Kraft Heinz's High Dividend Really Is Too Good to Be True

Kraft Heinz (KHC -0.57%) executed a surprising turnaround over the past year. At the beginning of 2020, the packaged foods giant was still struggling with sluggish sales, declining margins, big writedowns, a dividend cut, and an SEC probe over its accounting methods and delayed filings.

However, the pandemic caused consumers to stock up on Kraft Heinz's packaged foods, and its organic sales started rising again. As a result, its stock has rallied more than 40% over the past 12 months, and it still pays a high forward dividend yield of 3.7% after slashing its payout by 36% in 2019.

Image source: Getty Images.

Kraft Heinz's stock also looks cheap at 16 times forward earnings, which might make it an appealing investment as the market rotates from growth to value stocks. But before investors assume Kraft is an undervalued dividend stock, they should also recognize its biggest problems.

Its payout ratio is still high

Kraft Heinz's dividend payments consumed over 100% of its GAAP earnings in 2019 and 2020. On a non-GAAP basis, which excludes its divestments, writedowns, impairments, stock bonuses, and other "one-time" expenses, that payout ratio remained below 100%.

Data source: Kraft Heinz.

The bulls might claim Kraft's earnings-based payout ratio will stabilize over the long term, especially if we only look at its non-GAAP earnings, but those expenses will still reduce its cash position.

It should reduce its debt first

Kraft's free cash flow (FCF) surged 56% to $4.33 billion in fiscal 2020 as its organic sales grew 6.5% throughout the crisis.

Its FCF jumped another 619% year-over-year to $583 million in the first quarter of 2021, thanks to an easy comparison to the pandemic's initial impact a year earlier, as its organic sales rose 2.5%.

Kraft only spent about 41% of its FCF on its dividend over the past 12 months, and that low cash dividend payout ratio indicates its payments are still sustainable. Kraft gradually reduced its long-term debt over the past two years, but its net debt-to-adjusted EBITDA ratio remains very high.

Data source: Kraft Heinz.

Kraft has more than enough cash to cover the current portion of its long-term debt ($126 million), but it arguably makes more sense to improve its balance sheet before paying out big dividends.

It should invest in new products and marketing campaigns

Kraft struggled for many years because it focused on cutting costs instead of investing in new products, buying higher-growth brands, and launching fresh marketing campaigns. Today, it's still sticking to a "zero-based" budgeting strategy, which cuts costs across its existing businesses to free up more cash.

This frugal approach might prop up its operating margins, especially as competition and inflation squeeze its gross margins, but it could also prevent it from investing in new products and marketing campaigns to stay competitive.

After the pandemic ends, shoppers will likely stockpile fewer groceries and become more selective with their food purchases again. Competition from healthier and private-label brands will exacerbate that pressure. Those trends already hurt Kraft Heinz before the pandemic, and will likely return after the crisis ends. Instead of paying out nearly $2 billion in dividends every year, I believe Kraft Heinz should reduce those payments and invest more money back into its business.

Kraft Heinz still has a lot to prove

Kraft Heinz's CEO Miguel Patricio, who took the helm two years ago, seems to be stabilizing the company. But a lot of its recent growth should be attributed to the pandemic instead of meaningful improvements to its core business, and analysts still expect its annual revenue to decline over the next two years.

Kraft Heinz might not cut its dividend anytime soon, but investors might be better off sticking with General Mills (GIS -0.38%), which faces fewer near-term headwinds, pays a forward yield of 3.3%, and trades at just 17 times forward earnings. Coca-Cola (KO 0.60%), a Dividend King that trades at 23 times forward earnings, pays a 3% yield and owns much stronger brands. Both stocks have significantly outperformed Kraft Heinz over the past five years. Based on all these facts, I believe Kraft Heinz's stock is cheap for obvious reasons, and its high dividend is simply too good to be true.