Collecting dividends is a nice way to receive income, depending on your investment goals. However, it is important to look past a high dividend to see if it's sustainable. Otherwise, you could end up receiving far less than you expected. Additionally, when people anticipate these payments, investors often sell the stock after it cuts or eliminates them.
One such company whose dividends don't look secure is Kraft Heinz (KHC 1.80%). It's time to slice and dice this company to understand why that's the case.
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Larger doesn't mean better
When food staple companies Kraft and H.J. Heinz merged in 2015, it created Kraft Heinz. This put some of the world's best-known brands together, including the two namesakes, Oscar Mayer, Velveeta, Maxwell House, and Jell-O.
Unfortunately for shareholders, this has not worked out the way that management had planned. Since the deal was completed, the stock has lost 56% of its value while the S&P 500 has gained 82%.
Two years ago, the U.S. Securities and Exchange Commission (SEC) and U.S. Attorney's Office announced they were investigating the company's accounting practices. Kraft Heinz's own internal investigation caused the company to restate three years' worth of results.
Beyond that, the stock's underperformance was due to consumer tastes shifting to natural foods. While this was happening, management's attention was on aggressively reducing costs. Unfortunately, this took its focus away from product development that would have allowed Kraft Heinz to remain competitive.
Before the pandemic struck, Kraft Heinz's adjusted sales fell by nearly 2%. But with more people forced to stay home, the company's sales got a lift last year. Its third-quarter adjusted sales rose by more than 6% year over year to $6.4 billion. However, this didn't translate into higher profitability, with the company earning $0.70 compared to $0.69.
Recognizing the issues, last September management unveiled its new strategy. This includes streamlining from 55 to six categories, further cost cutting, and a focus on growth that includes ramping up marketing spending. However, its long-term goals only call for 1% to 2% annual sales growth and 4% to 6% adjusted earnings per share increases.
For the first nine months of 2020, Kraft Heinz's free cash flow was $2.9 billion. This easily covered the $1.5 billion of dividends. Looking to the prior year, which is more typical, free cash flow was $2.8 billion, which was a narrower cushion when compared to the $2 billion the company paid in dividends.
When typical consumer buying patterns return, I fear that sales growth will falter, causing earnings and cash flow to drop. This would pressure Kraft Heinz's dividend.
Previously cut dividend
Kraft Heinz has shown it is willing to slash its dividend. Two years ago, the board of directors lowered the company's quarterly dividend from $0.625 to $0.40, where it has remained.
Although the pandemic created a short-term boost, management's turnaround plan has not been tested. Higher marketing could boost sales, but whether this results in higher profitability remains unknown. So far, it hasn't.
So, while Kraft Heinz's stronger results buffet its dividend for the time being, it looks like the ongoing challenges will likely pressure the payment in the future, and you shouldn't get tempted by the 5% dividend yield. There are better alternatives that have more secure dividends and a long history of raising them.
