In search of income-producing stocks, it's always wise to check in with the dividend aristocrats. Only companies with top-flight management teams and a recession-tested, profitable track record can pay a growing dividend for more than 25 years.
But you shouldn't just focus on past performance. You want to look for strong dividend growth in coming decades as well.
Net income can be affected by depreciation, goodwill and other factors unrelated to a company's ability to send cash to shareholders every three months (sometimes monthly).
As a result, the best metric to determine dividend strength is the dividend payout compared to free cash flow, or FCF. The lower the FCF payout ratio, the more flexibility management has to raise it or make other investments to fuel growth.
Searching through the list of dividend aristocrats, you'll find two companies with warning signs. By my math, they will be hard-pressed to boost their dividends in the future. The good news: I've also found two aristocrats that are poised to continue payout increases for some time.
McDonald's Corp. (NYSE: MCD) has been steadily rewarding shareholders, raising the payout to a recent $0.85, from $0.67 a share a decade ago.
But can it continue? Since 2009, McDonald's has seen its free cash flow (as measured by cash from operations minus capital expenditures, commonly referred to as CapEx) remain essentially flat. However, the company has continued to raise the dividend and now uses nearly all of its free cash to pay the dividend. In fact, the dividend grew just 4.8% last year, the lowest growth rate since 2001.
A 78% free cash flow payout ratio leaves only a small cash cushion. That doesn't bode well for a company with well-publicized business struggles, which could require significant capital expenditure investments.
McDonald's may have to make the difficult choice to freeze the dividend or take on debt to give tiny dividend increases (simply in order to keep its current streak alive).
Food distributor Sysco Corp. (NYSE: SYY) has an equally impressive 44-year record of consecutively higher dividends. In fact, the payout has doubled in the past 10 years.
But this is another company with a cash flow problem, signaling dividend challenges ahead.
Sysco suffered severe financial difficulty in 2010 through 2012, when the dividend was not supported by the business performance. Sysco managed to bring its FCF payout to a reasonable 64% in 2013, but the improvement coincides with management's decision to slash capital expenditures 36% from 2012 levels. CapEx was subpar in 2014 as well.
Trouble is, skimping on CapEx now leads to diminished returns later. Sysco can certainly afford its current dividend, but it doesn't have the financial wherewithal to repeat its impressive dividend growth of the past 10 years. Shareholders should be prepared for low dividend growth in the years ahead.
Luckily for us, there are plenty of companies that can and will continue to heap dividends on investors.
Johnson & Johnson (NYSE: JNJ), for example, has parlayed its strength in healthcare into a 52-year dividend growth winning streak. Better yet, Johnson & Johnson's dividend is fully supported by its business operations. It steadily boosts free cash flow and rewards its shareholders with dividend raises year after year.
Johnson and Johnson pays just over half of its FCF as a dividend, while typically raising the dividend 8%-to-12% each year. Although JNJ's dividend rose just 6% in 2014 -- the smallest raise in 10 years -- it was accompanied by a doubling of the share repurchase program. The company is in great shape and I expect 7%-to-12% annual dividend increases for the foreseeable future.
If you like the consistency of a dividend aristocrat, but seek a more rapid rate of dividend growth, then consider Hormel Foods Corp. (NYSE: HRL). The company, which has been in operation for more than a century, has raised its dividend for 48-straight years.
Hormel only pays out a third of its cash flow in dividends and could easily support a much higher payout. Management knows this and has been raising the dividend rapidly. Its last six annual raises have been by an average of 18%.
The trade-off investors have to accept with Hormel is the low starting yield of less than 2%. But as long as Hormel keeps boosting the payout at a rapid clip, investors can sit back and let compounding work its magic.
Risks To Consider: If and when the Federal Reserve raises interest rates, dividend stalwarts could start see their appeal diminish as investors shift back to fixed-income securities. But any pullback would be a great opportunity start or add to a position.
Action To Take --> Avoid McDonalds and Sysco; there are better ways to get a 3% yield. Although I don't think the management of either company would let the dividend streaks end, the raises will struggle to keep pace with inflation. Hormel is a bit on the pricey side, but is a great long-term platform for dividend growth. Consider adding JNJ to your portfolio.
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