Finding Future Dividend Aristocrats

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The S&P500’s Dividend Aristocrat Index is made up of companies within the S&P500 index that have increased their dividends consecutively over 25 years. Dividends are a great source of income and return for investors and Warren Buffett elucidates the idea brilliantly in his 2010 Annual Letter to Berkshire Hathaway Shareholders:  

Coca-Cola paid us $88 million in 1995, the year after we finished purchasing the stock. Every year since, Coke has increased its dividend. In 2011, we will almost certainly receive $376 million from Coke, up $24 million from last year. Within ten years, I would expect that $376 million to double. By the end of that period, I wouldn’t be surprised to see our share of Coke’s annual earnings exceed 100% of what we paid for the investment. Time is the friend of the wonderful business.”

Considering the fact that Buffett paid a total of $1.3 billion for Berkshire’s stake in Coca-Cola (NYSE: KO), producer of the world famous soft-drink, and has gotten back $352 million in 2010 and $376 million in 2011 in dividends, companies that have the ability to increase dividends every year would certainly be a very attractive idea for any investor.

What clues, then, can companies provide us in their financial statements for hints of future ability to pay out increasing dividends year in, year out? In the S&P500’s Dividend Aristocrat list, I picked out 3 companies, including Coca-Cola, to highlight a particularly significant aspect of their financial statements over their last 10 completed fiscal years that showcase just why it is they can afford to increase their dividends every year safely.

Table 1 and Figure 1 shows how Coca-Cola’s Operating Cash Flow (OCF), Free Cash Flow (FCF) and Cash Dividends Paid (CDP) have changed over its last 10 completed fiscal years. OCF is the actual cash produced by the business in a financial year while FCF is the residual cash from OCF that is left-over after the company has invested in assets that it requires to maintain its business (also known as Capital Expenditures). FCF can be used for acquisitions for growth, repurchasing of shares and to pay out dividends to shareholders without resorting to borrowing money or issuing more shares for capital.

Table 1 - Coca-Cola's OCF, FCF, CDP over the last 10 fiscal  years (numbers in $Millions)

<table> <tbody> <tr> <td> <p> </p> </td> <td colspan="10"> <p>Fiscal Year</p> </td> </tr> <tr> <td> <p>Coca-Cola</p> </td> <td> <p>2002</p> </td> <td> <p>2003</p> </td> <td> <p>2004</p> </td> <td> <p>2005</p> </td> <td> <p>2006</p> </td> <td> <p>2007</p> </td> <td> <p>2008</p> </td> <td> <p>2009</p> </td> <td> <p>2010</p> </td> <td> <p>2011</p> </td> </tr> <tr> <td> <p>Operating Cash Flow</p> </td> <td> <p>4742</p> </td> <td> <p>5456</p> </td> <td> <p>5968</p> </td> <td> <p>6423</p> </td> <td> <p>5957</p> </td> <td> <p>7150</p> </td> <td> <p>7571</p> </td> <td> <p>8186</p> </td> <td> <p>9532</p> </td> <td> <p>9474</p> </td> </tr> <tr> <td> <p>Free Cash Flow</p> </td> <td> <p>3889</p> </td> <td> <p>4648</p> </td> <td> <p>5215</p> </td> <td> <p>5521</p> </td> <td> <p>4550</p> </td> <td> <p>5500</p> </td> <td> <p>5600</p> </td> <td> <p>6200</p> </td> <td> <p>7320</p> </td> <td> <p>6550</p> </td> </tr> <tr> <td> <p>Dividends Paid</p> </td> <td> <p>1990</p> </td> <td> <p>2170</p> </td> <td> <p>2430</p> </td> <td> <p>2680</p> </td> <td> <p>2910</p> </td> <td> <p>3150</p> </td> <td> <p>3520</p> </td> <td> <p>3800</p> </td> <td> <p>4070</p> </td> <td> <p>4300</p> </td> </tr> </tbody> </table>

<img src="/media/images/user_13475/coke-graph_large.jpg" />
Figure 1 - Coca-Cola's OCF, FCF and CDP over the last 10 fiscal years

We can see that Coca-Cola’s OCF and FCF have increased over the years and that FCF makes up a substantial portion of OCF. That is the magic which has allowed Coca-Cola to raise its dividends every year. Warren Buffett has written/spoken extensively on the predictability of Coca-Cola’s cash flows as well as their relatively limited capital expenditure needs. Companies that are engaged in capital un-intensive businesses with relatively predictable growth in cash flows make prime candidates for dividend aristocracy because they can generate great streams of FCF in the future, as demonstrated by Coca-Cola’s financial statement excerpts in Table 1 and Figure 1.

We can also see very similar trends in OCF, FCF and CDP for fellow dividend aristocrats, Lowe’s Companies (NYSE: LOW) and PPG Industries (NYSE: PPG) in Figures 2 and 3 respectively. Home improvement retailer, Lowe’s, requires pretty extensive capital expenditures each year. However, their prodigious OCF makes up for it and still allows them to produce a decent stream of FCF from which they can reward their shareholders with dividends. PPG Industries, which makes specialised paint-coatings as well as normal paints for the aerospace and housing industry respectively, has much smaller capital investment needs and find themselves in a similarly advantageous financial situation as Coca-Cola.

<img src="/media/images/user_13475/lowes-graph_large.jpg" />

Figure 2 - Lowe's OCF, FCF and CDP over the last 10 fiscal year

<img src="/media/images/user_13475/ppg-graph_large.jpg" />

Figure 3 - PPG Industries' OCF, FCF and CDP over the last 10 fiscal years

There are other companies that while not part of the dividend aristocrats list, actually show promise of being able to be part of such a group in the future. Sportswear giant, Nike (NYSE: NKE), has managed to increase their dividends over the past 10 completed fiscal years as shown in Figure 4. Nike has a powerful and global brand name, reflected by its return on equity of 21.4% in FY2012 on a relatively unlevered balance sheet (return on equity on an unlevered balance sheet is one of Warren Buffett’s favourite measures of a business’s profitability). Nike’s constant and deep involvement in a wide array of different sports such as soccer, football, basketball, golf etc also ensures that consumers would likely purchase their products for both fashion and function. Their relatively tiny capital reinvestment needs would also ensure a huge stream of FCF for Nike to pay out to their shareholders in the future.

<img src="/media/images/user_13475/nike-graph_large.jpg" />

Figure 4 - Nike's FCF, OCF and CDP over the last 10 fiscal years. **Cash Dividends include dividends to both Common and Preferred shares

Luxury handbag and leather goods maker, Coach (NYSE: COH), has only just begun to pay out dividends in FY2010 but they too have excellent FCF that makes up 82% of OCF on average, an achievement that not even Coca-Cola can boast of. Coach’s return on equity, a stunning 52.5% based on last 12 month’s figures, suggests that it might be an enduring brand and they are poised to ride on Asia’s economic growth and love of luxury products. This would mean that Coach has a high chance of producing materially higher FCF in the future, which can benefit shareholders in the form of potentially much higher dividend pay-outs.

<img src="/media/images/user_13475/coach-graph_large.jpg" />

Figure 5 - Coach's FCF, OCF and CDP over the last 10 fiscal years

Not every dividend aristocrat exhibits great OCF and FCF trends as well as having a relatively low debt-load. However, companies that are able to pay-out dividends due to increasing FCF every year while carrying minimal debt are the ones with the safest and most reliable dividends. By checking out the FCF history as well as well-informed estimates of their future growth path, there is a good chance of us finding the next big dividend aristocrat. 

serjing owns shares of Coach. The Motley Fool owns shares of Coach and Nike. Motley Fool newsletter services recommend Coach, The Coca-Cola Company, Lowe's Companies, and Nike. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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