With interest rates so low, any investment with a halfway decent yield has seen a flood of money come into it, pushing the price higher and the yield lower.
So when the stock of a solid company yields 4.5%, you might think you should jump at the chance. However, in the case of Kraft Foods Group (KRFT), the only jumping you should do is far away from the stock.
Kraft is spinning off its faster-growing snack food business, which will now be called Mondelez (MDLZ). The new business will include brands such as Oreos and Trident gum.
Kraft will retain brands such as Kraft Macaroni & Cheese, Jell-O, Cool Whip and Velveeta.
The company will invest significantly into reviving these brands, which are getting a bit tired, to say the least. When was the last time you ate Jell-O? For me, it was circa 1977.
But I’m not suggesting avoiding Kraft simply because I haven’t eaten Jell-O since the Carter Administration. The problem is it will pay investors too much cash in dividends.
Now, you’d think the guy who wrote the book Get Rich with Dividends would never make such a statement. But it’s possible to pay so much in dividends that it jeopardizes shareholders’ investments.
Kraft will pay $2 per share in dividends, or roughly $3.5 billion. Over the past 12 months, the company earned $3.6 billion. In 2012, it’s expected to earn $4.4 billion, climbing to $4.7 next year.
However, that means the company’s payout ratio will be 79% in 2012 and 74.4% in 2013, too high to be considered safe or likely to be raised – especially if the company’s brands don’t get revived and earnings disappoint. The payout ratio is the percentage of earnings that are paid out in dividends. I like to see a payout ratio below 75% to feel comfortable that the dividend is safe and will probably increase.
And with corn and other commodity prices sharply higher this year due to the drought in the Midwest, Kraft’s raw materials costs should be higher, which will squeeze margins if it’s unable to pass those increases on to the consumer.
Considering the yield is sharply higher than competitors Hillshire Brands (\HSH) with a yield of 1.9%, Kellogg (K) at 3.4%, or the industry average of 3.1%, it’s clear that by instituting such a high dividend, management is trying to make the stock more attractive to existing and potential shareholders.
But if Kraft is unable to sustain the dividend, shareholders will likely be punished severely. In the best of times, investors don’t like a dividend cut and usually send a stock lower. Now, however, when so many investors are focusing on dividends, particularly dividend growth, a reduction in the dividend will be a disaster for the share price.
Clearly, there’s no guarantee that the dividend will be cut. And I’m sure that management will do whatever it can to sustain it for at least a year. But for long-term investors who follow my strategy of dividend growth, Kraft is an unlikely candidate, unless coffee drinkers go back in time, forget about Starbucks and fall back in love with Sanka.
Rather than get enticed by a fat yield, look for companies that raise their dividends every year. That will not only keep your income well above the level of inflation, it should help the share price appreciate over the long term.
For example, Intel (INTC) has a 4% yield, which is lower than Kraft’s. However, Intel has a 10-year track record of raising the dividend significantly. Over the past five years it has boosted the dividend an average of 14% per year.
If Intel can continue to do that for another five years, investors will enjoy a 6.8% yield in five years, and 13% in 10 years. Meanwhile, unless Kraft revitalizes its business, it’s doubtful the company will be able to meaningfully raise its dividend over the coming five years.
So while you might get more money from Kraft this year, by next year, Intel should have a higher yield.
Kraft is a perfect example of why investors shouldn’t chase yield. The big number is enticing, but that’s exactly what it’s supposed to be. After that you’re stuck with a stock whose share price and dividend aren’t likely to be too exciting in the future.