Is This Dividend Aristocrat's 3.3% Dividend Yield in Jeopardy?

Share prices of Clorox (CLX 1.67%) fell 14.5% on Friday after the company reported worse-than-expected quarterly results and slashed its full-year guidance. The sell-off puts Clorox's stock price down 19% year to date and 39% down from its all-time high set in August 2020.

However, the company appears to be making enough in profits to be able to distribute an expected $4.64 per share to investors through its dividend, representing a yield of 3.3%.

Income investors are probably wondering if they can count on Clorox's ability to continue paying and raising its dividend in the years to come. Let's take a closer look at this consumer staple giant and see if we have an answer.

A regal reputation

Clorox is a Dividend Aristocrat that has paid and raised its dividend for 45 consecutive years. A Dividend Aristocrat is an S&P 500 component that has increased its dividend annually for at least 25 consecutive years.

This track record speaks volumes of Clorox's ability to foster shareholder value through its dividend and be a reliable source of passive income to its investors through thick and thin. This isn't to say that Clorox's streak can't be broken. But it would take an extreme situation for Clorox management to consider jeopardizing one of the core reasons investors hold its stock.

Insufficient earnings and free cash flow

In the table below, you'll notice that Clorox typically earns ample net income and free cash flow (FCF) to fully support its dividend, having an average payout ratio of 63% and an average FCF payout ratio of 56% between its fiscal year 2018 (FY18) and FY21. These are generally very healthy numbers, as they indicate Clorox is retaining plenty of profit and cash to grow its business, buy back stock, or grow its cash reserve.

Data Sources: Clorox, YCharts. 

However, Clorox's business is performing poorly right now. So much so that in the first half of its FY22, which represented the six months ended Dec. 31, 2021, Clorox distributed more money in dividends than it earned in net income or FCF.

How Clorox's struggles affect its dividend

Clorox's lackluster full-year guidance for FY22 suggests inflation-induced cost pressures will impact its gross margin by 750 basis points, bringing it down to an estimated 36.1% for the year. That would be a 10-year low, which is even more jarring considering Clorox had a gross margin over 45% in FY20, which was a 10-year high.

Clorox's gross margin is falling because it's spending more money on advertising while incurring higher costs to produce and distribute its products. Given that management expects it will take 12 to 18 months for it to return its gross margin percentage to the mid-40s level, Clorox could very well earn less FCF and net income than it pays in FY22 dividends.

If that happens, Clorox will have to resort to cutting the dividend or else use existing cash or maybe even short-term debt to continue funding the dividend. As of the first quarter of FY22, the company's net debt position reached $2.66 billion -- its highest level in over 10 years. But since then, Clorox has successfully reduced its long-term debt position to $1.89 billion and has $192 million in cash and cash equivalents on its balance sheet. 

Sometime this year, Clorox will probably make an incremental raise to its dividend to sustain its Dividend Aristocrat status. But make no mistake, its current operations will likely be insufficient to fund that raise.

Where to go from here

Clorox's dividend isn't in jeopardy and the company isn't in dire straits. It is still FCF positive and is likely to earn a sizable profit this year. But there's no denying Clorox needs to get its act together so it can return to a healthy payout ratio and FCF payout ratio. Companies occasionally encounter situations where unusual short-term financials push payout ratios to uncomfortably high levels. As long as the situation is clearly only a short-term issue, such companies often have the wherewithal to navigate their way out of the problematic situation.

Clorox's issue is testing some investors' patience, especially because management is saying it could take until at least FY24 for its business to rebound to FY20 levels. Right now, there's no real reason to pile into the stock even though it is priced at discount. However, investors with a cautiously optimistic disposition and a long-term horizon could consider picking up a few Clorox shares if it dips further.

Three years from now, Clorox could be in better shape and return to earnings growth. If that happens, its valuation will quickly look incredibly attractive. In the meantime, the company's 3.3% dividend yield provides an incentive for investors to keep holding the stock and give Clorox time to fix its problems and get back in the saddle.