance

Over the last decade, Ship Finance has expanded into the ownership of almost all classes

of ships including crude oil tankers, car carriers, container vessels, dry bulk carriers,

chemical tankers, jack-up drilling rigs, ultra-deepwater drilling units and offshore supply

vessels. The company now owns 73 vessels, which includes just 20 tankers remaining

from the original fleet obtained from Frontline. As of the end of 2013, just over half of

the company' revenue came from the offshore portion of the fleet, about a quarter was

from tankers, and the remainder split between dry bulk and container ships.

Long-term lease contracts remain the stabilizing factor in the business model. The

average remaining contract time is over 10 years. The Ship Finance ships are now spread

among 15 customers, which include some of the largest names in shipping such as

Seadrill, Maersk and Hamburg SUD.

The shipping industry contacts and financial strength of Ship Finance make the company

a go-to source for the financing of the most expensive vessels on the market. For

example, last June the company structured the purchase of a $600 million jack-up

drilling rig with a 15-year lease back to the selling company. The rig is being modified in

Norway and is expected to return to operation in May 2014. Over the term of the

contract, Ship Finance will earn 15% per year on the invested equity.

Cash Flow to Ensure Steady Dividend Payments

Ship Finance may be the poster child of cash flow analysis compared to the traditional

net income per share to determine the safety and potential dividend payments. Over

the last four quarters, SFL has reported net income per share of $0.20, $044, $0.24,

$0.37. Over the same period the dividends paid were $0.41, $0.41, $0.41 and $0.42 per

share. So you have net income of $1.25 per share and $1.65 per share was paid in

dividends.

There are several reasons why Ship Finance can pay this level of dividends:

A large portion of Ship Finance's charter business falls under the capital lease

classification and payments on the leases are booked as "repayment of investment to

finance leases, results in associates and long-term investments, and the interest income

from associates". As a result, the earnings from the leases do not fall directly to the

bottom line net income.


Also, as an owner of assets, Ship Finance will book a non-cash depreciation charge every

quarter. This expense currently runs at about $60 million per year, which is $0.75 per

share that does not show up on the net income line.

To get a firm handle on Ship Finance's true ability to pay dividends, we start with the

earnings before interest, tax, depreciation and amortization (EBITDA).

Since quarterly results can vary with the sale or disposition of vessels, it is better to look

at a full year's worth of cash flow.

In 2014, Ship Finance generated EBITDA of $553 million. Interest payments totaled $121

million, and since it is domiciled in Bermuda, the company pays no income tax. In

addition, for 2014 $234 million was paid to amortize loan balances. Subtract the real

cash payments from EBITDA and the remaining free cash flow is $198 million. Ship

Finance has about 79 million shares outstanding, so the cash required to pay last year's

dividends was $130 million. Even though the reported net income was less than the

dividend, the actual cash flow was enough to cover the dividends by a factor of 1.5

times.

2015 To Be a Year of Cash Flow Growth

The cash flow analysis above is pretty much how the results have come in for Ship

Finance for the last several years. Before a $0.40 dividend paid in June 2014, the

distribution rate had been at $0.39 for 10 of the previous 11 quarters. However, 2015 is

shaping up to be the year when Ship Finance returns to a practice of steadier dividend

growth.


During 2013, over $1 billion was invested to add to the company's fleet. The cash flows

for those investments have started to have a meaningful impact. The dividend has been

increased for two of the last three quarters.

A potential additional source of distributable cash is profit sharing payments from

Frontline. In late 2011, Ship Finance and Frontline restructured the lease agreements on

the tankers owned by SFL. Frontline received some lease rate relief in exchange for an

up-front cash payment and new, lower profit sharing thresholds based on the earnings

rates per day generated by the tankers. In the first quarter of 2015, tanker rates have

finally moved up to levels that will generate profit share payments from Frontline to

Ship Finance. These payments have the potential to add between 20 and 40 cents per

share to the free cash flow available to pay to share owners.

Potential dangers for investors would be if any of the Ship Finance customers ran into

financial troubles and were not able to make lease payments. The board of directors has

shown in the past that it is not afraid to temporarily reduce the dividend rate of current

and forecast cash flow are determined to not be high enough to support the dividend

rate. For example, when Frontline got into trouble in 2011, the SFL dividend was

reduced to $0.30 from $0.39 for one quarter until the situation was worked out with the

tanker company.

High Yield Stability with Potential for Growth

At the current $14.90 per share (as of publishing) and the $0.42 quarterly dividend, SFL

yields 11.25%.

The SFL share price tends to be quite volatile, swinging by $1 to $3 per share several

times a year. You can clearly see this in the following chart.


While we have this stock as a strong BUY for income investors, you may be able to get a

lower average cost by spreading out your total investment into three or four parts and

investing on the dips. I have no trouble recommending SFL at the current share price,

but dips below $14.50 are definite buy opportunities.

This recommendation is not dependent on future dividend increases, but if the

distribution rate does go up during the year, it is unlikely that SFL will see the underside

of $15 again. When the market realizes that SFL is starting to grow its dividend, the

share price will be bid up to push the yield down to a range of 7.5% to 8%, which means

a share price above $21.

Recommendation: Buy up to $16.00 for a minimum yield of 10.5%.


Ares Capital Corporation (Nasdaq: ARCC) New York, NY

www.arescapitalcorp.com

Last: $17.14


Market Sector: Commercial Financial Services

Ares Capital Corporation (ARCC)

Ares Captial is organized under special tax

rules as a business development company

(BDC). The laws governing a BDC require the

company to focus its business on providing

debt and equity financing for small to mid-

sized corporations. Think of a BDC as a

combination of a venture capital firm and a

business bank. If the company meets the tax code requirement to pay out 90% of net

income as dividends to investors, a BDC does not pay corporate income taxes, reducing

by one big one (the 35% corporate tax rate), a level where the government can suck

away investment earnings.

Of the two dozen BDCs, Ares Capital stands out as the largest, with a $5.2 billion market

cap. The large size allows the company to diversify its portfolio, and at the end of 2014

Ares Capital carried debt or equity contracts with 205 different companies. Ares

provides a range of financing options and the year-end portfolio consisted of 41% first

lien senior secured loans, 21% second lien senior secured loans, 23% of the company's

pooled senior secured loan program, 6% senior subordinated debt, and the remaining

9% was preferred and other equity positions. The bottom line is that Ares Capital is the

senior lender on 80% of the securities in its portfolio, putting it first in line if one of the

client companies runs into financial difficulty.

Why we like ARCC

Ares Capital combines the high-yield, pass-through tax characteristics, safety of the

dividend, and distribution growth that are the cornerstones of the investments selected

for The Dividend Hunter portfolio and integral to winning the war on your income. A

dividend has been paid every quarter since the company's initial public offering in 2004.

In 2009, when many BDCs ran into serious financial difficulty and suspended dividend

payments, Ares Capital reduced its dividend to $0.38 from $0.42, maintaining a high

payout to investors. The current quarterly rate of $0.38 per share has been paid since

mid-2012. However, four bonus dividends totaling $0.20 per share have also been paid

out over the last two years.

With a high-yield, high-payout stock investment, an important analysis check is to see if

the company has the required free cash flow to cover and maintain the dividend rate. In

2014 Ares Capital generated net investment income of $1.94 per share, covering the

dividend payments by 124%. ARCC has a current yield of 9.8% and investors can expect

slow to moderate growth in the dividend payments. The slower growth rate is

compensated for with the high current yield and bonus dividend payments.

Investment hint: ARCC has a historical tendency to fall by several percent points after

each dividend payment and then recover by the next earnings report. Timely share


purchases can lower your average cost of ownership. Try to get in after the share price

dips after the dividend is paid out. ARCC has typically paid dividends between the 11th

and 13th of the months in March, June, September, and December.

Recommendation: Buy up to $18.00 for an 8.5% yield.


W.P. Carey, Inc. (NYSE: WPC) New York, NY

www.wpcarey.com

Last: $68.72


Market Sector: Financial, REIT - Diversified

W.P. Carey, Inc. (WPC)

Real estate investment trust (REIT) is

another type of business tax organization

choice that allows a company to avoid the

corporate tax bite in exchange for paying out

90% of net income to investors.

As the classification implies, REITs own real

estate assets, with different REITs typically

focusing on just one type of commercial real estate, such as shopping centers,

apartment buildings, office building, or industrial space. W.P. Carey is classified as a

triple-net (NNN) REIT. Long term lease contracts with built-in rent increases and a

customer base of clients who take whole properties are what set NNN REITs apart. This

category or REITs also often owns real estate across a range of property types.

Started in 1973, W.P. Carey has grown into a company with a $7.3 billion market cap

and a property portfolio valued at over $15 billion. The company stands out due to its

diversified asset base; owning office, industrial, warehouse, distribution and retail

properties. As of the end of 2014, the company owned 783 properties with 219 different

tenants. Geographically, properties are located in 45 states and 10 European countries.

W.P. Carey also has a significant fee generation business as a manager of non-traded

REIT companies. Over the last two years, W.P. Carey has merged with two of the non-

traded REITs it managed, bringing immediate, additional value to WPC shareholders.

Why we like WPC

The standout feature of W.P. Carey as an investment is the company's long history of

dividend growth. The dividend rate has been increased every year since the company

went public in 1998. The current dividend rate is just 85% of the cash flow available,

called funds from operations (FFO) in REIT jargon. Going forward, the company will

generate growth through property acquisitions and built in rent increases. 98% of W.P.

Carey's lease contracts include some type of annual rent escalator.

Approximately one-third of the company's properties are in Europe, which provides

diversification away from the U.S. commercial real estate market. There is a much lower

level of competition in Europe, which allows W.P. Carey to generate higher profit

margins on its European acquisitions.

WPC currently yields just under 6% and that cash return will just continue to grow as the

company increases the dividend year after year.

Recommendation: Buy up to $70.50 to lock in a minimum 5.4% yield.


Plains All American Pipeline (NYSE: PAA) Houston, TX

www.paalp.com

Last: $49.06


Market Sector: Materials, Oil & Gas Pipelines

Plains All American Pipeline (PAA)

Master limited partnerships (MLP) are a

third type of pass-through structure that

allows a company to pay less in taxes and

more to investors. Investors in an MLP are

technically limited partners who own units

and receive partnership distributions.

However, MLP units trade just like stock

shares on the stock exchange and you can buy and sell shares exactly the same.

The difference between LP and stock share investing is the tax consequences. The

distributions you earn from an MLP like Plains All American Pipeline are classified as tax-

free return of capital. At the end of the year you receive a Schedule K-1 that lists your

share of the company's profits to claim on your tax return. An MLP like Plains All

American Pipeline is constantly adding and upgrading to its energy transportation

network, which provides large amounts of tax sheltering depreciation. The tax burden of

MLP ownership often works out to much less than the taxes you would pay on a stock

paying taxable dividends.

With a market cap of $20 billion, Plains All American Pipeline is one of the largest MLP

and infrastructure companies in the U.S. The company owns an extensive portfolio of

energy transport and storage facilities and equipment including:

18,150 miles of crude oil and fuels pipelines

120 million barrels of liquids storage

97 billion cubic feet of natural gas storage

Facilities to handle 235,000 barrels per day of energy liquids fractionation

8.5 billion cubic feet per day of natural gas processing capacity

24 crude oil and natural gas liquids rail facilities

7,400 crude and NGL railcars

840 truck tractors and 1,700 liquids trailers

60 tug boats and 130 barges

Plains All American Pipeline puts these assets to work using long term, fee-based

contracts. The company generates three-quarters of its annual revenues from the

transportation and storage of crude oil. Fee-based business also accounts for about 75%

of revenues. The remaining quarter of the company's revenues come from the supply

and logistics services provided with trucks, trailers and railcars. This portion generates

earnings from a combination of fees and margins generated by buying oil in one region

and selling for higher prices at the other end of the transport.


As an MLP, Plains All American Pipeline offers an infrastructure investment that pays an

attractive distribution yield with steady year-over-year growth in the distribution rate

per unit. With the U.S. Energy Information Agency forecasting 20-plus years of future

growth in domestic oil and gas production, this company fills the very important need to

move crude oil from the drilling regions to the refineries. Plains All American Pipelines

also provides pipeline transport of crude oil from Canada to the U.S. refineries. If the

Keystone XL pipeline is approved and built, it will be years before the pipeline competes

with Plains and projected growth in Canada's oil production will more than take up the

extra capacity.

Why We Like PAA

This MLP offers a conservative way for investors to get started with MLP investing. The

company provides the combination of an attractive yield, steady and even more

attractive distribution growth, and a conservative management philosophy.

PAA currently yields 5.5% and has increased the distributions paid to unit holders by a

compounded 8.4% over the last 10 years. For the next couple of years, PAA

management has provided guidance of 10% distribution growth per year. In 2014, the

company generated enough free cash flow to cover the distributions by 1.3 times, so

you can count on an 8% to 10% increase. A steadily growing distribution will result in a

share price that also increases over time. As a result, you can expect an average annual

total return of about 15% from PAA, and a large portion of that return will be tax-

advantaged cash distributions into your brokerage account cash balance.

Recommendation: Buy up to $51.40 for a 5.25% and growing yield.

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All data, including equity prices and yields current as of when this report was published.

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