The aim of dividend growth investing is to select companies with track records of increasing their dividends. It's also important that these companies are able to deliver dividend increases that at least keep up with rising prices of goods and services known as inflation. This allows an investor's purchasing power to remain intact or grow over time.
One company with an impressive track record of upping its dividend is the candy maker Tootsie Roll Industries (TR +0.64%). When including Tootsie Roll's 3% annual stock dividend (since an investor could theoretically sell their stock dividend and receive the cash), it has raised its overall dividends for 52 consecutive years, making it an unofficial Dividend King.
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However, not all Dividend Kings are stocks that investors should want to own. Here are four reasons why you may be better off avoiding Tootsie Roll.
1. Tootsie Roll is a stagnant company
Best known for its eponymous Tootsie Roll brand and Tootsie Pop brand, Tootsie Roll hasn't been innovating as of late with new product launches. For instance, the company has only introduced six new products in the past five years.
This has resulted in a nearly 3% annual decline in sales and a 1% annual dip in earnings per share over the past five years.
Even though Tootsie Roll's sales increased 17.6% year over year through the first three quarters of this year to $399.4 million, its sales are only up 2.7% compared to the same period in 2019 preceding the COVID-19 pandemic.
And due to supply chain challenges, Tootsie Roll's net margins declined 160 basis points from 12.9% in the first three quarters of 2019 to 11.3% year to date. The significant decline in net margins coupled with a 3% increase in Tootsie Roll's average shares outstanding has led to a 13% decline in year-to-date earnings per share (EPS) over the past two years to $0.67 this year.
Tootsie Roll's year-to-date operating results show that the company will take a while before it can recover to pre-COVID-19 levels. Analysts' 9% annual earnings growth forecasts over the next five years may seem promising at first glance. But it's worth noting that part of this earnings growth is rebounding from COVID-19 when EPS declined 7.3% year over year to $0.89 last year.
And unless Tootsie Roll's pace of product launches begins to pick up in the near future, I actually believe that 9% annual earnings growth even over last year is too optimistic.
2. Ownership structure leaves little hope for innovation
When a company culture is stagnating like Tootsie Roll's appears to be doing, the most common means of implementing a turnaround is from outside pressure from activist investors.
Unfortunately, that likely won't be happening anytime soon because the Gordon family owns the majority of the overall voting power of Tootsie Roll's common stock.
Simply put, nothing will change at Tootsie Roll without the approval of the Gordon family. And considering the lack of innovation over the past several years, it seems unlikely that anything will change unless the family steps aside.
3. A safe dividend, but with poor growth prospects
Tootsie Roll's dividend payout ratio of 39% over the last year means that the dividend is safe. But considering that the company's growth problems in recent years are likely to persist, I don't expect the dividend to grow beyond low single-digit percentages annually.
Even adding in the annual stock dividend that investors could sell each year to boost their yield to 4.1% (the 1.1% cash yield plus 3% stock dividend), I don't believe this yield is high enough to compensate for Tootsie Roll's modest growth potential.
4. The stock is significantly overvalued
Aside from the lack of innovation that has plagued Tootsie Roll for years, the biggest problem with buying shares here is that the stock is priced well beyond its fair value.
At its current $32 share price, Tootsie Roll is priced at a P/E ratio of 35.3. For context, this is nearly double the confectioner industry average P/E ratio of 20.7. Given that Tootsie Roll's 9% annual EPS growth estimate over the next five years is in line with the industry average of 8.9%, the stock should arguably be trading around the industry average P/E ratio. If investors' expectation that Tootsie Roll could be acquired by a larger competitor at a premium valuation wanes, the loss of its premium could result in significant capital losses at this share price.
