Will Kellogg's Dividend Growth Go Cold?

| About: Kellogg Company (K)

Summary

Kellogg's strategy is relatively simple: to win in breakfast and in emerging markets. The acquisition of Pringles continues to perform better than expected.

The main support for the firm's dividend has been its strong cash flow generation, as free cash flow has exceeded $1 billion in each year since 2011.

Though Kellogg's productivity and cost savings initiatives are impressive, we aren't expecting much pass-through to dividend growth in the near term.

Let's take a look at the firm's investment considerations as we attempt to uncover the drivers behind its Dividend Growth Cushion.

By The Valuentum Team

Kellogg has a nice dividend, but we're not expecting much growth in the payout in coming years.

--> Kellogg (NYSE:K) has a number of iconic brands. Pop-Tarts is a great example and has an impressive 80%+ share in the toaster pastries market thanks to strong advertising and innovation efforts. Other brands include Kelloggs, Keebler, Cheez-It, Murray, Austin, and Famous Amos. More than 100 years ago, W.K. Kellogg founded the company, and it is based in Michigan.

--> Kellogg's strategy is relatively simple: to win in breakfast and in emerging markets. Becoming a global snacks leader and growing frozen foods are other key priorities. India, Brazil, and the Middle East offer tremendous opportunities.

--> Kellogg's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively.

--> The firm's acquisition of Pringles continues to perform better than expected. Pringles' potato chip business gives Kellogg a brand with more than $1.5 billion in annual sales and a solid growth engine in emerging markets. It's hard not to like the transaction.

--> As with many of its global peers, currency will pose a stiff headwind in the near term. But even adjusting for such a factor, currency-neutral comparable sales are falling modestly, which isn't helping operating profit.

Note: Kellogg's annual dividend yield is above average, offering a ~2.8% yield at recent price levels. Though we generally prefer companies with strong yields, other factors keep us from truly considering Kellogg for addition to our dividend growth portfolio. This article explains why.

Dividend Strengths

Kellogg has a solid quarterly dividend with a compelling yield. Management is looking to keep this yield near 3% in the near future and is targeting a payout ratio of 40%-50%. The main support for the firm's dividend has been its strong cash flow generation, as free cash flow has exceeded $1 billion in each year since 2011. Cash flow is expected to continue to grow in line with earnings growth moving forward, which will be driven by productivity and cost saving initiatives. Kellogg is not anticipating robust top-line growth, but approximately $450-$500 million in savings in 2016 is expected to drive bottom-line expansion. Material savings are expected to continue through 2018, providing opportunity for increased free cash flow generation.

Dividend Weaknesses

Though Kellogg's productivity and cost savings initiatives are impressive, we aren't expecting much pass-through to dividend growth in the near term. The firm remains focused on investments and acquisitions aligned with its strategy, particularly in natural
and organic foods, emerging markets, and global snacks, and despite its strong free cash flow generation, the company has a material debt position that weighs on our optimism for dividend expansion. The price of grains and other input costs can also have an impact on short-term results for the firm, and we want to see some sustained success from its costs savings plan before anointing management.

From the Comments Section: How to Interpret the Dividend Cushion Ratio -- A Ranking of Risk

As for how to interpret the Dividend Cushion ratio, itself, it is a measure of financial risk to the dividend, much like a credit rating is a measure of the default risk of the entity. Said differently, a poor Dividend Cushion ratio of below 1 or negative doesn't imply the company will cut the dividend tomorrow, no more than a junk credit rating implies a company will default tomorrow. That said, the Dividend Cushion ratio does punish companies for outsize debt loads because in times of adverse conditions, entities often need to shore up cash, and that means the dividend becomes increasingly more risky.

We think investors should look at a variety of different metrics in assessing the sustainability of the dividend. Because the Dividend Cushion ratio is systematically applied across our coverage, it can be used to compare entities on an apples-to-apples basis. Dividend payers with significant free cash flow generation and substantial net cash on the balance sheet often register the highest Dividend Cushion ratios, as they should. These companies have substantial financial flexibility to keep raising the dividend.

Dividend Safety

We think the safety of Kellogg's dividend is poor. Please let us explain.

First, we measure the safety of the dividend in a unique but very straightforward fashion. As many know, earnings can fluctuate, so using the payout ratio in any given year has some limitations. Plus, companies can often encounter unforeseen charges, which makes earnings an even less-than-predictable measure of the safety of the dividend. We know that companies won't cut the dividend just because earnings have declined or they had a restructuring charge that put them in the red for the quarter (year). As such, we think that assessing the cash flows of a business allows us to determine whether it has the capacity to continue paying dividends well into the future.

That has led us to develop the forward-looking Dividend Cushion™ ratio, which we make available on our website. The measure is a ratio that sums the existing net cash a company has on hand (on its balance sheet) plus its expected future free cash flows (cash flow from operations less capital expenditures) over the next five years and divides that sum by future expected cash dividends over the same time period. Basically, if the score is above 1, the company has the capacity to pay out its expected future dividends and the expected growth in them.

As income investors, however, we'd like to see a ratio much larger than 1 for a couple of reasons: 1) the higher the ratio, the more "cushion" the company has against unexpected earnings shortfalls, and 2) the higher the ratio, the greater capacity a dividend-payer has in boosting the dividend in the future. For Kellogg, this ratio is 0.6, revealing that on its current path the firm's net debt and dividend obligations are nothing to scoff at.

Dividend Cushion Ratio Cash Flow Bridge

The Dividend Cushion Cash Flow Bridge, shown in the graph below, illustrates the components of the Dividend Cushion ratio and highlights in detail the many drivers behind it. Kellogg's Dividend Cushion Cash Flow Bridge reveals that the sum of the company's 5-year cumulative free cash flow generation, as measured by cash flow from operations less all capital spending, plus its net cash/debt position on the balance sheet, as of the last fiscal year, is less than the sum of the next 5 years of expected cash dividends paid.

Because the Dividend Cushion ratio is forward-looking and captures the trajectory of the company's free cash flow generation and dividend growth, it reveals whether there will be a cash surplus or a cash shortfall at the end of the 5-year period, taking into consideration the leverage on the balance sheet, a key source of risk. On a fundamental basis, we believe companies that have a strong net cash position on the balance sheet and are generating a significant amount of free cash flow are better able to pay and grow their dividend over time.

Firms that are buried under a mountain of debt and do not sufficiently cover their dividend with free cash flow are more at risk
of a dividend cut or a suspension of growth, all else equal, in our opinion. Generally speaking, the greater the 'blue bar' to the right is in the positive, the more durable a company's dividend, and the greater the 'blue bar' to the right is in the negative, the less
durable a company's dividend.

Dividend Cushion Ratio Deconstruction

The Dividend Cushion Ratio Deconstruction, shown in the graph below, reveals the numerator and denominator of the Dividend Cushion ratio. At the core, the larger the numerator, or the healthier a company's balance sheet and future free cash flow generation, relative to the denominator, or a company's cash dividend obligations, the more durable the dividend. In the context of the Dividend Cushion ratio, Kellogg's numerator is smaller than its denominator suggesting weak dividend coverage in the future. The Dividend Cushion Ratio Deconstruction image puts sources of free cash in the context of financial obligations next to expected cash dividend payments over the next 5 years on a side-by-side comparison. Because the Dividend Cushion ratio and many of its components are forward-looking, our dividend evaluation may change upon subsequent updates as future forecasts are altered to reflect new information.

Please note that to arrive at the Dividend Cushion ratio, divide the numerator by the denominator in the graph below. The difference between the numerator and denominator is the firm's "total cumulative 5-year forecasted distributable excess cash after dividends paid, ex buybacks."

Dividend Growth

Now on to the potential growth of Kellogg's dividend. As we mentioned above, we think the larger the "cushion" the larger capacity the company has to raise the dividend. However, such dividend growth analysis is not complete until after considering management's willingness to increase the dividend. To do so, we evaluate the company's historical dividend track record. If there have been no dividend cuts in the past 10 years, the company has a nice dividend growth rate, and a solid Dividend Cushion ratio, we characterize its future potential dividend growth as excellent. However this is not the case for Kellogg, which has a rating of poor.

Because capital preservation is also an important consideration to any income strategy, we use our estimate of the company's fair value range to assess the risk associated with the potential for capital loss. In Kellogg's case, we currently think shares are overvalued, meaning the share price lies above our estimate of the fair value range, so the risk of capital loss is high (our valuation analysis can be found by downloading the 16-page report on our website). If we thought the shares were undervalued, the risk of capital loss would be low.

Wrapping Things Up

Kellogg is one of the most recognizable brands in the breakfast foods market. Its position in breakfast is part of a strategy that includes an emphasis on emerging markets. This emphasis is exactly why we think the acquisition of Pringles was such a favorable one for Kellogg. Cost savings initiatives have been material for the firm through 2018, which will help it combat less-than-exciting top-line growth. As for its dividend, the company boasts a solid yield, but we're not expecting much growth in coming years. Shares have been trading near the upper bound of our fair value range for some time now, making Kellogg even less attractive in our eyes.

Breakpoints: Dividend Safety. We measure the safety of a firm's dividend by adding its net cash to our forecast of its future cash flows and divide that sum by our forecast of its future dividend payments. This process results in a ratio called the Dividend Cushion. Scale: Above 2.75 = EXCELLENT; Between 1.25 and 2.75 = GOOD; Between 0.5 and 1.25 = POOR; Below 0.5 = VERY POOR.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.