Dare you trust these dividends?

Dare you trust these dividends?

21 Sep 2015

Perhaps the most pertinent question for UK stock investors today is “can I trust those high dividend yields?” Glaxo has pre-announced that it will maintain its dividend at 80p per share this year and next year. That’s a yield of 6.2%. Royal Dutch appears to yield 7.5% on the basis of paying $1.88 (c.120p) also “guaranteed” for 2015 and 2016. If these companies can be relied on to continue these pay-outs, it matters little whether Janet Yellen dares to raise the federal funds rate from irrelevant to insignificant or indeed whether Mark Carney goes mad and does the same with the bank rate. 

Here is what I previously wrote about the interpretation of high dividend yields.

Shares that yield 5%

The market does not like these companies. They are seen as unreliable. This may be because there are external threats that are beyond the power of management to prevent or mitigate or it may be that management is simply mistrusted. It might also be the case that they are mature businesses that are, rightly or wrongly, thought to be approaching the end of their life-cycle.

 

Shares that yield 6%

The market does not trust the dividend. It expects it to be cut (or “rebased”, in modern corporate terminology).

Naturally I agree with every word of this and everything that follows should be seen in the context of those comments.

I will briefly discuss Glaxo and Royal Dutch before moving on to some humbler companies.

There is a summary at the end.

GLAXO           Price:  1296p                    Hoped for dividend:  80p                       Yield: 6.2%

Glaxo is showing off by paying a bonus 20p in respect of Q4 (year-end March 2016). This seems to me an unnecessary answer to the sceptics who would anyway be confounded merely by flat progress. People dislike Big Pharma about as much as they dislike Big Tobacco and they both look like industries that spend a fortune on lobbying. Glaxo needs to generate $3.8bn of free cash flow to pay its 80p dividend without adding extra debt (nearer $5bn this year with the bonus). In 2014 it made free cash flow of $5.5bn; in the year to March 2015 free cash flow was $3.4bn.

I know next to nothing about the pharma industry but Glaxo looks as if it spends its time putting out fires (metaphorically) and I dislike the strutting, hubristic body language of the bonus dividend.

ROYAL DUTCH      Price: 1598p                   Hoped for dividend:   120p                     Yield: 7.5%

Royal Dutch is a giant in a land of super giants. Its response to the unexpected collapse of the oil price has been to cut $10bn off its capex budget (from $40bn to $30bn). The dividend should cost $12bn a year but many small Royal Dutch investors take scrip dividends instead (new shares in lieu of cash) so the actual pay-out was $9.4bn last year. Free cash flow was $12bn in 2014 (boosted by the lower capex) but was zero in 2013. Moreover, Royal Dutch has chosen to up the stakes with the dangerously transformational takeover of BG (costing $20bn in cash) and the pledge to spend another $25bn on pointless share buy-backs in the next couple of years.

I expect Royal Dutch to maintain its dividend in the foreseeable future but the takeover and other big decisions smell as much of fear as of confidence. The 7.5% dividend yield smells quite strongly of fear. If you are feeling intrepid you could argue that the fear is in the price.

VODAFONE        Price:  218p                     Hoped for dividend:   11.1p                          Yield: 5.1%

Vodafone looks to many people (such as its customers) like a company with a licence to print money. It has roughly the same amount of (pension liability adjusted) net debt as Royal Dutch despite being just one sixth the size in terms of revenues. Creditors want to lend to Vodafone.

This means that if capital expenditure exceeds cash flow in one year and Vodafone needs to borrow to pay its dividend, everyone is cool. Vodafone has net operating cash flow of c.£10bn and its dividend costs £3bn a year. It has high and rising capex costs (Project Spring) but it looks as if its decisions are in its own hands.

It guidance for the 2016 (March end) financial year includes:

  • Organic EBITDA growth: EBITDA in the range of £11.5 billion to £12.0 billion

  • Positive free cash flow after all capex, before M&A, spectrum and restructuring costs

  • Capex of £8.5 billion to £9.0 billion, reflecting the second year of Project Spring investment

  • Intention to grow dividends per share annually, demonstrating confidence in future cash flow generation

This is a cash cow company yielding more than 5% pledging to grow dividends every year. It is a fairly mature business that is turning into a utility company but I do not see that it will be approaching the end of its natural life-cycle until most of us have no further use for our pensions.

CENTRICA      Price:  229p                    Hoped for dividend:  12p                          Yield: 5.2%

Centrica is another company that has suffered from bad press. It is widely believed that companies like Centrica trick their residential customers into overpaying for energy. Hence they look like easy targets for ignorant politicians who potentially can influence regulators. Two years ago the struggling Labour party said that it would freeze energy bills if it were to win the 2015 election. Aside from the sheer economic ignorance (because it would have stopped charges from falling in line with wholesale prices, as they have since done), anyone with any business experience could have foreseen that this was a major disincentive to investment.

And so it came to pass. From 2011-14 Centrica annual capex averaged at £1.7bn. It has now said that it will limit capex to £1bn a year. Obviously this not all the fault of Ed Milliband. Energy policy is regarded with distaste by UK politicians. Energy ministers come and go and they seem to make up strategy as they go along. In the last budget, George Osborne imposed a carbon tax on energy from renewable sources, thereby demolishing the supposed logic for the carbon tax in the first place.

Any lingering obligation that Centrica and other energy companies might have felt to invest in the country’s long-term energy needs has probably dissipated. Check out this letter from one very unhappy Drax investor.  

Last year Centrica “rebased” its dividend i.e. cut it by 30%. Today’s yield is based on that reduced dividend. The new dividend will cost £600m a year. With its lower capex, the company generated free cash flow of £800m in the first half of this year. Its published strategy includes the following points:  

We will manage the Group within a clear financial framework:

  • Compound annual growth rate (CAGR) in operating cash flow of 3-5% per annum until 2020, based on flat real oil and gas prices and normal weather.

  • Operating cost growth below inflation, with the cost efficiency programme more than offsetting inflation in the near term.

  • Capital expenditure limited to £1 billion per annum in the near term and no more than 70% of operating cash flow longer term, to underpin dividend and credit rating.

  • Progressive dividend policy, in line with sustainable operating cash flow growth.

Clearly factors beyond its control – international energy prices, weather and politicians – are risks that will never go away for Centrica. Yet, it is focused on generating cash and re-growing its dividend. It looks like a decent bet to me.  

KCOM         Price:  90.5p                    Hoped for dividend:  5.91p                           Yield: 6.5%

KCOM is a company founded on the 1902 granting of a licence to operate telecommunications in the Kingston upon Hull region. It continues to do that but has moved on a little and now has a business that offers national IT and communication services for businesses and public enterprises including HMRC.

Consistent with its roots as a public enterprise (Hull City Council finally sold out in 2007), KCOM loves to spread happiness with a progressive dividend. Its policy is to raise its dividend by 10% every year. It has achieved this for the last five years and obviously expects to do so again for the current financial year (to March 2016). If it does so, the shares are yielding 6.5%.

It will cost just over £30m to pay this year’s dividend. The balance sheet is sound and cash flow last year was £51m after tax. To set against that is the fact that the company is rapidly rolling out its fibre network for the fortunate householders of East Yorkshire. (Hull has been designated the UK City of Culture in 2017. Not quite sure what to say about that but I thought it worth mentioning). This means that capex has been growing from £28m to £32m last year.

I have no doubt that KCOM can pay its next dividend, even if it is not completely covered by free cash flow. It has ample borrowing facilities, good until June 2019, to fund its capital expenditure.

The share price tells us that investors are wrong-footed by KCOM’s focus on the dividend because, unlike Vodafone, and despite the fact that it’s been around for more than 100 years, it is not an obviously mature business. It also offers cloud hosting for business and home customers. Last year the company took an impairment charge against some old (2004) acquisitions. This gives the impression, arguably correct, that the core of the company is rather outdated (it published the UK’s first telephone directory in 1954).

The company’s guidance consists of words rather than numbers (the dividend apart). This again hints at a certain lack of confidence. Having noted this, the fact remains that this is a financially sound business with decent and reliable cash flows.

TATE & LYLE       Price: 561p                      Hoped for dividend:  28p                        Yield: 5.0%

Tate & Lyle makes ingredients for the food and beverage industries. It sold out of sugar in 2010 and the “Tate & Lyle Sugar” brand is licenced to the new owner. The sugar price continues to affect the price of many of its sweetening products. Its main raw material is corn and it has suffered in recent years as global agricultural prices have been low. There have been signs of stabilization this year and Tate raised the price of sucralose, one of its key products, by 20% in March.

Tate is another company that has pre-announced that it will maintain its dividend (at 28p) in the current financial year (to March 2016). The dividend costs £130m. In 2013 and 2014 free cash flow (after capex) was £153m and £172m but in 2015 it fell to just £54m and the dividend was effectively covered by borrowing. Net debt (including pension liabilities) rose in the last year from £574m to £767m, though €240m is expected to be raised from the disposal this year of a European bulk ingredients business. The debt position is quite sound at Tate & Lyle but clearly paying dividends with borrowed money is not a sustainable position.

The decision to “guarantee” its dividend is said by the management to reflect the Board’s confidence in its own strategy. This looks like a statement of defiance because Tate & Lyle has embarked on a period of high capital expenditure. Capex was a mere £70m in the year to 2011. Last year it was £155m and is guided to be £166m this year and £200m next. It seems pretty clear that the dividend will be uncovered by free cash flow for some time.

Fundamentally, I believe that Tate & Lyle is a decent quality business that should make operating margins of 10% or so. But the reliability of the dividend is suspect and is unlikely to survive any unforeseeable bad news. Tate & Lyle fits well with my previous definition of high yielding shares (“seen as unreliable”).  

J SAINSBURY          Price: 232p                    Hoped for dividend:  11.5p                       Yield: 5.0%

The story of Sainsbury and the supermarket sector is well known and has been commented on here. Given its borrowing, its pension liabilities and the size of its lease obligations, Sainsbury is being suitably prudent and has cut its dividend (from 17.3p to 13.2p) and, as in the case of Centrica, the share price has fallen enough to restore the 5%+ yield.

The new guidance for its dividend is that it will be covered twice over by underlying operating profit (adjusted in this case for real estate profits as well as restructuring costs). A dividend of 11.5p will cost c.£220m. Last year underlying operating profit was £782m, which covers that dividend 3.5 times.  

Analyst consensus, for what it’s worth (source: company website) is for a dividend of just 10.3p. This implies some entrenched pessimism.

The ultimate determinant of a dividend is the ability of the business to pay it out of free cash flow. For many years Sainsbury has produced c.£1bn of annual free cash flow, after tax. For most of that time it is has been spending at least that much on annual capital expenditure.

New guidance is that capex will be approximately halved to £550m implying that a £220m dividend should be covered comfortably, assuming that cash flow does not reverse sharply. The company says that one of its priorities is to improve operating cash flow. That’s good to know though there is obviously no guarantee of success.

It seems to me that Sainsbury has taken some sensible tough decisions and that the dividend has a fighting chance of short-term survival and long-term improvement.

FENNER          Price:  164p                     Hoped for dividend:  12p                        Yield: 7.3%

Fenner is a global leader in reinforced polymer technology. All clear? It supplies a number of engineering industries and specialises in conveyor belts. The latter are heavily used by the mining industry which is a difficult area at present. Its engineered products division has a 30% exposure to the oil and gas industry, also under pressure currently.

Following a series (I make it four) of negative trading updates between March 2014 and March 2015 the company has issued two successive “in line with expectations” statements, most recently on 9th September.

Fenner has a very good record of dividend increases. In respect of the year ended August 2015 it expects to hold the dividend at 12p. The balance sheet is sound. The company’s policy is to have the dividend covered at least two times by “underlying earnings”. In H1 of 2014/15 the cover was 1.95x on the basis of “underlying EPS” (if that’s what the company means). The dividend would cost £24m in real money.

Free cash flow last year was £41m which is clearly fine. In the recent conference call (after the August year-end) management stated that it expects to hold the final dividend. The final results will be announced on 11 November.  

My opinion is that this is probably a high quality company beset by challenging markets beyond its control. The chances are that now is a decent buying opportunity.

SUMMARY

PROBABLY CHEAP

CENTRICA

It is budgeting in favour of cash flow and progressive dividends.

FENNER

A high-quality, global UK engineer with a management that seems informed and realistic.

SAINSBURY

It has reacted to market challenges with good sense and humility.

VODAFONE

Looks like a bargain price for a cash cow.

 

POSSIBLY CHEAP

GLAXO

Management under pressure asks us to trust it and puts our money where its mouth is.

KCOM

A nice business but management exudes a hint of optimism that is not yet backed up by numbers.

ROYAL DUTCH

The proposed BG deal fuels the impression that the company is gambling at the top table.

TATE & LYLE

Maintaining the dividend while prices are low and capex is high is stubborn but risky.

 

 

 

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