Chevron Corporation (CVX), BP plc (ADR) (BP): Adding Oil To The Ultimate Dividend Growth Portfolio

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Big oil companies are known for being reliable dividend stocks, but are they also good dividend growth stocks? So far my Ultimate Dividend Growth Portfolio is void of any energy companies, so today I’ll add two. I’ll also add a non-oil stock to the portfolio, and this will bring the total number of positions up to 17.

Chevron Corporation (NYSE:CVX) Chevron Corporation (NYSE:CVX)

Chevron is not the largest oil company, with a market capitalization of $230 billion which pales in comparison to Exxon Mobil Corporation (NYSE:XOM)’s nearly $400 billion. But Chevron offers a superior dividend, currently yielding 3.33% after an 11% increase starting with the payment going ex-div on May 15. Luckily, Chevron Corporation (NYSE:CVX) is being added to the portfolio just in time to receive this dividend payment.

Chevron’s dividend growth has been steady over the past decade, with an increase every year including during the financial crisis. The dividend has grown at an annualized rate of 10.5% since 2003 as the EPS has grown at a faster 16% annualized rate. If this kind of dividend growth continues into the future the 3.33% yield makes this stock an ideal dividend growth stock.

There is a little reason for concern, however. While the payout ratio with respect to net income is extremely low, about 26% in 2012, the dividend ate up 86% of the free cash flow. This was due largely to an increase in capital expenditures and a slight decline in the operating cash flow. Capital expenditures are expected to increase even further next year, rising to $36.7 billion from $30.9 billion in 2012.

For the last few years capital expenditures has been increasing at a much faster rate than the operating cash flow, and this could cause the company to slow the dividend growth. Presumably the investments being made haven’t fully paid off yet, so hopefully we’ll see increases in operating cash flows in the coming years. One positive point is that the company has $17.3 billion in cash and just $14 billion in debt, so there is plenty of cash to pay the dividend if the cash flow remains pressured.

I think it’s reasonable to believe that Chevron Corporation (NYSE:CVX) can raise the dividend roughly in line with past growth rates, plenty fast to justify inclusion in The Ultimate Dividend Growth Portfolio. Based on the current market price I’ll add 41 shares of Chevron to the portfolio with a total cost basis of $4,931.07. The projected annual dividend income from this position based on the upcoming $1 per share quarterly dividend is $164.

BP plc (ADR) (NYSE:BP)

BP is smaller than Chevron Corporation (NYSE:CVX), with a market capitalization of just $138 billion. After the Deepwater Horizon oil spill in 2010 BP plc (ADR) (NYSE:BP) slashed its dividend dramatically. The company went from paying $3.36 per share in 2009 to just $0.84 per share in 2010. Since then the dividend has regained some ground, with the 2012 payment totaling $1.98. Between 2003 and 2009 the dividend grew at an annualized rate of 14%.

The current dividend gives BP plc (ADR) (NYSE:BP) an astounding yield of 4.99%. Dividend growth doesn’t need to be all that fast to justify the investment with this high of a yield, so we have a bit of a buffer against slower future growth. BP plc (ADR) (NYSE:BP) has a problem similar to Chevron Corporation (NYSE:CVX), though: high capital expenditures. In 2012 capital expenditures actually exceeded the operating cash flow, which is concerning. The payout ratio in 2012 with respect to net income was 54% after a dramatic drop in net income from the year before.

The big selling point here is the yield. BP plc (ADR) (NYSE:BP) expects to increase its operating cash flow by 50% by 2014 along with spending between $24 and $27 billion on capital expenditures. This should bring the free cash flow into positive territory, but the company will still sport a high payout ratio with respect to that free cash flow.

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