Coca-Cola (KO): Dividend Safety

Coca-Cola (K) is the quintessential dividend growth stock. The soda-giant is a Dividend King with 59 straight years of dividend growth. The company has also paid a dividend for over 100 years, one of only 18 companies in the U.S. to have done so. That being said, Coca-Cola’s dividend growth at about $0.04 annually has been nothing to write home about for the past few years. In addition, the dividend safety has declined as debt has risen and the company struggled with consistent top line and bottom line growth. However, there is a lot for dividend growth investors to like here. Furthermore, there are signs of improvement for capital allocation and dividend safety. Hence, it pays to take a more in depth look at Coca-Cola’s dividend safety.

Overview of Coca-Cola

Coca-Cola was founded in 1886. Today, it is the largest non-alcoholic beverage company as well as one of the largest packaged food and drink companies in the world. Note that Coca-Cola recently entered the hard seltzer market. Coca-Cola is truly a global brand with operations in over 200 countries. In fact, the company has about 13% volume share in developed markets and 5% volume share in developing & emerging markets. The company makes and sells almost every type of non-alcoholic drink included carbonated soft drinks, water, enhanced water, sports drinks, dairy, juices, teas, coffees, and energy drinks. The company sells its beverages through a network of company-owned, company-controlled, affiliated, or independent bottlers, distributors, wholesalers, and retailers worldwide. Companywide sales were $33,014 million in 2020 and $33,433 million in the LTM.

Coca-Cola’s brands are extremely well-known to most consumers worldwide. The company owns hundreds of brands including Coke, Diet Coke, Sprite, Minute Maid, Fanta, Fresca, PowerAde, Schweppes, Dasani, Gold Peak, Honest Tea, Topo Chico, FUZE Tea, Costa, Schweppes, and many others. Many of these brands are billion dollar brands or more with Coca-Cola and Diet Coke ranking in the top 5 each year. Interbrand ranked Coca-Cola as the No. 6 global brand in 2020. The number of master brands has been reduced from about 400 to ~200. The eliminated or transitioned master brands represented only ~2% of volume and ~1% of revenue. Coca-Cola has about 4,700 products worldwide. The company has the No. 1 value share in sparkling soft drinks; juice, dairy & plant; water, enhanced water & sports drinks; and ready-to-drink tea & coffee.

Coca-Cola’s Dividend and Growth

Coca-Cola has paid a dividend every year since 1920 making the company one of the few to have paid a dividend for 100+ consecutive years. The company is also a Dividend King on the basis of 59 consecutive years of annual dividend growth. Coca-Cola is also a Dividend Aristocrat. Coca-Cola’s popularity as a dividend growth stock is demonstrated by the over 277,000 followers on Seeking Alpha. Furthermore, Coca-Cola has a reasonably high yield of over 3%, dividend growth, and acceptable dividend safety (more on that below). Granted, the COVID-19 pandemic resulted in some top and bottom line challenges, but the dividend was not cut or suspended pointing to its resiliency. COVID-19 negatively impacted volumes and thus sales due to government restrictions on large gatherings around the world.

The chart below from  StockRover* shows the dividend and growth rate since 2007 superimposed over the stock price chart (in gray). The growth in the regular cash dividend has been approximately 6.0% in the past decade, 3.7% in the trailing 5-years, and 2.5% in the past 3-years. Growth has been driven by rising sales from organic growth, bolt-on acquisitions, and expansion of the payout ratio.

The forward dividend is currently $1.68 per share giving a forward yield of about 3.1%. This is more than double that of the average yield in the S&P 500. The relatively high yield places Coca-Cola in the Dogs of the Dow 2021 list. The yield history for Coca-Cola is seen in the chart below. The average 5-year yield is about 3.28%. The current yield is lower than that value suggesting that the stock is overvalued based on yield. The chart below indicates that the yield rarely goes over 3.5% and the yield has only gone over 4% during the depths of the COVID-19 pandemic bear market. These levels of yield have proven to be good times to add to extant positions or as an entry point.

Coca-Cola’s Dividend Safety

I like to take a look at three dividend safety metrics: earnings, cash flow, and debt. It is important to me as a dividend growth investor for all three to meet my criteria. Granted, there can be short-term fluctuations that results in a stock not meeting my criteria. But those are usually transient and not long term. Let’s do a deep dive into Coca-Cola’s dividend safety.

The dividend is covered by adjusted non-GAAP earnings, but the ratios are higher than desired. In fiscal 2020, Coca-Cola earned $1.95 per share and paid a dividend of $1.64 per share giving a payout ratio of about 84%. This value is high and above my threshold of 65%. However, sales and earnings were down in 2020 due to the COVID-19 pandemic. But in 2019, earnings per share were $2.11 and the dividend was $1.60 per share resulting in a more conservative payout ratio of ~76%. Looking forward, consensus fiscal 2021 earnings per share is $2.18 and the forward dividend is $1.68 per share giving a payout ratio of roughly 77%, which is an improvement.

That said, dividend coverage is worse after accounting for unusual items, but these vary year-to-year and are common for Coca-Cola. The company typically takes charges for mergers, restructuring, asset write downs, and other items.  For example, in 2020, diluted GAAP earnings per share was $1.79 per share indicating that the dividend was just barely covered by earnings. However, the dividend is covered by diluted earnings in most years as seen in the chart below from TIKR*.

The dividend is better covered by free cash flow but again the ratios are higher than desired. On a trailing basis, operating cash flow was $9,844 million in 2020 based on data from TIKR*. Capital expenditures were $1,177 million giving free cash flow of $8,667 million. The forward dividend requires about $7,241 million ($1.68 x 4,310 million shares). Assuming a similar FCF in 2021 as a low-end estimate, the dividend-to-FCF ratio is about 74%, which is slightly above my threshold of 70%. 

That said, the cash flow required to pay the dividend has increased dramatically from $4,300 million in 2011 to $7,047 million in 2020 and about $7,241 million in 2021. The share count has fluctuated during this time but has generally trended down. Before current management, Coca-Cola was in the habit of issuing shares and debt and conducting large share buybacks. This has been greatly reduced as issuance of common stock and share repurchases have been significantly lowered.

However, of concern is Coca-Cola’s debt load, which has risen over the past decade as seen in the chart below. In addition, at the end of Q1 2021, short-term debt was $1,933 million, the current portion of long-term debt was $2,880 million, and long-term debt was $40,417 million and this was offset by only $12,595 million in cash, equivalents, and short-term investments according to data from TIKR*.

The main problem for Coca-Cola from the perspective of debt is that interest coverage has weakened significantly, and the leverage ratio has risen due to the high debt load. Interest expense was about $1,437 million in 2020. Ten years ago, total annual interest expense was about $417 million. During that time interest coverage has reduced from over 25X to about 6.0X. This is not too low of a value, but the downward trend is problematic for a dividend growth stock. Simultaneously, the leverage ratio rose from about 1.13X at end of 2011 to 2.83X at end of 2020. Despite the increase in leverage ratio and lower interest coverage, at the end of 2020, Standard & Poor’s gave an A+ credit rating and Moody’s gave an A1 credit rating to Coca-Cola. Both ratings are investment grade and in the upper medium grade.

Our deep dive into Coca-Cola’s dividend safety shows that it has declined over the trailing 10-years based on earnings, free cash flow, and debt. Currently, the metrics do not clearly indicate that the dividend is at risk but ideally, I would like debt and the leverage ratio to be lower and interest coverage to be higher.

Has Coca-Cola’s Capital Allocation Improved?

The real question remains, what is current management’s capital allocation strategy. We can see based on the metrics that prior management oversaw deteriorating dividend safety metrics. The chart below indicates that the company intends to maintain a 75% dividend payout ratio. This is higher than my target of 65%. However, one must realize that Coca-Cola generates consistent cash flow and earnings from repeat buyers expect perhaps during the COVID-19 pandemic. Additionally, many consumer staples companies are able to maintain high payout ratios. Importantly, Coca-Cola intends to maintain a leverage ratio of 2.0X to 2.5X, which I believe is sustainable over the longer-term.

Final Thoughts on Coca-Cola (KO) Dividend Safety Analysis

Coca-Cola is popular stock since it is a Dividend King and typically has a decent yield. Coca-Cola is also a major holding for Warren Buffett and in his top 10 adding to its popularity. That being said, dividend growth has been muted for the past 5-years. I attribute this to poor capital allocation in the past and rising debt. However, the company is seemingly focused on lowering debt and raising the dividend again. Despite the weak dividend safety, it is unlikely in my opinion that Coca-Cola will place its Dividend King or Dividend Aristocrat status at risk.

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