Coca-Cola (NYSE: KO) is one of today’s most enduring dividend stocks. With an iconic product, a decades-long streak of dividend increases, and a higher-than-average yield, it continues to attract interest as an income stock.
Nonetheless, stagnant free-cash-flow growth and the increasing cost of the payout should cause investors concern. Hence, the question is whether this payout remains worthwhile for new shareholders.
Whether one is a Coca-Cola bull or bear, few can question the endurance of its dividend. The company made its first payment in 1920, soon after the stock began trading. In 1963, it started a trend of increasing the payout annually.
That unbroken streak has helped Coca-Cola attract interest as an income stock, most notably from Warren Buffett’s Berkshire Hathaway. Despite Buffett’s seemingly late start in 1988, his $1.3 billion investment now generates $736 million in yearly dividend income, a 57% (and rising) yearly return.
New buyers will not make that much. At an annual payout of $1.84 per share, they will earn a 3% dividend yield. But this is approximately double the current S&P 500 average cash return of around 1.5%. If the goal is a growing source of income, a payout backed by a popular soft drink sold globally could still draw investors.
However, despite the high yield, investors have increasing reasons to hold off, and not just because some certificates of deposit (CDs) can guarantee returns above 5%. Coca-Cola has a slightly negative total return over the last year and underperformed the S&P 500 on a five-year time horizon. Given such a performance, you can understand why Buffett’s team has not added any shares since 1994.
Furthermore, the rising cost of the dividend should spark increasing concern. In the first two quarters of 2023, Coca-Cola generated $4 billion in free cash flow. The payout cost the company almost $2.1 billion in the first quarter alone, implying that it fell short of fully covering this expense.
Management responded by pushing the latest dividend payment date back to early in the third quarter, a cost it had incurred in the second quarter in previous years. That might indicate the cost has become a strain on the company.
Fortunately, Coca-Cola forecasts $9.5 billion in free cash flow for the year, enough to cover an anticipated $8.4 billion in dividend costs. Still, this leaves just over $1 billion that it can devote to share repurchases or reinvesting in its business.
Moreover, abandoning a 61-year streak of payout hikes would probably undermine confidence in the stock, making such a scenario unlikely. Thus, one has to assume that the dividend cost will rise.
This year’s payout increase took the dividend higher by 4.5%. Coca-Cola could slow the pace of increases if the struggles continue. Nonetheless, if free cash flow does not rise along with the payout, dividend costs will place an added strain on the business.
Given current conditions, investors should not buy the stock for the dividend. While an end to the payout hikes still appears unlikely, Coca-Cola’s total return has underperformed the indexes. And you can now earn a higher return on CDs with less risk, further dampening the appeal of the payout.
Admittedly, longtime investors like Warren Buffett hold a massive capital gain on the stock, and the high dividend yield leaves such shareholders with no reason to sell. But since Buffett has not added shares in nearly 30 years, prospective investors and current shareholders should probably follow his lead and do nothing.
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Will Healy has positions in Berkshire Hathaway. The Motley Fool has positions in and recommends Berkshire Hathaway. The Motley Fool recommends the following options: long January 2024 $47.50 calls on Coca-Cola. The Motley Fool has a disclosure policy.
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