I've certainly been critical of Coca-Cola (NYSE:KO) at times in the past for various reasons. I think this company has demonstrated a complete lack of ability to grow at any sort of meaningful rate and the consequence of that viewpoint is that the stock always appears extremely expensive. But apart from that, KO's very famous dividend has run into some trouble in recent years from the simple fact that management continues to raise it at terrific rates despite the very obvious headwind of flat-to-declining free cash flow. In this article, I shall demonstrate that time is nearly up on KO's dividend in terms of financing it with FCF and the implications that could have on the stock going forward.
For this article, I'll be using data from Morningstar.
We'll begin by taking a look at KO's per share payout to see where the dividend has come from and what all the fuss is about.
If you're a dividend investor, this is a thing of beauty. KO has made boosting the dividend a priority for many, many years at this point and this ten year period is just a snapshot of that. There aren't many stocks with a better track record of raising the dividend than KO and this is why.
Seen another way, this is the same data but viewed in light of the increase each year to get an idea of the vigor with which management bumps the payout annually.
These increases are huge if you consider how long KO has been paying a dividend; it isn't like this is a new payout that is being ramped up over the course of a few years. Even so, KO's average increase in the past ten years is better than 8%, a stunning figure to consider. So we all know that KO is a master of raising the dividend, but how is it paying for all of that?
Any company that pays a dividend has to come up with cash to do so. After all, just like any other item the company spends money on, there has to be cash in order to pay for it, even if the money comes from somewhere else from an accounting perspective. For this reason, FCF is king when it comes to sustainable dividends because the only truly recurring source of cash for any corporation is FCF. Temporary boosts can be had from asset sales or borrowing, but over time, eventually, you have to be able to pay for the dividend with cash sourced from the business. So how has KO done on this front?
This chart gives us an idea of what KO has done in terms of producing FCF against the ever-rising cost of the dividend and if you love KO's dividends, this chart is something you'll want to have a look at.
KO's dividend has roughly doubled in size in the past decade, as you'd expect given all the increases. The problem is that its FCF is barely any different over the same time period and while it was around $8B for a period of time, last year's number was right back at just over $6.5B. That's a problem because, as you can see, the dividend and KO's FCF are on a collision course that has important implications for shareholders that plan on collecting that dividend for years to come.
This is a huge problem; KO already borrows every year on a net basis, which means that it has been supplementing its diminishing FCF for some time in order to finance not only the dividend, but the buyback as well. These things take cash to execute and while KO is still producing $6.5B in cash, it simply isn't enough to cover the growing dividend and the buyback. In fact, at this point, it is barely enough to cover the dividend, completely ignoring everything else.
This chart shows the percentage of FCF which is consumed by the dividend each year and these numbers are downright alarming.
It's been in relatively good shape for this time period but the problem is that, as the dividend has continued to grow, FCF hasn't and that has produced the situation you see above. Last year, KO spent 92% of its FCF on the dividend, which is an unacceptably high level. At that level, if it persists, KO will be borrowing every single year in order to pay the dividend, buy back stock, or anything else it wants to do. Essentially, KO is promising almost every dollar of FCF it earns to shareholders as a dividend and that is simply an unsustainable practice.
But KO's borrowing capacity is virtually unlimited at this point given its track record, so couldn't it just finance the dividend that way? Of course, that's always an option. However, keep in mind that KO likes its 8% increases and that presents a sizable problem when it comes to the way it is currently being paid for. If KO carries on with these increases, its dividend is fairly rapidly going to exceed the amount of FCF it produces each year, meaning that it will be borrowing to pay the dividend, to buy back stock and whatever else it needs to spend cash on each year. This is not sustainable over the long term; KO has to stop raising the dividend by so much when it is so blatantly obvious it cannot afford to do so.
No company can just increase its dividend into the stratosphere without a way to pay for it and right now, KO has no way to pay for it. If it can get its FCF back to the $8B mark, it will have bought itself a couple more years. But what happens then? KO has no ability - as demonstrated year after year - of boosting FCF above current levels so is it going to borrow itself into oblivion to pay the dividend? Or will it slow its increases down or even stop them? Neither of those are good outcomes for shareholders and if you own KO for the dividend, it is certainly something to consider.
I'll leave you with this: KO's FCF peaked around $8B from 2012 to 2015. If KO raises the cost of the dividend by 8% for four more years, its dividend will cost roughly $8.2B. That implies that even if KO figures out a way to get back to $8B in annual FCF, it will still be spending every penny of it and more on the dividend each year. That is completely unsustainable and something must change. What that will be is up to management of KO and for now, we don't know. But one thing I do know is that KO's current course is unsustainable and for that reason, if you own it for the dividend, tread lightly.
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.