Investing in Future Dividend Aristocracy

By Markets

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In the investing world, mature corporations attempt to climb the social ladder by raising their dividend payouts each year for as long as healthy operations permit, cultivating an aura of perpetually increasing returns. Investors who prize quality, relative safety, and income growth, in turn, actively seek out "S&P 500 dividend aristocrats" --S&P 500 Index constituent companies that have raised dividends annually for 25 years or more.While the current S&P dividend aristocrat list is easy enough to find on the web, it's much harder to divine from today's vantage point which companies will be minted into the aristocracy a couple of decades from today.

You don't need to comb through the social register, however, to find at least one candidate that could join such distinguished company. The Kraft Heinz Company(NASDAQ: KHC), formed from the 2015 merger of consumer staples blue bloods Kraft Foods Group and the H.J. Heinz Company, recorded its second annual dividend increase last quarter. Let's review the conditions that imply many more dividend hikes in the years to come.

Targeting higher profits, and cutting Warren Buffett loose

Kraft Heinz hasflown past its benchmark, theS&P 500 Consumer Staples Index,so far this year. As of the date of this article, the condiment conglomerate has returned 25% on a total-return basis since January 1 versus 5% for the index.

Investors are enthused that the organization is realizing synergies promised from the merger.For example, on the company's second-quarter 2016 earnings call, CEO Bernardo Hees highlighted $300 million in cost savings realized during the last three months.

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These synergies are accompanied by margin improvements from implementing the operational playbook of 51% shareholder 3G Capital Partners, favorable commodity pricing, and crisp organic revenue growth.All factors combined have translated into a 19% improvement in adjusted EBITDAduring the first six months of 2016.

Will investors share in the widening profit? Until recently, the dividend available to common shareholders has been constrained by a 9% dividend on $8 billion of preferred stock payable to Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B), which acquired the shares when it teamed up with 3G Capital to purchase the H.J. Heinz Company in 2013. If you just did some rough calculations in your head, you're correct: The yearly dividend outlay on the preferred shares equals a cool $720 million.

On June 7, 2016, a little less than a full year after the Kraft Heinz merger was completed, the company relieved itself of this payout burden by redeeming the preferred stock. Berkshire Hathaway remains a nearly 27% common stock shareholder.

Kraft Heinz redeemed Warren Buffet's prized preferred certificates through a mix of financing, which included issuance of dollar-denominated and euro-denominated debt, issuance of commercial paper, utilization of the company's securitization programs, as well as the pitching in of some cash on hand.In total, the ongoing refinancing cost -- treating preferred stock obligations as credit rating agencies do, as being equivalent to debt -- should run Kraft Heinz about $240 million per year by my calculation. That's a savings of $480 million over what the company was obligated to pay Berkshire Hathaway annually.

Now, the savings aren't earmarked to go directly to shareholders. While the company did announce a 4.3% dividend increase, to $0.60 per share, alongside Q2 2016 results -- which pushes the current yield up to 2.7% -- Kraft Heinz is most likely to use the additional funds for initiatives like manufacturing efficiency investments and marketing to push "big bet" innovations, including the new "Seriously Good Mayonnaise" product line launched in Europe this spring.

Implications for future aristocracy

Despite reinvestment of the interest expense savings into the business, Kraft Heinz's preferred share redemption opens up a path to steady dividend increases. Since preferred stock dividends have priority over those of common shares, the $180 million quarterly preferred dividend payment to Berkshire Hathaway had reduced the amount of "net income available to common shareholders" each quarter until now.

With this obligation dispensed with, Kraft Heinz's payout ratio -- common stock dividends divided by net income -- drops from a current level of 80% to 65%. This is still a pretty steep payout ratio, but the company's ability to significantly improve earnings before interest, taxes, depreciation, and amortization (EBITDA) post merger indicates that the ratio will decrease naturally going forward, as profit gains outpace dividend increase percentages.

A stated focus on balance-sheet leverage will also help. Kraft Heinz's debt-to-EBITDA ratio hovers around 4.0 at present. The company maintains that it wants to reduce total debt to no more than three times EBITDA over the medium term.Management plans to attack the ratio from both sides, by paying down borrowings with cash generated from operations, while pushing up operating margins. The net result of this de-leveraging goal will be increased cash flows that can be used for shareholder friendly actions.

Will Kraft Heinz actually transcend to the status of dividend aristocrat? Of course, there's no obligation for the company to ink consecutive annual dividend hikes. But I predict management will do just this, in the interest of stock price performance. Distributing excess cash flow to owners helps propel investor purchases of the most highly regarded consumer goods stocks. It's a time-honored signal in the marketplace that can attract constant flows of buying interest in company shares, year after year.

As a common-sense caveat, no one can foresee what crises might burst into being over time to thwart a formidable streak. Acknowledging this, I'd hazard to guess that investors already have formed an expectation of consistent and more robust distributions from "KHC" as we move into next year and beyond. In mutual self-interest, the company should have no issue with meeting, and every desire to attain, such expectations.

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Asit Sharma has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares). 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.