SDY - 2 Dividend Aristocrats To Avoid

2023-12-04 05:04:25 ET

Summary

• High-yield Dividend Aristocrats have underperformed the market this year, with the SPDR S&P Dividend ETF down over 3%.
• Dividend growth strategies offer benefits such as compounding reinvested dividends and generating a high yield on cost.
• Companies like Walgreens and Air Products may have to slow their dividend growth or potentially cut their dividends due to weak cash flow performance.

By Brian Nelson, CFA

Dividend Aristocrats are companies that have increased their payouts in each of the past 25+ years. Half a century is a long time for anything, but to have the type of operations that can support continuous increases year after year is quite something. High yield Dividend Aristocrats, however, haven't fared that well this year so far with the SPDR S&P Dividend ETF ( SDY ) down more than 3% on a price-only basis, while the market-cap weighted S&P 500 ( SPY ) has advanced more than 20%. This year has been particularly difficult for these kinds of stocks, but the group has trailed the market for many years now. Buying Dividend Aristocrats isn't a foolproof strategy by any stretch.

That said, there are several benefits to a dividend growth strategy: 1) reinvested dividends compound over time; 2) generating a high yield on cost; 3) exposure to some of the strongest companies. By reinvesting dividends, it allows the investor to gain an incrementally greater share of the business and incrementally more dividends as well. A greater amount of dividends on an appreciating stock is not a bad deal at all, assuming the stock keeps rising.

Second, over time, when a company keeps raising its payout, the yield on the original cost of the investment goes up. Let's use Microsoft as an example. As of January 2012, its share price was about $26 while it paid an annualized dividend of $0.80 per share at that time. Microsoft's ( MSFT ) shares are now trading for $370+ each (up 14+ fold), and its annual dividend rate is now $3.00 (more than tripling), reflecting a yield on cost on an original investment of ~11.5%.

Dividend Aristocrats tend to be stronger companies that generate robust levels of free cash flow, which often makes them a better bet when it comes to expectations that they'll deliver on their dividends going forward. There's also some inherent pressure in the board room of these companies -- we might imagine -- to keep raising the payout in order to continue to be included in dividend growth indices, of which there are many, including the SPDR S&P Dividend ETF ( SDY ) and the ProShares S&P 500 Dividend Aristocrats ETF ( NOBL ).

But every now and then there are companies that have to reconsider their dividend payouts. We think two of the main factors where this might arise are under the condition that a firm has net debt on its balance sheet and free cash flow is not sustainably covering the cash dividends paid. These companies can go about paying their dividends for some time, but eventually things catch up with them. Either they have to improve their cash management, dividend growth slows, or the dividend might even be cut.

First, let's look at Microsoft to get a feel for the types of dividend growers that we like. Microsoft has a robust net cash position on the books that gives it extra cushion in the case cash flow from operations starts to deteriorate or if capital expenditures start to become a greater burden. But we have no worries on this front. At Microsoft, cash flow from operations continues to expand nicely, and after deducting capital expenditures to arrive at free cash flow, it becomes clear that Microsoft can easily cover cash dividends paid (see image below). One may think that every dividend payer's cash flow statement looks like the following, but this isn't always the case.

In fact, there are some Dividend Aristocrats that are pushing the limit with respect to their dividend coverage and some aren't generating sufficient free cash flow to even cover their payout. With a focus on the cash flow statement of such entities, let's look at two Dividend Aristocrats that might have to slow their payout growth (or put an end to it) in the coming years. Importantly, we're not saying that they will cut their payouts in the near term as both of these entities have lots of cash on the books. We're stating that based on their cash flow performance, the risk of slowing dividend growth or a dividend cut is significantly higher than, let's say, a company like Microsoft whose financials are fortress-like in almost every respect.

Walgreens ( WBA )

Walgreens is a household name, but its wheeling and dealing over the past few years has created a convoluted situation that can best be observed by the company's deteriorating operating cash flow. As shown in the company's cash flow statement above, capital expenditures are eating up a high percentage of operating cash, and its fiscal 2023 free cash flow -- as measured by cash flow from operations less all capital spending -- is now materially below that of cash dividends paid. The firm also issued guidance recently that came in below expectations, which leads us to believe that there may be further deterioration to come; and the company has a large net debt position to boot. Walgreens' dividend health is risky, in our view, and the market seems to agree, with shares yielding ~9.2% at this time. A dividend cut seems likely.

Air Products and Chemicals ( APD )

When it comes to free cash flow performance, Air Products looks to be in worse shape than Walgreens. Prior to this year, Air Products was at least generating positive free cash flow, but due to increased capital investment, free cash flow was negative in fiscal 2023, and based on the size of its capital expenditures the past few years, incremental cash return on such investments hasn't been great. Cash flow from operations in 2023 was actually less than it was in 2021. Despite all of this, the company is still paying out huge sums in cash dividends to shareholders. Air Products has a net debt position, and if free cash flow doesn't turn the corner in the years ahead, the pace of dividend growth will likely slow as the probability of a dividend cut increases. The market appears to be giving Air Products the benefit of the doubt that its dividend is safe for now given that it only yields ~2.6%, but its financials speak of risk to the payout, in our view. Its share price has fallen nearly 13% in the past 52 weeks.

Concluding Thoughts

We may be stating the obvious for some of our readers, but if free cash flow doesn't cover a company's cash dividends paid, there may be trouble on the horizon. Both Walgreens and Air Products have a decent amount of cash on the books where they may be able to keep paying their dividends for some time yet, but we'd only expect modest increases in the payout until they can get their free cash flow moving in the right direction again. If free cash flow doesn't turn the corner, the high current probability of a dividend cut in coming years may become reality for these two entities. It becomes clear after looking at the cash flow statements that dividend growth investors should prefer companies like Microsoft over these two Dividend Aristocrats, both of which have seen better days. If you like this kind of free cash flow work, please read more about why we like Microsoft here .

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