Dividend stocks are presently the crowd favourite and the trend is likely to continue.
Just recently Woodside Petroleum boosted its payout ratio to 80%, sweetened with a special dividend payment of $0.63 per share, and the share price shot up by 10%. Other big companies looking to boost the share price could follow suit.
But how safe is the dividend? Will this year’s stellar yield of 7% or 8% be slashed in half next year? When buying the next hot dividend stock, make sure you check out the stability, or reliability, of the dividend. But how do you do that?
The table below lists stocks that pass an initial test, based on yield and growth potential. We then analyse these stocks for dividend reliability.
For yield we chose 6% or greater. The P/EG ratio takes “next year” into account through earnings estimates.
We found 7 prospects based on fully franked dividend yields over 6% with a P/EG below 1.5.
Term deposit currently return about 4.6% for both one and five years. In comparison, fully franked dividends carry substantial tax benefits.
There is a serious flaw in the comparison argument all investors should remember. That flaw is represented in the 52-week price change column in the table. Stocks are volatile. Stock dividends are not guaranteed while term deposits are.
As it stands above, every stock in our table looks like a possibility. All have attractive current valuation metrics and reasonable to superior forward-looking earnings growth. Having said that, below are some metrics that can help assess the risk inherent in a particular company’s dividend yield.
52 Wk Price Change
Health Care Equipment
• Payout and Dividend Cover Ratio
The Payout Ratio is the percentage of the company’s earnings that are returned to shareholders. Dividends should come out of free cash flow but many companies choose to dip into retained earnings to keep up their dividends. This is especially true for companies recognised as solid dividend payers. If the ratio is over 100% that means the company is paying out more than it is taking in.
The Dividend Cover Ratio represents the number of times a company can cover its dividend payments through earnings. The higher the number the better, but a ratio of 1.2 is minimally acceptable and ratios under 1 can be downright dangerous.
• 5 Year Earnings and Dividend Growth
Ideally you should see positive growth in both earnings and dividends over the past five years. However, if you really want to get a good idea of the company’s earnings and dividend history you have to go beyond the 5 Year figure. Look for the actual earnings and dividends per share going back as many years as possible. Some company websites have this information. Averages can be deceiving due to one year spikes, upward or downward.
• 5 Year Total Shareholder Return
High yielding stocks can border on the financially pointless if the share price has dropped so much over time the investor ends up with negative total returns. Total shareholder return includes dividend payments and capital appreciation (or depreciation) of the stock price.
• 2 Year Dividend and Earnings Forecasts
You can find a variety of earnings and dividend forecasts on different financial websites. Certainly forecasts can go up or down but a two year period is a reasonable time to assess whether future earnings can support dividends. You will find five year expected but in these volatile times five years seems like an eternity.
Now let us revisit our candidates and see how they measure up on these additional metrics. In theory, we should be able to better differentiate potential winners from riskier investments. Here is the second table:
Payout Ratio (%)
Dividend Cover Ratio
5 Year Earnings Growth
5 Year Dividend Growth
5 Year Total Shareholder Return
2 Year Earnings Growth
2 Year Dividend Growth
Based strictly on the numbers we could immediately cast aside both WHK Group (WHG) and Australian Pharmaceuticals (API) due to the high payout ratios and substandard dividend cover ratios. However, unlike some technical analysts who live and die strictly by the numbers, we believe numbers need to be viewed in context. Both these companies show significantly high 2 year earnings growth forecasts, so let’s look a bit behind the numbers.
WHK prides itself in being the 5th largest accounting business in Australasia. The company provides ten “core” services to SME (small to medium sized enterprises) and high net worth individual customers. Some of these services are discretionary, however, which has lead to declining demand in the current environment.
The company has been in merger talks with SFG Australia (SFW). On 24 April the stock was halted pending an announcement, and the news was disappointing. The company reported $36 million in earnings for FY2012 and is now forecasting $26 million for FY2013. The 2 Year forecasts in the table do not reflect this recent change. Here is the company’s one year price chart:
In our table a 7% year over year decline in share price does not sound that bad until you put it in context of the entire year. This stock has NEUTRAL ratings from both Macquarie and UBS with both expressing the opinion there may be value here when the deal gets done. However, it is hard to consider a scenario that justifies buying WHG as a dividend/income investment right now.
Australian Pharmaceuticals (API) makes and distributes over the counter pharmaceuticals as well as health and beauty products. The company also offers a variety of marketing and administrative services to a network of more than 4000 independent pharmacies throughout Australia. The company’s EPS went from $0.051 in FY 2010 to a loss of $0.04 in 2011 before bouncing back to $0.03 in FY 2012.
On 18 August the company reported mediocre half-year results, with a decline in EPS from $0.038 in the first half of 2012 to $0.026 for the half year 2013. Revenues declined 0.4% but NPAT rose 6.8%. An analyst at Deutsche Bank doesn’t expect much until the company’s franchises pick up or the cost cutting measures take effect. API has an attractive P/B ratio of 0.40 as well as a P/EG of 0.31, but as a dividend investment, there are safer opportunities.
There are two companies in our table that met every metric for dividend reliability, Sky Television (SKT) and Monadelphous Group (MND).
MND provides diversified engineering, construction, and maintenance services to the resources, energy, and infrastructure sectors around the world. The company and its shareholders benefited handsomely from the resources boom, with a total average annual return over 10 years of 44.4% and a five year return of 15.4%. However, with the mining boom grinding to a halt, that figure dropped to just 0.2% on a one year basis.
MND reported half year results showing a year over year EPS increase of 35% coupled with a 24% increase in dividends per share but cautionary comments about 2014 led to downgrades to SELL from UBS and Deutsche Bank. Citi and JP Morgan maintained SELL and UNDERWEIGHT recommendations.
However, CIMB Securities believes market reaction to the disappointing news on 2014 was overdone and the current share price represents a buying opportunity. CIMB upgraded MND from NEUTRAL to OUTPERFORM. However, although the company’s P/E of 11.97 appears reasonable, the Sector P/E is 8.53 and a P/B over 7 looks a bit stretched when compared to a Sector P/B of 1.19. Still, MND has a solid track record and a solid base of loyal customers.
Sky Television has 2 year growth forecasts close to twice those of MND. A comparison of the one year stock price movement of SKT and MND suggests investors get the point. Here is the chart:
If you believe the future of the resources, energy, and infrastructure sectors is not as bleak as some think, MND is worth a look. Certainly there is risk but this company has increased both earnings per share and dividends per share every year for the past ten years. EPS went from $0.092 to $1.424 and dividends went from $0.062 to $1.25.
Sky Network Television (SKT) may be the hidden gem here. The company operates exclusively in New Zealand where it is the sole provider of pay TV services via its own satellite platform. SKT gets little analyst coverage from Australian firms but Morningstar Australia calls the company’s position in New Zealand “unassailable.” The analyst there predicts Sky’s solid cash flow and low gearing put the company in a position to declare special dividends every year. News Corporation is currently the largest shareholder with 44% which the company plans to sell. The analyst at Morningstar sees this as positive as well. Although SKY suffered a bit from the GFC, both earnings and dividends per share have increased every year since.
The case for dividend reliability of the remaining three companies in our table is less than compelling.
Prime Media Group (PRT) has seen a hefty year over year jump in stock price, fueled by speculation regarding regulatory changes in the free-to-air regional TV and radio markets where it derives its advertising revenue. The company’s recent half year results presentation showed an interim dividend of $0.04 per share matching the previous corresponding period (pcp) but earnings per share fell from $0.044 to $0.013. Major analysts like this stock, with Deutsche Bank at a BUY, noting the possibility of higher yields from potential changes in media ownership laws. CIMB Securities, JP Morgan, and Macquarie all have BUY or Overweight recommendations with the dividend yield featured in their comments. However, none disputes the challenging environment in advertising, especially in radio.
Ruralco Holdings Limited (RHL) is an agribusiness company specialising in products and services in rural markets. On 08 April the company issued a market update warning that continued deterioration of market conditions will result in lower earnings in the immediate future. The stock price plummeted. Here is the chart:
Finally, there is Bradken Limited (BKN), a supplier of consumable products to the resources, energy, and rail industries. Bradken has manufacturing and distribution facilities in mining and energy markets in Australia, North America and China. As you might expect, the company’s stock price has tracked movements in the price of iron ore. Here is the one year chart for Bradken:
On 18 April the company announced the opening of a new foundry in China and supplied a gloomy forecast for its revenue generating segments with the exception of oil and gas, particularly in the US market. What makes Bradken potentially appealing is the company’s low payout ratio, high dividend cover, and solid dividend growth forecast.
Granted that Bradken is in a challenging environment and those forecasts can be revised dramatically downward, but an analyst at Macquarie sees the 8% yield as sustainable given the company’s solid cash position. Between FY 2011 and FY 2012 the company’s operating cash flow went from $32.4 million to $121.2 million. On a trailing twelve month basis, operating cash flow now stands at $181.4 million. However, the risk of further declines in the resources sector makes Bradken a riskier proposition.