When you are dealing with the bluest of the blue chips that have well-earned pedigrees of raising dividends for decades and displaying a firm commitment to putting more and more money into the pockets of shareholders on an annual basis, an informal social contract has tended to emerge from those expectations. And that is this: in good times, the dividend growth rate will tend to be slower than the earnings per share growth rate. However, during periods of sustained economic depression, the dividend growth rate will likely be greater than the earnings per share growth rate.
This has to do with the kind of investor class that the top-quality American stocks tend to attract. Generally, conservative blue-chip investors prefer not only regular dividend growth from their highest-quality holdings, but consistency in the type of dividend growth offered as well. And although Procter & Gamble (PG) has a twenty-five year dividend growth rate of 10.85%, it seems likely that the next five years will offer owners an incremental downshift towards 6-7% annual dividend growth.
For extended periods of Procter & Gamble's late 20th and early 21st century business history, it was able to offer dividend growth of the 10% variety because it was growing earnings by nearly that much, or had a low payout ratio that gave the company wiggle room to give shareholders a nice raise even when the short-term business performance did not justify it.
Take a look at a couple of examples that demonstrate the increasing tendency for Procter & Gamble's dividend to speak for an ever-growing chunk of the company's overall profits:
In 1997, Procter & Gamble was generating $1.14 in profits while only sending $0.45 of them to the pockets of shareholders. The dividend only spoke for $0.39 of every dollar the household care giant generated in profits.
This "safe" trend largely continued through the early years of the millennium. By 2003, Procter & Gamble had grown those $1.14 in profits per share to $2.04, and the dividend had almost doubled, coming in at $0.82 per share. Still, the dividend was only now speaking for 40 cents on every dollar of profit, indicating a dividend growth rate in line with earnings per share growth, and great room for the company's management team to use retained profits to focus on growth.
But then the Great Recession came, and Procter & Gamble demonstrated its blue-chip resiliency by giving investors sizable, annual increases to feel confident with their investment selection while the general investing public was preoccupied with bank failures, rising unemployment, escalating war costs, and deficits last seen during the Roosevelt administration when the nation was warding off the encroachment of two ne'er-do-well regimes.
To put it in specific terms: Procter & Gamble paid out $1.28 in dividends in 2007, $1.48 in 2008, $1.64 in 2009, and $1.80 in 2010. Given the global economic headwinds at the time, P&G's dividend performance was beautiful.
But that beauty came at the price of an elevated payout ratio. At the onset of the recession, P&G was only paying out 42% of its profits to shareholders (using end of 2007 figures). Now, Procter & Gamble has a commitment to pay shareholders $2.406 in annual dividends (since there are only so many places in the world that deal in half pennies, we'll round that up to $2.41). But right now, Procter & Gamble is pumping out $3.94 in total profits. Now, the company has 61% of its profits taken up by the dividend, and the company now finds itself carrying $31.5 billion worth of debt.
Is this hazardous to Procter & Gamble's long-term viability as a profitable enterprise? Absolutely not.
Is the company still on my list of top ten firms with the highest earnings quality in the world? Yes.
Why do I say that? Because these products generate over $1 billion in sales each year, in over 180 countries total: Ariel (laundry detergent), Bounty, Braun, Charmin, Crest, Dawn, Downy, Duracell, Febreze, Fusion, Gain, Gillette, Head & Shoulders, Iams, Innova (cat foot), Lenor (fabric softener), Olay, Oral-B, Pampers, Pantene, Sk-II (beauty), Tide, Vicks (medicine), and Wella (hair care).
Those are well-branded, recession-resistant subsidiaries that make Procter & Gamble one of the few companies you can put in that vaunted "hold until I die" category with the reasonable probability that P&G's dividends will be there to take care of your kids, grandkids, and so on, until the gene pool gets diluted and Freddy, who somehow married into the family, convinces everyone else that it is time to roast the golden goose for a tasty final meal in the form of a large one-time windfall.
Despite the excellent quality of the company, we need to be honest in our appraisal of the company's dividend growth over the next five years or so. Procter & Gamble's management team is probably going to want to move the payout ratio in the direction of 50% rather than 75% so that they may hold on to retained earnings for growth and have the flexibility to be as generous in raising the dividend during the next recession as the previous one. Those factors combine to give us the indication that the medium-term dividend growth rate will be lower than the earnings per share growth rate.
And there is very little to indicate that P&G is currently poised for anything resembling its historical 10% earnings per share growth rate. Right now, P&G's management is calling for 6-7% annual earnings growth. Sales are growing by 2%, and the company's cost-containment plan probably hasn't materialized considering that employee costs are currently increasing rather than decreasing. The volume losses have stopped, but that is because P&G has stopped raising the prices of most of its products.
Here are the big picture conclusions with Procter & Gamble's dividend: The company's earnings power and wildly diverse stream of profits make it as stable as it has ever been. But high dividend growth above 7% annually for the next five years isn't going to be there, because the company has to contend with only 2% sales growth, $31.5 billion in debt, moderately negative currency fluctuations, organic growth of only 3.8%, and a payout ratio of 60% that will hopefully decline so that the company will enter the next economic recession from a position of economic strength similar to 2007. When you combine the high earnings quality with the lower expected growth, the wise course of action is to hold the shares you already have, but wait for a significant drop of over 15% before adding to your position.