Ep. 106: What Actually Backs a Dividend — KHC's 6% Test, Realty Income, and the Value Traps

What if I told you that a massive 19% dividend yield could
actually make you significantly poorer over time?
I mean, it sounds completely backwards.
Yeah, exactly.
Like you see this huge payout, you think you found the ultimate income hack
and you just jump in head first, right?
But honestly, you might just be buying a ticket on a sinking ship,
which is exactly why today in this deep dive, we are completely
tearing apart the concept of the dividend.
It's long overdue, really.
The allure of a double digit yield is, well, it's probably one of the most
dangerous psychological traps in investing.
Oh, for sure.
We have this fascinating stack of sources for you today, everything
from, you know, fiercely debated blue chip staples to completely
battered apparel brands all the way to ETFs that are employing some pretty
wild financial engineering, just to manufacture yield.
Yeah.
And we are going to ignore the flashy headlines today.
We're strictly following the actual cash flow.
Right.
We want to know what actually backs a dividend.
Exactly.
Because to determine if a payout is a hidden opportunity or, you know,
a devastating value trap, you really have to look at the unglamorous plumbing
of a business.
The plumbing, I like that.
Yeah, we need to see if the cash coming in the front door can actually
support the checks they're mailing out the back door.
Well, let's put that plumbing to the test with, um, probably one of the
most polarizing stocks on Wall Street right now, Kraft Heinz.
Oh, yeah, the ultimate battleground stock, the analyst divide on this
company is just staggering.
I mean, Morningstar is throwing a five star deep value rating at it, basically
calling it a generational bargain, but then you have JP Morgan looking at the
exact same company and rating it underway.
It's wild.
And to put some numbers to that divide, Kraft Heinz ticker KHC is
treating it roughly $26 a share right now, which gives it a very, very
tempting 6.1% dividend yield.
Right. And one camp sees that yield as a fortress and the other sees a
total house of cards.
Well, the bears seem to have a massive piece of ammunition here.
I'm looking at their income statement and the sources and there is a
glaring $5.8 billion dollar gap net loss for the year.
Yeah, that's a scary number to look at.
Right.
I mean, looking at that is like buying a house where the previous owner left a
massive ugly mess in the living room.
To a casual observer, seeing a nearly $6 billion loss means the
company is bleeding out.
How is that dividend not doomed?
Well, that massive scary number is exactly why we have to dig into the
mechanics of accounting versus actual cash.
OK, walk me through it.
So that $5.8 billion gap loss is what's called a non cash
impairment, non cash.
So not actual dollars leaving the bank.
Exactly.
Let's say you buy a bakery for a million dollars, mainly because it has
this famous brand name, OK, a few years later, you realize, well,
the brand isn't actually as popular as you thought.
So you officially declare on paper that it's only worth half a million, right?
So you have to record a $500,000 loss on your books.
Yes, but you didn't actually write a check for $500,000 that day.
The cash register is completely unaffected.
Ah, got it.
So the day-to-day operations didn't suddenly lose half a million bucks, right?
That is the core mechanism of an impairment charge.
Kraft Heinz essentially just wrote down the value of their historical assets.
So if we want to know if the dividend is safe, what's the actual metric we should be
looking at?
We have to look at free cash flow.
That's the actual physical cash leftover after paying the operating bills and,
you know, maintaining the factories.
And how does that look for them?
Surprisingly good.
Kraft Heinz generated $3.66 billion in free cash flow.
Wow.
And what was the actual bill for the dividend payout?
They paid out $1.90 billion to shareholders.
Okay.
So that leaves them with what?
Like a 1.93 times coverage ratio.
Exactly.
The dividend is only consuming about 52% of the actual cash they brought in.
So the cash generation is doing the heavy lifting, completely ignoring those ugly
accounting write downs.
Right.
And it gets even more compelling when you factor in their debt because they carry a lot of it.
Right.
They do.
But if you take their market cap and add their $18.6 billion net debt,
you get their enterprise value on that basis.
Kraft Heinz has a 7.4% free cash flow yield.
Compare that to a competitor like Mondalez, which sits at just a 3.3% yield.
Oh, wow.
That's a huge difference.
Yeah.
So Kraft Heinz is generating significantly more cash relative to its total price tag.
Exactly.
But wait, JP Morgan isn't blind.
I mean, if the cash is flowing that well, they must be seeing some severe crack somewhere
else in the plumbing to rate it underway.
Oh, they definitely are.
They are looking at the structural pressure on that cash, the kind of pressure.
Well, that comfortable 1.93 coverage ratio, it's slightly artificially inflated
because Kraft Heinz had a very light year for capital expenditures.
Meaning they didn't spend as much on upgrading stuff.
Right.
They only spent $800 million upgrading and maintaining their equipment.
If you normalize that to what a massive industrial food company usually needs to spend,
the coverage ratio drops to 1.84, which is still technically safe, but that margin of error shrinks.
Yes.
And carrying $18 billion in debt creates a massive choke point because of the interest payments.
Exactly.
If you combine their required interest payments on that debt with the dividend payout,
those two obligations alone consume about 64% of their operating cash flow.
Wow.
And that's before they spend a single dime on like fixing a broken assembly line
or marketing a new product.
Right.
So if inflation pushes their ingredient costs higher or if consumers keep switching to generic store brands,
that's 64% burden gets very heavy, very quickly.
So the real takeaway for you as a listener looking at a high yield play like Kraft Heinz is that
you have to continuously audit the cash flow.
The headline earnings might look catastrophic, but as long as the cash generation holds up,
which our sources noted actually has over the last four years, the yield survives.
Yeah, you essentially have to act like a forensic accountant.
You just cannot take the net income line at face value.
Absolutely.
Now Kraft Heinz is wrestling with, you know, sector wide grocery inflation.
Let's look at what happens when the damage is entirely self-inflicted or maybe macro-driven,
causing truly iconic global brands to completely fall off a cliff.
Oh, we're talking about the falling knives now.
Yeah.
I'm looking at Nike, which is down 44% from its high and ST Lauder down 30%.
Yeah.
Nike is trading around $44 a share right now, which actually pushes its dividend yield up to 3.66%.
Which is incredibly high for a company historically valued for relentless growth, right?
Very unusual for them.
And ST Lauder is sitting around $82 a share.
These are companies that usually trade at massive premiums.
Right.
So when blue chip stocks drop this violently, it always sparks the exact same debate.
Are these generational buying opportunities where you can lock in a rare high yield?
Or are we just trying to catch a falling knife?
Well, the answer lies in the mechanics of their respective downfalls.
Nike committed a massive, unforced error regarding their distribution model.
The direct to consumer pivot, right?
Exactly.
A few years ago, they decided to go all in on direct to consumer sales.
They basically wanted you buying exclusively through the Nike app or Nike stores,
completely bypassing the middleman, which sounds great for margins and theory in theory.
Sure.
But in doing so, they aggressively pulled their products from wholesale partners, like footlocker and those guys.
Exactly.
They alienated the massive retail networks that helped build the brand in the first place.
And I'm guessing that severely backfire.
Oh, totally.
Competitors just flooded the shelf space at Nike abandoned.
Oh, wow.
Now Nike has brought in a new CEO, Elliot Hill, who is actually currently buying shares with his own money
to rebuild those wholesale relationships.
But supply chains and retail partnerships, those take years to negotiate and optimize, right?
Yes.
Analysts do not expect a fundamental turnaround in Nike's numbers until 2027 or even later.
So Nike broke its own distribution machine.
What happened to Estee Lauder?
Estee Lauder is trapped in more of a macro economic vice.
They are highly dependent on the Chinese consumer market, which is experiencing a severe slump right now.
Ah, and simultaneously, they rely heavily on travel retail, like the duty free cosmetic counter
is at international airports.
Exactly.
That specific segment dried up, which completely crushed their growth margins, which normally sit at a stellar 74%.
So the structural damage for both of these companies means you aren't just waiting for a bag
quarter to pass.
You're waiting for entire business models to be reconstructed, right?
Which turns their current dividend into what we call a waiting room payout, a waiting room payout.
I like that.
Yeah, you're basically collecting that 3.6% from Nike while you sit in the waiting room for the renovations to finish.
Buying durable motes during cyclical downturns is a proven strategy, but only if your time horizon is measured in decades.
Yeah, if you need this stock to bounce back in six months, you are definitely going to get burned.
Absolutely.
But you know, waiting 10 years for Nike to turn around requires immense patience.
Let's pivot to a company.
The market thinks is a slow, boring turnaround, but is actually hiding a massive growth engine under the hood.
Ah, Abbott laboratory.
Yes, ticker ABT.
It's such a fascinating case of market miscategorization.
It really is.
The market basically looks at it as a legacy healthcare staple.
Because it's a dividend aristocrat, right?
I mean, 54 years of consecutive increases paid out for 410 consecutive quarters.
It's beta is super low, like 0.6.
Right.
It barely fluctuates compared to the broader market.
The market basically treats Abbott like a reliable old station wagon, you know, baby formula and a metronomic 63 cent quarterly dividend.
But looking at our sources, it seems like they just dropped a sports car engine under the hood.
That's a perfect analogy.
Because the underlying fundamentals show a company undergoing a massive internal transformation, Abbott is trading at a 17 times forward PE right now.
And just to clarify that metric for everyone, that means investors are willing to pay $17 for every $1 of earnings Abbott is expected to generate next year.
Exactly.
And that 17 times multiple is actually relatively cheap and it's being dragged down by their legacy nutrition segment, which is currently shrinking by about 6%.
So the market is just fixated on these struggling baby formula division and completely ignoring the medical technology side.
Totally.
Their medical devices segment is compounding at an incredible rate.
It's up 13.2% to $5.5 billion.
Wow.
What's drive that the primary catalyst is the freestyle Libre.
It's their continuous glucose monitor.
And this isn't just a basic medical supply.
This is a highly sticky recurring revenue technology.
Management is actually projecting the total addressable market for these monitors will expand from 12 million global users today to 80 million users.
Wait, 80 million.
That is an astronomical expansion of their customer base.
It's massive.
And they aren't just relying on in-house research either.
They're actively buying growth.
Right.
The exact sciences deal.
Yes, they executed a $21 billion acquisition to bring colla guard, the non-invasive cancer diagnostic into their portfolio.
And that's supposed to be huge for them, right?
Yeah, Abbott's management anticipates this will add $3 billion in incremental sales by 2026.
They are basically using the reliable cash flow from their slow growth legacy divisions to fund this high margin diagnostics and device empire, which completely flips the narrative on what a quote-unquote safe dividend looks like.
Sometimes safety isn't found in a stagnant company, simply defending its territory with a high yield.
True safety might be a dividend attached to a company actively compounding and transforming its core business.
Exactly.
Abbott is basically a growth compounder wearing the disguise of a boring bond proxy.
Speaking of bond proxies and boring income stocks, Abbott relies on retaining its capital to buy out companies like exact sciences.
But some companies are structurally forced to pay out their cash.
Right.
The REITs.
Yeah, let's look at a company completely tied to macroeconomic forces and actual bond yields, realty income ticker.
Oh, often literally referred to as the monthly dividend company.
Their track record is almost difficult to comprehend.
They trade around $63 a share with a roughly 5.1% yield, but they have paid over 670 consecutive monthly dividends and delivered 114 consecutive quarterly increases.
The operational discipline is just flawless.
It is, but as a real estate investment trust or REIT, they are legally required to distribute at least 90% of their taxable income to shareholders.
So they can't just hoard cash like a tech company.
No, because they pay out almost everything they make, they cannot fund new property purchases with their own cash pile.
They always have to borrow money, which means their entire business model is dictated by the spread between borrowing costs and rent collection.
That is the core mechanism of a REIT.
Yeah, they borrow capital at, let's say, 4%, they buy a commercial property, and they lease it out at a 7% yield.
And that 3% spread is their profit.
Exactly.
So over the past couple of years, as the federal reserve aggressively hiked interest rates, realty incomes borrowing costs surged.
Their profit spread compressed.
And at the same time, investors realized they could get a risk-free 5% return from a government bond.
Right, which makes realty incomes 5.1% yield look far less appealing, given the added risk of real estate.
But the macroeconomic winds are shifting dramatically in our sources.
Recent data shows June's CPI cooling to 3.5%, down from 4.2% in May.
Yeah, inflation is finally backing off.
And as inflation cools, the probability of the Fed cutting interest rates skyrocket, which is huge for a REIT.
It's the ultimate catalyst.
Their borrowing costs drop, which immediately widens their profit margins.
Plus, as government bond yields fall back down to, say, 3% or 4%, income investors will rotate back into realty income to capture that 5.1% yield.
Which drives the stock price up.
Exactly.
But real estate is never without risk.
If they are buying up massive amounts of commercial property, who are they actually renting to?
Well, that's the bear caveat.
They are heavily concentrated in retail tenants, think gyms, pharmacies, dollar stores.
So if consumer spending falters in recession, those tenants could really struggle to make rent.
Precisely.
Additionally, there are adjusted funds from operations, which is basically the reequivalent of earnings is only projected to grow at about 3% to 4%.
So their internal growth is capped very capped.
And if inflation unexpectedly reaccelerates, the rate hike threat returns.
And this entire thesis gets heavily damaged.
OK, so we've evaluated realty incomes 5.1% yield and craft hines is 6.1% yield.
Why on earth would our sources highlight a company like Donaldson company that only yields 1.4 or 5% right?
It seems so out of place.
Yeah, Donaldson ticker DCI is an industrial filtration company.
Why dedicate time to a yield that barely outpaces a basic savings account?
Because Donaldson represents the ultimate lesson in the quality over temptation screen.
When a company isn't forced to pay out its cash like a reate, it can reinvest that money internally to compound its own value.
So we are basically looking at how efficiently management uses the cash they choose not to give us.
Exactly.
And the fundamentals here are bulletproof.
Our sources show Donaldson boasts an 8 out of 10 for profitability driven by a massive 25.8% return on equity.
Wow.
So for every dollar of shareholder capital they retain, they generate nearly 26 cents of profit.
Yeah.
They are incredibly efficient at turning retained cash into business graph.
And a business that efficient usually doesn't have to borrow heavily to survive, right?
Their balance sheet is ironclad.
They score an 8 out of 10 for health.
They have a highly conservative debt-to-equity ratio of 0.36.
Okay, that's really low.
But more importantly, their Altman Z score is 7.96.
The Altman Z score, that's the bankruptcy predictor.
Yes, it's a complex formula weighing profitability, liquidity, and solvency.
Any score over 3 is generally considered safe.
And they are at almost 8.
Right.
A score approaching 8 means bankruptcy is virtually a mathematical impossibility, which brings us to the safety of that small 1.4 or 5% dividend.
Well, the most vital number for dividend safety here is their payout ratio.
It is a mere 31.68%.
So they are using less than a third of their profits to fund the dividend.
Exactly.
The rest goes toward that highly efficient internal growth.
In fact, their earnings are projected to grow at 10.04% annually, which easily outpaces their 5.89% historical dividend growth.
So for you, the investor, Donaldson, is for the person who prioritizes absolute financial health and capital appreciation over a flashy quarterly check.
It's the anti-yield trap.
And it's actually the perfect transition into how looking solely at the yield percentage can completely blind you to a fund's actual strategy.
Let's take that concept to the absolute extreme.
Our sources highlight an ETF with the word dividend, right in its name, yet it yields less than 1%.
Oh, RDVY.
Yes, the first trust rising dividend achievers ETF ticker RDVY.
It yields a poultry 0.84% and has a higher than average expense ratio of 0.47%.
All right.
If I'm an income investor, paying yearly half a percent in fees to get less than 1% in yield sounds like a massive disappointment.
Why is this fund managing $24 billion?
Well, if you buy this fund for immediate income, you will absolutely be disappointed.
RDVY isn't actually an income vehicle.
What is it then?
It's a total return growth vehicle disguised as a dividend fund.
How does screening for dividends result in a growth fund?
It's all in the underlying mechanics of their algorithm.
They do not sort stocks by the highest yield.
Instead, they look for companies that have consistently grown their dividend over the last three and five years.
Okay, that makes sense.
Then they require positive earnings growth.
Finally, and most importantly, they demand a cash to debt ratio greater than 50%.
So they are hunting for companies with massive cash reserves, low debt, growing earnings,
and management teams confident enough to bump up the dividend every single year.
Exactly.
And when you run that specific set of filters, you accidentally exclude most traditional,
slow-growing utility or telecom stocks.
The usual dividend suspects, right.
Instead, the fund aggressively swoops up technology and financial juggernauts.
Tech companies often have massive piles of cash and minimal debt.
And while they're starting dividend yields are tiny, they raise them consistently,
which explains why RDVY's top holdings feature names like applied materials and lamb research.
Exactly.
They are basically using the dividend hike as a polygraph test for the company's financial health,
rather than an income stream and the results.
Stunning by focusing on elite financial health, rather than high yield,
RDVY delivered a 16.5% average annual return over the past decade.
Wow.
Yeah, it beat both the Vanguard S&P 500 ETF and 97% of actively managed large cat mutual funds.
That completely shatters the idea that dividend investing is just for retirees looking for fixed income.
Sometimes a growing dividend is the loudest signal that a company is fundamentally dominating its sector.
Absolutely.
But you know, if RDVY uses screens to build a growth fund, other funds use financial engineering
to manufacture extreme income.
Okay, let's swing the pendulum to the absolute extreme then.
We went from 6% to 1.4% to under 1%.
Now let's look at a targeted yield of 19 to 23%.
This is where things get crazy.
The NEO's boosted NASDAQ 100 high income ETF ticker XQQI.
I look at a 23% yield and my immediate thought is that targeting that kind of yield
sounds less like investing and more like putting your portfolio on a red table and betting on black.
How is this even mathematically possible?
It requires highly aggressive complex option strategies combined with leverage.
XQQI is built on top of an already high yield fund QQQI.
But it doesn't just hold stocks and pass the dividends to you.
They employ professional options management.
A covered call strategy, right?
Let's break down the mechanics of a covered call quickly for someone who maybe needs a refresher.
Sure.
When a fund writes a covered call, they own the underlying stocks in this case and NASDAQ 100.
But they sell a contract to another investor, giving that investor the right to buy those stocks at a set price
if the market goes up in exchange for basically giving away the
potential upside of the stock.
The fund receives an immediate upfront cash premium.
That premium is what gets paid out to you as the massive monthly distribution.
So you are trading your future growth potential for a huge pile of cash today.
Yes, but XQQI takes it a step further.
They use what are called section 12 56 contracts, which are highly tax efficient,
allowing you to keep more of that premium and then they apply 150%
additional leverage.
Whoa.
Yeah, they are effectively borrowing money to amplify the size of the options contracts.
They're rating turbo-targing the cash generation leverage is a powerful tool.
But it is never free.
It amplifies everything in both directions.
What is the hidden tradeoff here?
The bear case here is urgent to understand the trapdoor opens during a sustained down market.
Let's trace the math.
If the NASDAQ crashes 20%, this fund takes the full hit magnified by the leverage.
Ouch. Okay.
But when the market eventually bounces back, this fund cannot fully recover because
they continually sell covered calls.
They cap their own upside.
So they absorb all the devastating drops, but cap the recoveries over time in a volatile
market, this downside decay slowly cannibalizes the principal value of the fund.
So you might be collecting a 20% yield, but your initial investment is shrinking so fast
that you're told net worth is actually dropping exactly.
This is not a set it and forget it holding.
It is a highly tactical, aggressive instrument for investors with a very specific
risk tolerance, who actively manage their exposure.
Wow.
We have covered an immense spectrum of financial machinery today in this deep dive
from digging through Kraft Heinz's free cash flow statements to cover its gap losses
to evaluating Abbott's hidden tech growth.
Yeah, and understanding real estate incomes macro sensitivity to weight cuts.
Right. And then weighing Donaldson's boring, but beautiful compound growth against
the extreme leverage of XQQI.
The through line here is so clear, you have to know exactly how the cash is being
generated to know if you're dividend is safe.
Absolutely.
The mechanics are diverse, but the analytical framework never changes.
Whether a stock yields 1% or 20%, a dividend is only a promise.
The cash flow foundation is the only thing that keeps that promise alive,
which brings us to the ultimate stress test for your own portfolio.
Yeah, I'll leave you with this lingering thought.
Take a close look at the highest yielding stocks you own.
If a company's dividend yield is consistently higher than its actual earnings growth rate,
are you truly making a profit?
Or is management just slowly liquidating the underlying business and handing your
own money back to you in installments?
That is a brutal, but necessary question to ask because falling for a massive yield
without checking the cash flow is a guaranteed way to watch your capital disappear.
Thank you for joining us on this deep dive.
Keep questioning the numbers behind your portfolios and we will catch you next time.