Dividend Stability in 5 Top Performing Income Stocks

Income investors brave enough to return to the sharemarket in 2012 were well rewarded by increased total returns through dividend payments – and the trend towards higher yields should continue into 2013.

A search strategy favoured by some income investors is to look for stocks with the highest yields.  More experienced investors know dividend stability is more important than current dividend yield.

The following table shows some of the highest-yielding stocks on the ASX with market caps above $250 million. We’ll drill down into each in an attempt to address the key question of dividend stability.

Can these companies continue to post high yields in the future?

We excluded property trusts because rental income offers some level of stability not seen in stocks in other sectors.  In the table a few paragraphs below are five companies for our analysis.

The dividend yield, payout ratio, gearing, and dividend cover figures in the table are for the company’s full year reporting period.

Payout ratios represent how much of the company earnings are distributed as dividends.  Dividend cover is a measure of a company’s ability to pay dividends from current earnings.  It is calculated by dividing earnings per share by dividends per share.  A ratio of 1.3 is considered safe.

In reality dividend yield is a theoretical number as it can vary daily with movements in the stock price and dividends paid to date.  Yield is the current share price divided by dividends paid per share.

For example, the current dividend yield for Seven West Media (SWM) is 7.93%, based on the current share price and expected annual dividends.  The number is also subject to variation if a company elects not to make a dividend payment.

Here is how Seven West has fared over the past ten years:

The annual 2012 yield of 14% appeared in the third quarter of 2012 and as the share price advanced high towards year end, the yield dropped.  Even the current yield of 7.93% appears outstanding, but how stable is the dividend?

Dividend stability is a simple concept to understand but a difficult one to measure.  You won’t find Dividend Stability listed along with P/Es and Dividend Yields on many financial websites.  When used, calculating dividend stability involves looking back over a ten-year history to see how many times the dividend has been cut and by how much.  A percentage derived from multiplying the two numbers yields a dividend stability percentage.  A figure of 100% indicates the dividend has never been cut.  Beyond the complexity of crunching this number there is the issue of how to treat companies with dividend history less than ten years.  If a financial website uses the calculation on a company paying dividends for the first time the stability percentage could be 100.  This can obviously be quite misleading.

There is no easy way out here.  If you want to assess the dividend stability of a prospective high-yielding stock you have to look at the company’s financial history.  So here is a ten-year history for SWM of the indicators that serve as a starting point:

First note that the same dividend per share of 42 cents in 2010 and 2011 produced widely varying yields.  Further note the 2012 dividend is only 3 cents higher than the dividend paid way back in 2003.

The payout ratio comes from dividing dividends per share by earnings per share, the inverse of the dividend cover ratio.  High ratios mean most of the company’s earnings are going to the shareholders. In theory, high ratios near or over 100% are not a sign of dividend stability as troubled times could lead to large dividend cuts.  In practice, continued higher payout ratios remaining below 100% coupled with low gearing and growing cash flows can be a sign company management is doing an excellent job.  Cash flow is critical for dividend stability and is often ignored in the face of a tantalisingly high yield.  Let’s take a look at cash flow at Seven West for the last three years:

Think of cash flow as money “in and out the door.”  Operating cash flow is money generated by the business.  Investing cash flows come from the sale of company assets, income from other investments, and capital expenditures to maintain or grow the business.  Financing cash flows result from borrowings and equity raises as well as debt and dividend payments.

For a healthy business to sustain its dividend payments, you can’t have a consistent pattern of total negative cash flow. Cash carries over from one year to the next but still a negative number for all cash flow sources in any given year is not a positive sign.

As you can see, in two of the last three years, that is what transpired at SWM.  However, note that operating cash flow has increased every year, a positive sign.

Seven West has solid brand identification in Australian Media and major analysts applaud its turnaround efforts.  UBS, Macquarie, Credit Suisse, BA-Merrill Lynch, Deutsche Bank, Citi, and JP Morgan have BUY or OVERWEIGHT recommendations on the stock.  However, there may be better dividend opportunities out there.

Cabcharge (CAB) started over thirty years ago with a payment processing system for taxis.  They have expanded into buses and water taxis and own nine taxi companies throughout Australia.  Analysts are getting nervous about the possibility of regulatory changes that may see Cabcharge face increased competition (ending its near monopoly status).  The company’s share price has not recovered its pre-GFC glory days.  Here is its ten year chart:

Despite the dramatic decline in share price around the onset of the GFC, Cabcharge’s dividend stability enabled investors to enjoy a 10% total average annual return.  Here is the company’s ten year dividend history.

Note that, with the exception of 2011, dividend payments to shareholders have increased every year, with an additional forecasted 2.1% increase over the next two years.  The company’s most recent cash flow performance also suggests the stability of the dividend going forward.  Here is the 3 year table:

In truth, if you are looking for dividend stability a small cut in the dividend in a tough period can actually be a positive indicator.  Note the drop in operating cash flow in 2011, and yet the company managed to reduce the dividend by only four cents and returned to the pattern of consistent increases in 2012.