Is Fonterra Co-operative Group Limited (NZSE:FCG) A Smart Pick For Income Investors?

Dividend paying stocks like Fonterra Co-operative Group Limited (NZSE:FCG) tend to be popular with investors, and for good reason - some research suggests a significant amount of all stock market returns come from reinvested dividends. Yet sometimes, investors buy a stock for its dividend and lose money because the share price falls by more than they earned in dividend payments.

With a 2.2% yield and a eight-year payment history, investors probably think Fonterra Co-operative Group looks like a reliable dividend stock. A 2.2% yield is not inspiring, but the longer payment history has some appeal. There are a few simple ways to reduce the risks of buying Fonterra Co-operative Group for its dividend, and we'll go through these below.

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Payout ratios

Dividends are usually paid out of company earnings. If a company is paying more than it earns, then the dividend might become unsustainable - hardly an ideal situation. Comparing dividend payments to a company's net profit after tax is a simple way of reality-checking whether a dividend is sustainable. Fonterra Co-operative Group paid out 31% of its profit as dividends, over the trailing twelve month period. A medium payout ratio strikes a good balance between paying dividends, and keeping enough back to invest in the business. Plus, there is room to increase the payout ratio over time.

We also measure dividends paid against a company's levered free cash flow, to see if enough cash was generated to cover the dividend. Fonterra Co-operative Group paid out 13% of its free cash flow as dividends last year, which is conservative and suggests the dividend is sustainable. It's positive to see that Fonterra Co-operative Group's dividend is covered by both profits and cash flow, since this is generally a sign that the dividend is sustainable, and a lower payout ratio usually suggests a greater margin of safety before the dividend gets cut.

We update our data on Fonterra Co-operative Group every 24 hours, so you can always get our latest analysis of its financial health, here.

Dividend Volatility

One of the major risks of relying on dividend income, is the potential for a company to struggle financially and cut its dividend. Not only is your income cut, but the value of your investment declines as well - nasty. Looking at the last decade of data, we can see that Fonterra Co-operative Group paid its first dividend at least eight years ago. It's good to see that Fonterra Co-operative Group has been paying a dividend for a number of years. However, the dividend has been cut at least once in the past, and we're concerned that what has been cut once, could be cut again. During the past eight-year period, the first annual payment was NZ$0.3 in 2013, compared to NZ$0.1 last year. This works out to a decline of approximately 68% over that time.

We struggle to make a case for buying Fonterra Co-operative Group for its dividend, given that payments have shrunk over the past eight years.

Dividend Growth Potential

Given that dividend payments have been shrinking like a glacier in a warming world, we need to check if there are some bright spots on the horizon. It's not great to see that Fonterra Co-operative Group's have fallen at approximately 6.0% over the past five years. A modest decline in earnings per share is not great to see, but it doesn't automatically make a dividend unsustainable. Still, we'd vastly prefer to see EPS growth when researching dividend stocks.

Conclusion

When we look at a dividend stock, we need to form a judgement on whether the dividend will grow, if the company is able to maintain it in a wide range of economic circumstances, and if the dividend payout is sustainable. It's great to see that Fonterra Co-operative Group is paying out a low percentage of its earnings and cash flow. Earnings per share have been falling, and the company has cut its dividend at least once in the past. From a dividend perspective, this is a cause for concern. While we're not hugely bearish on it, overall we think there are potentially better dividend stocks than Fonterra Co-operative Group out there.

Market movements attest to how highly valued a consistent dividend policy is compared to one which is more unpredictable. However, there are other things to consider for investors when analysing stock performance. For example, we've picked out 2 warning signs for Fonterra Co-operative Group that investors should know about before committing capital to this stock.

If you are a dividend investor, you might also want to look at our curated list of dividend stocks yielding above 3%.

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This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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