When determining whether or not to buy an ownership interest in a certain company, there are a number of things that are often considered. Such things include the durability of the company's business model, the company's balance sheet, valuation, and historical earnings growth.
Another important consideration for many investors is the strength and sustainability of the dividend that the company pays out. Dividends are very important, as they accounted for about 42% of the total return of the S&P 500 from 1930 to 2012. The portfolios of many dividend-oriented investors are composed of dozens of dividend-paying stocks from a wide variety of sectors.
In today's article, I will delve into the consumer goods sector with a look at the dividends from three of the biggest companies in that space. They are Coca-Cola (NYSE:KO), PepsiCo (NYSE:PEP), and Dr. Pepper Snapple (NYSE:DPS). These are all companies that operate in the non-alcoholic beverages industry, while PepsiCo also operates in the snack foods arena. I will examine the important aspects of each company's dividend, such as the dividend's history, whether or not the dividend can be covered by the company's earnings, and look for clues as to whether the company can continue paying out and growing their dividends going forward.
Many seasoned investors will look at these companies and say that this article is akin to determining whether Michael Jordan was a great basketball player. There may be some truth to that, but the main idea of this article is to provide a framework by which an investor can determine what company in a given sector has the strongest and most sustainable dividend in the event that the investor can only choose one from the group.
Usually, the first and most obvious consideration when analyzing a company's dividend is the dividend yield, which represents the percentage of your original investment that you will get back over the next 12 months, provided that the dividend does not change during that period. Let's compare the dividend yields of the three companies.
|Dr. Pepper Snapple||3.2%|
Table 1: Dividend Yields Of Coca-Cola, PepsiCo, and Dr. Pepper Snapple
The dividend yields shown in Table 1 reflect the recent dividend increases by all three companies. It should be noted that PepsiCo's increase takes effect in June. So, these yields are forward yields, not trailing yields.
Many investors will use a company's historical dividend yield, along with other metrics like historical P/E ratios, as a way to help determine if a stock is cheap or expensive. According to data from YCharts, the last time Coca-Cola's dividend yield was this high was in July 2010, three and a half years ago. PepsiCo's dividend yield is at its highest level since March 2012, nearly two years ago. Over the last 12 months, the dividend yield of Dr. Pepper Snapple has ranged between 2.8% and 3.4%.
When it comes to dividend yield, there is no clear winner here, but some may argue that Coca-Cola and PepsiCo are both very attractive right now because their dividend yields are the highest that they have been in a long time.
When evaluating the quality of a company's dividend, there is more to it than just the yield. Sometimes, a company's stock may have a high yield due to poor fundamentals that have caused the price of the stock to fall relative to its dividend payout. These poor fundamentals could then lead to dividend cuts, which can then lead to a drop in your net worth.
Dividend growth is another very important factor. For one, dividend growth helps to preserve the purchasing power of your income stream by protecting it against inflation. Secondly, when a company increases its dividend that is a sign of confidence by management when it comes to the company's fundamentals and future outlook. And third, growing dividends allow investors to share in the benefits of growing earnings. It should also be mentioned that dividend growth can supercharge an investor's yield on cost over the years. For instance, Warren Buffett and Berkshire Hathaway (NYSE:BRK.A) received a whopping 40% yield on cost in 2012 on shares of Coca-Cola that were purchased back in 1988. This is due to the dividends that grew almost fourteen-fold since the purchase.
Let's take a look at the dividend growth rates over the last 5 years of our three consumer goods stocks. The numbers in the table represent the average dividend growth rate over the last five years.
|Dr. Pepper Snapple||16.5%|
Table 2: Five-Year Dividend Growth Rates Of Coca-Cola, PepsiCo, and Dr. Pepper Snapple
It should be mentioned before I proceed further that Coca-Cola and PepsiCo both belong to the list of S&P 500 Dividend Aristocrats, an elite group of stocks that have increased their dividends for at least 25 consecutive years.
While the dividend growth rates of all three of these companies are impressive and easily outpacing inflation, Dr. Pepper Snapple has the highest rate of dividend growth. Dr. Pepper Snapple has increased its dividend in each of the last 5 years since its spinoff in 2008. These numbers are skewed a bit due to the company increasing its dividend by a whopping 34% between 2010 and 2011. Since then, the company's dividend increases have gotten progressively smaller. The company's most recent dividend increase was 7.9%, announced earlier this month. That's more inline with the 5-year averages of the other two companies.
Coca-Cola's dividend growth over the last 5 years has been the most consistent, averaging 8.3% over that time. Over the last five years, annual dividend increases have ranged between 7% and 10%. Last week, they announced an 8.9% increase. That increase marks the 52nd straight year that the company has increased its dividend.
PepsiCo has also been strong in this area. The company recently announced a 15% increase in its dividend, to be paid out in June. However, this is quite a jump from the 4-7% increases that we have seen from the company in the years leading up until now. PepsiCo has increased its dividend now for 42 straight years.
These are all impressive numbers and serve as testaments to the strong business models and long-term earnings growth of these three companies. While Dr. Pepper Snapple has the highest trailing 5-year dividend growth rate, I would say that Coca-Cola's dividend growth record looks the best in terms of strength and consistency.
Dividend Payout Ratio
In many cases, it's not enough to only look at the dividend yield and the historical dividend growth rates of the stock in question. We need to make sure that the company is making enough money to support these dividend payments. This is where the dividend payout ratio comes into play. It represents the percentage of profits that the company has been allocating toward dividend payments, as opposed to being used for buying back stock or reinvesting into the company's operations. Generally speaking, the lower the payout ratio, the better. This is because lower payout ratios often indicate that there is plenty of room left for dividend increases in the future. Payout ratios that approach or even exceed 100% may indicate dividend freezes or cuts in the future.
Table 3 shows the trailing twelve-month payout ratios, as well as the average payout ratios over the last four years for Coca-Cola, PepsiCo, and Dr. Pepper Snapple. These percentages are based on core earnings (non-GAAP).
|Dr. Pepper Snapple||46.1%||41.5%|
Table 3: Dividend Payout Ratios Of Coca-Cola, PepsiCo, and Dr. Pepper Snapple
From looking at Table 3, none of the dividend payments of our three companies appears to be in any sort of danger. The payout ratios over the last twelve months have expanded a little bit for each company versus the 4-year averages.
While all of these payout ratios are very good, Dr. Pepper Snapple has the lowest of the three.
But What About Free Cash Flow?
What we just did above was analyze the safety of the dividends relative to the company's earnings. However, earnings don't pay dividends, cash does. And, earnings can include a lot of non-cash items (like depreciation, amortization of patents, asset writedowns, actuarial gains on pension plans, etc.) that can distort one's perception as to the safety of a company's dividend. For this reason, a more accurate measure of determining a company's ability to pay its dividends is the payout ratio as a percentage of free cash flow. In other words, what percentage of actual cash that comes in over the course of a 12-month period gets paid out to shareholders?
Table 4 shows the free cash flow payout ratios of our three companies over the last 12 months, as well as the four-year averages. Note that free cash flow is calculated as operating cash flow minus capital expenditures.
|Dr. Pepper Snapple||44.0%||51.4%|
Table 4: Free Cash Flow Payout Ratios Of Coca-Cola, PepsiCo, and Dr. Pepper Snapple
Table 4, like Table 3, shows that the current dividends of each company are well-supported. Coca-Cola has the highest free cash flow payout ratio of the three, but it's still healthy. PepsiCo's free cash flow payout ratio is lower than what it has averaged over the last four years. It will be interesting to see how this figure changes later on, after its 15% dividend increase factors in. Dr. Pepper Snapple has the lowest of the three, both on a trailing 12-month and 4-year average basis.
Other Tools To Predict Dividend Sustainability Going Forward
Many investors would stop at this point and vote yea or nay as to whether or not the dividends of the company in question are of good enough quality. And that's fair enough. However, what we have done so far is look at past dividend and cash flow data. Aside from what we have done so far, there are some other tools that we can employ in order to evaluate the ability of our three companies to pay out increasing dividends in the future.
Interest Coverage Ratio
The interest coverage ratio is simply the company's earnings before interest and taxes [EBIT] divided by the company's interest payments during the time period in question. This ratio shows whether a company can generate enough money to cover its interest payments, which must be made before any dividends can be paid out. The higher this ratio, the better. If the company is paying an exorbitant amount of interest relative to its pre-tax profits (a low interest coverage ratio), then that doesn't leave much room for dividends, which may be indicative of dividend cuts in the future. For this reason, dividend investors like to see high interest coverage ratios.
Table 5 shows the interest coverage ratios of Coca-Cola, PepsiCo, and Dr. Pepper Snapple over the last 12 months.
|Dr. Pepper Snapple||8.5|
Table 5: Interest Coverage Ratios Of Coca-Cola, PepsiCo, and Dr. Pepper Snapple
From Table 5, we see that all three companies exhibit very healthy interest coverage ratios. At this point in time, interest obligations should not interfere with the dividend payments from either company. While PepsiCo and Dr. Pepper Snapple look very good in this area, Coca-Cola steals the show. Their interest coverage ratio is defined here as infinite, as during the last several years, Coca-Cola has received more in interest than it has paid in interest. Last year, Coca-Cola received a net $71M in interest income. So, while PepsiCo and Dr. Pepper Snapple are spending money on interest, Coca-Cola is making money on it. That's not a bad position to be in.
Net Debt To Equity Ratio
The net debt to equity ratio is also very important. The amount of debt not only influences the amount of interest that must be paid, but also, the amount of debt that at some point will need to be repaid. Right now, a lot of companies are choosing to refinance their debt due to the presence of very low interest rates, as opposed to paying it off. However, if and when interest rates go higher, refinancing may be a less attractive option. As a result, extinguishing debt may have an effect on future dividend payments.
The net debt to equity ratio is calculated by dividing the net debt by the company's equity position. Net debt is simply the combination of short and long-term debt minus the company's cash position. The lower this ratio, the better. Ratios typically below one are considered to be good. Table 6 shows the values of these ratios for our three companies.
|Dr. Pepper Snapple||1.06|
Table 6: Net Debt To Equity Ratios of Coca-Cola, PepsiCo, and Dr. Pepper Snapple
Table 6 shows that both Coca-Cola and PepsiCo are in really fine shape when it comes to their debt and equity positions, with Coca-Cola having the lowest net debt to equity ratio. Dr. Pepper Snapple is the highest of the three, but by no means in terrible shape.
Earnings Per Share Growth Forecasts
While dividend growth can be achieved to some extent through the expansion of the payout ratio, ultimately there must be free cash flow growth in order for there to be long-term dividend growth. And, free cash flow growth stems largely from earnings growth. In order to get a better idea as to whether the company can sustain growing dividends going forward, you may want to consider analyst projections for earnings growth over the next couple of years. Table 7 shows earnings per share growth estimates for all three companies from the analysts at S&P Capital IQ. The estimates are for fiscal 2014 and 2015.
|Dr. Pepper Snapple||10%||6%|
Table 7: Earnings Per Share Growth Forecasts For Coca-Cola, PepsiCo, And Dr. Pepper Snapple
The earnings per share growth forecasts for all three companies look very respectable, with both PepsiCo and Dr. Pepper Snapple expected to average 8% earnings per share growth over the next two years. Coca-Cola also has a nice forecast with 7% expected annual growth. Keep in mind that earnings per share growth can be fueled by stock buybacks as well as by cost cuts and revenue increases. When shares are repurchased, the same amount of money that's allocated for dividends will be divided among fewer shares, resulting in per-share dividend increases, without actually having spent more money on dividends.
In this article, we have analyzed the dividend strength of Coca-Cola, PepsiCo, and Dr. Pepper Snapple by looking at a number of factors, including the dividend yield, dividend growth rates, payout ratios, interest coverage ratios, net debt to equity ratios, and analyst estimates for earnings per share growth. From looking at all of these items, it can be said that none of the dividends from these three companies appear to be in any kind of danger at this point in time.
Dr. Pepper Snapple has the lowest payout ratio of the three companies, both on an earnings and free cash flow basis. With dividends accounting for just 44% of the company's 2013 free cash flow, investors should continue to expect robust dividend growth going forward, provided that the company can continue its record of free cash flow generation.
Coca-Cola has the strongest and most consistent record of dividend growth. Coca-Cola also has the highest interest coverage ratio and the lowest net debt to equity ratio of the three companies, so debt should not be an issue at all going forward for Coke when it comes to paying its dividend. Coca-Cola also looks best in terms of its historical dividend yield, which is at its highest level in 3 1/2 years. While the company's payout ratios are higher than those of both PepsiCo and Dr. Pepper Snapple, the dividend should still continue to grow as long as the company can continue to grow its free cash flow.
PepsiCo is also in great shape when it comes to all of the categories discussed in this article. Once the higher dividend for this year kicks in, I would expect to see an expansion in the company's payout ratio about to where it matches that of Coca-Cola. However, that should be sustained without a problem as long as the company comes through with its expected growth.
When it comes to who has the best dividends going forward in terms of growth and sustainability, it's just too close to call. If you have to choose just one of these three companies, you should consider other factors such as the fact that Coca-Cola sells over 500 products in over 200 countries, the fact that PepsiCo also has a huge global footprint with diversification into snack foods as well as beverages, and the fact that Dr. Pepper Snapple is quietly retiring about 5% of its share count every year in spite of the fact that its operations are confined to North America.
In my humble opinion, the best way to go is to own all three!
For more information on how I analyze financial statements, please check out my website at this link. It's a website I created just for fun, as well as to help fellow investors make intelligent financial decisions. Thanks for reading and I look forward to your comments.
Disclosure: I am long DPS, KO, PEP. 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.