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Ben Reynolds
Ben Reynolds
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Procter & Gamble: Is the Dividend Still Safe?

Analyzing the company's investment prospects in detail

November 26, 2018 | About:

The primary goal of dividend investors is to generate income over time. Typically, this means the investor is also looking to buy the stocks of companies that can increase their payouts over time to offset the erosion of inflation, in addition to improving the investor’s yield on cost. This doesn’t always happen, however. Sometimes, companies overextend themselves and, thus, dividend cuts become necessary. This is a dividend investor’s worst nightmare as it means not only has their income stream been disrupted, but such an event also is generally accompanied by a decline in the share price.

Companies tend to cut their dividends because at least one of three factors is present. First, the company’s business could change such that its ability to generate earnings has deteriorated. Second, it could be employing too much leverage and, thus, its interest servicing costs are too great to afford its debt and dividend payments. Third, the company could simply change its mind about wanting to pay its dividend. Given all of this, dividend investors should strive to find companies that do not fit these criteria, to the best of their ability, in order to avoid a painful dividend cut.

To that end, we believe a model company that is extremely unlikely to see a dividend cut is Procter & Gamble (NYSE:PG). The company employs reasonable amounts of leverage with outstanding interest coverage, it has increased its dividend for 62 consecutive years and it has very shareholder-friendly management. Indeed, when investors are looking for attractive dividend stocks, they could do much worse than to model off of Procter & Gamble.

Business model and dividend safety

Procter & Gamble is a behemoth in the consumer products space, operating in just about every country in the world. It generates $65 billion or so in annual sales from its sprawling product assortment, covering everything from razors to laundry detergent to toothpaste. The company has a market capitalization of $228 billion as its share price has seen some recent strength. As mentioned, Procter & Gamble’s dividend has increased for 62 years in succession, putting it in very rare company among dividend stocks.

The company released first-quarter earnings on Oct. 19, in which results beat expectations. Revenue was up fractionally to $16.7 billion from the year-ago period, besting analyst estimates by $220 million. Adjusted earnings per share came in at $1.12, which also beat expectations slightly. Organic revenue rose a respectable 4% for the period, helping to drive adjusted earnings per share 3% higher. Particular strength came from the Beauty products category, which saw a 7% increase in organic sales. Fabric and Home Care rose 5%, while the only segment with an organic sales decline was Baby, Feminine and Family Care, which was off fractionally year over year. Management maintained earnings per share guidance as well, though the range is quite wide at 3% to 8% adjusted earnings per share growth. Analysts currently have a consensus estimate of $4.41 in earnings per share for the year.

Procter & Gamble satisfies the first criteria for a company that is unlikely to cut its dividend in that its business is always going to be necessary. In other words, it is unlikely that technological or consumer preference changes will cause significant harm to the company given the products it makes are largely necessary for daily living. Of course, there are competitors to the company's products, but its brands have proven tremendously resilient over time and there is no reason to believe that will change. Near-constant pricing increases and volume growth have collectively afforded Procter & Gamble steady and meaningful growth in the past decades. We expect the company will accrue mid-single-digit annual earnings growth in the years to come, continuing its decades-long trend and making future dividend growth a possibility.

In addition, the company’s leverage is very reasonable and, thus, is nowhere near the point where it would become a problem for the dividend payment. Total liabilities come in at just 55% of total assets, meaning Procter & Gamble’s balance sheet is actually quite clean. As a result, its interest coverage is superb with the company being able to cover its interest obligations roughly 30 times over. Again, it is extremely unlikely this will cause a dividend cut at any point in the future.

Finally, Procter & Gamble’s capital allocation policy has one of the longest track records of any company in the U.S. Its 62-year history of increasing dividends means that management is highly unlikely to simply decide to stop raising or paying the dividend. The company’s steady business model will help with this as well; shifting industry trends can derail certain companies’ dividend policies, but not this one.

High cash flow generation leads to further dividend growth

Procter & Gamble’s high margins lead to generous levels of free cash flow, which afford it the ability to continue to pay and raise its dividend. Combined with shareholder-friendly management, the company is a model dividend stock.

It has produced at least $9 billion of free cash flow every year for the past decade. In most years, it is more like $11 billion. With the dividend costing roughly $7 billion annually, the company has more than enough free cash flow each year to continue to pay and raise the dividend over time. It enjoys operating margins in the mid-20% range thanks to its efficient operating structure and strong pricing power, so again, this should continue to be the case indefinitely.

The stock is trading for 20.8 times this year’s analyst earnings estimate of $4.41, which compares somewhat unfavorably to our fair value estimate of 18.8 times earnings. That implies a modest headwind to total returns in the coming years as the valuation moderates, but the 3%-plus yield is certainly what draws investors to Procter & Gamble shares. Indeed, that yield is roughly congruent to what it has been for most of the last decade, so on that measure, shares are reasonably priced.

Final thoughts

Procter & Gamble exhibits all of the traits one would expect from a company that is unlikely to cut its dividend in the future. It has a stable, growing business that is recession-resistant, it has very high interest coverage thanks to low leverage and it has very shareholder-friendly management. Companies that cut their dividends violate at least one of these criteria, but Procter & Gamble serves as a model for investors to find stocks that are unlikely to cut their payouts.

Disclosure: I am not long any of the stocks mentioned in this article. 

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About the author:

Ben Reynolds
I run Sure Dividend, a website that finds high quality dividend stocks for long term investors using the 8 Rules of Dividend Investing.

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