For the past couple of days, we have discussed the ways in which IBM can prove to be a superior investment going forward, despite the narrative that’s become familiar to many—the technology service firm has been having trouble growing its revenues. Because of IBM’s low 25% dividend payout ratio, and its extensive commitment to repurchasing stock that is currently in the 10x earnings range, you can easily way a way IBM can prove to be a lucrative long-term investment even while its revenues stagnate.
Now, I want to talk about another excellent company where the opposite is true—revenues are having trouble growing, and it tells you something about the current state of Kraft’s “internal compounding engine” since the Modelez spinoff.
Here’s what I mean: In 2011, Kraft generated $18.6 billion in revenue. In 2012, Kraft generated $18.3 billion in revenue. They went down a little bit more to $18.2 billion in 2013. And though 2014 isn’t over yet, it looks like the revenue is on target for somewhere in the $18.2-$18.4 billion range, somewhere below the 2011 figures.
When revenue is stagnating, there are three ways you can grow profit per share: (1) you can cut costs, (2) you can increase productivity or expand into businesses that have higher profit margins, and/or (3) you can repurchase stock.
Kraft has been doing the two first two in the past three years—in a sign of the times, they have laid off some employees, modestly improved productivity output due to factory consolidation, and traded out some minor businesses and acquired a few as well. That’s why the profit per share has increased from $2.75 to $3.15 from 2011 through 2014 (I took the average of what Wall Street expects for the fourth quarter and added that to the first three quarters of actual reported profits) despite revenue figures that have not improved.
The third option—stock repurchases—does not exist in Kraft’s case. IBM buys back something like $3 billion worth of stock per quarter. And thought the amount and the repurchase price vary somewhat, IBM averages retiring 1.5% of its outstanding stock every 90 days. That’s an important offset to stagnating revenue. In the case of Kraft, you have modest share dilution such that the profit pie is currently split up into 594 million pieces (compared to 592 pieces in 2011).
Kraft pays out a dividend of $.55 per share, or a current commitment to give out $2.20 to shareholders each year. If the company makes $3.15 per share in profit this year, the dividend will account for 70% of profits. They make $1.8 billion in profits per year—and about $1.26 billion of it gets deposited in the accounts of shareholders as a cash dividend, and the other $500+ million is retained to grow the business.
They got saddled with some debt after the spinoff—they currently have $10 billion in debt on the books, and they’ve been wise to cut that by $1.5 billion in the past two years (you don’t want to head into a rising interest rate world where you have significant chunks of debt that needs refinancing down the road). The problem is this—when you’re in a slow growth business selling Kraft cheese, Oscar Mayer meats, and the faster-growing Maxwell House coffee brands, have a meaningful debt load, and are sending out 70% of your profits to shareholders as a dividend, you are going to struggle to achieve a high profit per share growth rate.
What are the implications of this? I can think of three.
One, if you already own Kraft, it makes sense to continue doing so. It’s not some hardship in life to own a company with an extraordinarily high quality of current profits even if its future rate of growth appears to be less than spectacular. You’ve got a 3.89% yield based on current profits (and you’d be collecting a higher yield on your invested capital if you’ve been an owner of the company for awhile) that will march upwards over the course of your lifetime.
If you ever reached a point where you could live entirely off of Kraft income—and I know there are some of you who have been long-time owners of Altria who picked up shares of Kraft, Mondelez, and Philip Morris International just by refusing to hit the sell button throughout the lucrative spinoffs in the past six years—you would have it made. Financially speaking, you would have won at life because you could spend your time doing whatever you wanted because your passive ownership interests could singlehandedly support your lifestyle. (It’s not as crazy to draw up these scenarios as you’d imagine if you came to your Kraft share by way of the Altria spinoff—you were compounding your wealth at a rate of 15-22% annually depending on your investment time, so if you made a substantial financial commitment to the stock or had been an owner for over 20 years, your Kraft dividends alone would be making more than the average American household’s income per year).
If we suffered through another Great Depression type of scenario, the profits would not fall by that much. Dividends would still get paid. Heck, they did during the actual Great Depression. It’s inconceivable to think of a scenario in which North Americans (that’s what the Mondelez spinoff did—it made Kraft a North American grocery company) stopped consuming cheese, meat, and coffee. Collecting high-quality cash and deploying it elsewhere, or using it to support your lifestyle, has a useful place in any portfolio. Kraft is a great friend to have around when these generational recessions show up.
The second implication—when you’re dealing with something that has a slower compounding growth rate—think utility companies, telecom companies, and large grocers, you get superior returns by having discipline when you buy the stock. Someone buying Visa can be less disciplined with their initial starting price; that’s the fun thing about finding companies growing at 15% per year (you can pay $225 instead of $200, and you’ll still be very happy ten years down the line). When the growth rate is slower, overpaying hits you harder as the price of the stock can justifiably stagnate for three, four, five years at a time as it takes a while for the earnings to catch up to the valuation.
And third of all—it’s a reminder that the right stock selection depends on your personal goals and what you’re trying to accomplish with your funds. For a retiree looking for stable income, choosing Kraft is going to be more attractive than a U.S. savings bond if you’re at a point in your life where you don’t get worried by volatility with your high-quality holdings—I’d much rather be committed to Kraft’s 3.89% dividend that will go up annually if my alternative is a 3.05% Treasury yield that will remain static. For accepting volatility, you’re getting a payout that will increase faster than inflation and make you a bit richer each year. For the “safety” of a Treasury bond, you get a static payout that will be able to buy just a little bit less each year due to inflation.
That being said, not everyone is a retiree looking for stable income. If your time horizon is measured in 10+ year holding periods, and you want to make singular decisions today that will go on growth autopilot to make you richer at a nice clip with a high degree of certainty, it makes more sense to focus on Becton Dickinson, Visa, Disney, and compounds with internal compounding engines that are above 10% per year. For someone who needs to spend their dividend income soon, those stocks make less sense. For someone looking to build paper wealth and have a higher dividend yield on invested capital years and years down the road, they make a lot of sense.
In short, if someone is looking for income now, has owned Kraft for a while, or is looking for diversification in that “I want to build a fifty-stock fortress” kind of way, Kraft makes perfect sense. If someone has limited funds, and is trying to be selective about maximizing their compounding rate in a high certainty way, you will be able to find better growth opportunities than Kraft. The appeal of something like Kraft right now depends entirely on what you’re trying to build with your financial life.