Coca-Cola (NYSE:KO) enjoys a well-deserved reputation around the world as one of the most valuable brands to ever exist. In addition, its immense, long-lived success has ostensibly made many millionaires who invested in the stock and held for the long term. Part of the returns that these shareholders received were in the form of cash dividends that KO has been increasing now for fifty years. Indeed, with Treasuries paying a pittance in interest thanks to the Federal Reserve's endless quantitative easing efforts, I wager that many investors in KO shares buy it at least mainly for the dividend. With this in mind and KO's sterling reputation as a Gibraltar among dividend payers, it seems fair to me that we should assess the relative safety of KO's dividends. After all, a great yield is meaningless if the company can no longer afford it.
First, the most basic measure that is cited in financial media for dividend safety is the payout ratio. Simply put, it is the amount of money a company pays in dividends divided by the company's net income; Coke's is below.
What we see here looks like terrific news for shareholders. KO hasn't exceeded about 60% in terms of its payout ratio for the past six years. In fact, last year, that number was right at 50%. From this we can infer that KO is earning roughly double its dividend payments in net income each year. This is well within the range of what dividend investors would consider "safe" and includes some cushion for dividend raises in the future. However, I would argue that the payout ratio is a virtually pointless metric as companies do not make dividend payments with "earnings" as defined by GAAP. Net income is simply an accounting metric that helps investors get a complete picture of its financial performance for the year and is also handy for getting tax deductions. However, net income is not a cash flow and as such, comparing it to dividend payments is meaningless. Instead, we can compare dividend payments with the company's operating and investing cash flows.
Operating cash flows are those that the company's assets produce while conducting business. Investing cash flows are those that are produced (or used) in acquiring those assets. Therefore, it can be inferred that the operating cash flows of a company minus its investing cash flows would produce a pretty good estimate of how much cash a company produces from its assets and uses to acquire those assets during the normal course of business. It is with this cash that a company then can pay dividends.
This graph shows the amount of operating cash flow KO produced minus its investing cash flow in relation to its reported GAAP net income. What we see here is pretty interesting as, without exception, KO's net income is higher than cash flows. It should be pretty obvious how this could potentially be a problem but this provides a bit more clarity as to just how KO's payout ratio is so low. In fact, due to heavy investments, KO's cash flow (as measured here) was negative last year while the company reported over $9 billion in net income.
Next, we'll take a look at my cash flow calculation in relation to the amount of dividends KO pays each year.
This graph shows that in 2007 and last year, KO's cash flows were nowhere near enough to cover even the dividend payments. In 2009, the totals were about even and in the other three years, KO's strong cash flows provided more than enough to pay the dividend. The only problem is that dividends are not the only cash needs the company has and as a result, KO has been issuing debt in order to finance its operations.
Coke is a perennial issuer of debt and after examining its cash flows, it is quite apparent why that is.
This graph shows the total amount of cash the company produced each year, by my measure of cash flow, including net new debt issuances. It is important to note that KO has issued far more debt than this graph would suggest but the company also pays some of it back each year; we are simply looking at net new debt here. If we look at 2007, for instance, KO's cash flow was meaningless but the company issued $4.3 billion in new debt to finance its operations. 2008 saw virtually no new net debt and interestingly enough, 2011 and 2012 saw an enormous amount of new debt issued by KO. The company's cash flow was negative last year and it issued over $4 billion of new net debt again to finance operations, buybacks, dividend payments and the like.
With this information, we can now examine the amount of dividends Coke has paid over the past six years in relation to the amount of net debt it has issued.
We see some interesting things here and although the relationship is erratic, we can see a clear correlation in the past two years between the amount of new debt that Coke has taken on in relation to its dividend payments to shareholders. In fact, in the past two years, KO has issued $9.2 billion in new debt while paying $8.9 billion in cash dividends. I'm not suggesting without doubt that KO is financing its dividend payments with debt as only the Board of Directors knows for sure, but what I am suggesting is that it appears to this investor that KO is unable to produce enough cash for its ever-growing dividend.
Finally, given the information we've reviewed here, I think it is appropriate to show KO's payout ratio that is oft-quoted as being a measure of dividend safety versus my measure of cash flow in relation to dividend payments.
First, the two boxes I drew in are because the values for 2007 and 2012 were such outliers that it made the graph incomprehensible. In 2007, KO paid out 731% of its cash generated from operating its business and in 2012 we saw that cash flow was negative so the number is meaningless at -605%. The point is that even when the numbers are meaningful, we can see that KO's dividend payments versus cash flow are higher than its payout ratio without exception. This should be alarming to KO investors as, once again, the company cannot pay dividends with "earnings"; rather, they must be paid in cash the business generates. In KO's case, it appears the dividend may have gotten ahead of the cash-generating abilities of the business.
Nobody wants to be the CEO of Coca-Cola when the dividend increases finally stop so I don't blame the Board and Muhtar Kent for issuing debt to continue to increase the dividend. However, at some point, something will give in this relationship; either the company will finally generate enough cash to fund the dividend and the company's operations or the dividend increases will need to stop until the business catches up.
Coke is valued primarily on its dividend yield, currently sitting at about 2.7%. By many fundamental metrics, including the venerable P/E ratio, Coke shares are expensive for a company that barely grows each year. In addition to that, the stock is trading within a hair of its all-time highs set during the dot com craze. I respect this business as it is a great American success story that has been very profitable for shareholders for decades. However, when a business cannot support its dividend payments and the company borrows to keep the streak of increases alive, I see a red flag. If you decide you want to own KO shares, please just be aware of the risk that the shine will come off of the shares one day if the increases do stop due to cash generation concerns. No one can predict when this might happen but for a company that only has $16.5 billion in cash and equivalents, issuing another $4.5 billion per year in new net debt seems a bit unsustainable.
In addition, since KO is paying roughly $400 million per year in interest expense to fund this debt, applying KO's forward multiple of 18 to this wasted money means that KO shares are giving up roughly $7.2 billion in market value. This equates to roughly 4% of the share price today meaning that KO's 2.7% dividend isn't enough to make up for the capital gains that have been forgone due to lower net income as a result of interest expense. In addition, as KO borrows more and more each year, the haircut the stock takes in terms of lower price will become greater and greater. While this may not matter to some investors who simply use KO shares as a bond-equivalent, it does matter to other investors and it should be taken into consideration.
The bottom line is that with shares trading at their all-time highs and a precarious situation with the dividend increases, I would be cautious with Coke shares here. I'm not suggesting that a dividend cut is imminent but I am also not suggesting that KO will be able to continue its dividend increases indefinitely. If blue chip investors of Coke stock knew that their beloved dividends were from borrowed money, it may tempt them to look elsewhere for yield. Finally, KO's forward P/E of 18 for a company that doesn't grow more than a couple of percent per year is a joke and yet another piece of evidence that KO shares are probably overvalued.