Safe Stock, Rising Dividend

07/02/2009 1:00 pm EST

Focus: STOCKS

Josh Peters

Editor, Morningstar DividendInvestor

Josh Peters, editor of Morningstar DividendInvestor, and analyst Erin Swanson say Kraft Foods is ideal for those looking for a defensive stock with a pretty safe dividend.

Kraft Foods (NYSE: KFT) is one of the largest players in packaged foods, with nine brands that generate revenue of more than $1 billion. The firm’s products are found in more than 99% of US households and include such heavy-hitting brands as Oscar Mayer, Oreo, Maxwell House, and Nabisco.
 
Kraft strengthened its brand portfolio in 2007 with the acquisition of Groupe Danone’s biscuit business. Not only does this purchase increase Kraft’s international presence, but it also provides a platform over which the firm can expand the distribution of some of its existing brands.

During the past few years, Kraft has been restructuring to leverage its global scale and lower its cost structure. Beyond work force cuts and consolidation of manufacturing facilities, Kraft has pruned its portfolio of slower-growing, less profitable offerings (such as its flavored water, juice, and hot cereal brands) and enhanced its product mix with faster-growing, more profitable items. Although we doubt Kraft is likely to sell off as many assets as it has in the past, we believe these actions will improve its focus in this highly competitive segment.

Further, the firm intends to reinvest these savings in its product development and the marketing of its core brands. Despite these moves, commodity cost increases and challenging macroeconomic conditions present Kraft with some hefty external head winds.

To offset a portion of these costs, Kraft has raised prices across its portfolio. However, as consumers tighten the reins on their spending, it is likely that Kraft’s volume could come under pressure. This is of particular concern in the cheese aisle, where the firm faces significant competition from lower-priced private-label offerings.

Though operating income covers interest expense by a respectable 4.5x, Kraft sports $20 billion in debt. After years of dividend growth in excess of earnings growth, Kraft’s dividend burden is large, too, at 60% of operating earnings. But with relatively little variability in cash flows and no trouble accessing the capital markets, Kraft’s balance sheet and dividend are sustainable, in our opinion.

Restrained by Kraft’s immense size but encouraged by recent internal improvements, we believe 3%–4% annual revenue growth is sustainable long term. With even a modest pickup in margins, and excess cash flow used for debt reduction or share buybacks, a 6%–7% per-share growth rate for earnings and dividends looks well within the company’s grasp. [That] annual dividend growth potential, [plus a 4.5% yield,] suggests total returns in the 11% area.
 
(The stock closed below $27 Wednesday—Editor.)

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