3 Big Dividends That Could Be Under Threat

Published in Investing on 22 March 2012

Dividend cover at these FTSE 100 firms offers little margin of safety.

Perhaps the oldest and most well-established form of investing is investing for income (rather than for capital gains).

Delightful dividends

Since the 13th Century, investors have been handing over their capital to governments and businesses in return for a share of any ongoing profits.

In today's high-speed financial world, shares are bought and sold in tiny fractions of seconds by high-frequency trading algorithms backed by massive computing power. Despite this frenzied and faceless approach to turning a profit, there is still plenty of room for private investors seeking to boost their incomes by collecting dividends -- the regular cash payouts to shareholders from businesses.

Indeed, high-yield investing -- picking shares and funds that pay generous dividends -- has been an increasingly popular investment style since the Fifties. However, one lesson that high-yield investors must learn is that the highest dividends usually (but not always) come with the highest risk.

Cover me!

One simple way for investors to gain confidence when picking high-yield shares is to ensure that any dividend is comfortably covered by earnings.

To do this, you divide a company's earnings per share by its dividend per share. If this figure is less than one, then the dividend is not fully covered by earnings and, therefore, could well be under threat. On the other hand, dividend cover approaching two -- or even higher -- provides a solid margin of safety.

With dividend cover of two, earnings could halve and the dividend would still be fully covered (but could still be cut, of course). Personally, I wouldn't rely on any dividend that isn't covered by earnings with at least a 30% margin of safety. In other words, I would look very unfavourably on dividend cover below 1.3.

Checking bumper dividends

To find out how many firms fall into this category, I screened for companies with market values above £1 billion and dividend yields of 4.5% or more. This revealed a total of 37 big businesses -- all members of the FTSE 100 or FTSE 250 -- paying handsome dividends.

I then checked the dividend cover of these 37 firms and found that it ranged between 0.25 and a whopping 4.5. However, these are historic figures and, therefore, may not reflect dividend payouts for this and future years.

I then sorted these 37 candidates to look for well-known names with high dividend yields, let down by low dividend cover. This sort identified 10 firms with dividend cover below 1.3.

Here are three FTSE 100 companies with low dividend cover that offer little in the way of margin of safety to income-seeking investors:

1. United Utilities

Of my three 'low-cover companies', United Utilities (LSE: UU) is probably the lowest-risk investment.

In a trading statement released this morning, United confirmed it was "on track to deliver a good underlying financial performance for the year ending 31 March." It expects full-year revenue to increase by 3% to 4%.

However, thanks to higher capital spending, United forecasts underlying operating profit to be lower in its second half than in the first. Also, net debt is "slightly higher" than the £5 billion reported as at 30 September.

As I write, United's share price is 620p, valuing the group at £4.2 billion. Right now, it offers a dividend yield above 4.9%, covered only 1.17 times. In other words, a drop in earnings of 14% to 15% would leave United's dividend uncovered.

Then again, as a regulated utility with a large, established customer base, United has strong, predictable earnings. Thus, I do not expect to see any dividend cuts from United now or in the immediate future.

2. Standard Life

Founded in 1825, and with 1.5 million private shareholders and 6.5 million customers worldwide, Standard Life (LSE: SL) is a household name.

When Standard Life reported its 2011 results earlier this month, it raised its dividend by 6%. Alas, with a full-year dividend of 13.8p and earnings per share of 12.9p, last year's dividend was not fully covered by earnings.

Today, with its share price at 233.5p, Standard Life is valued at £5.6 billion and offers a dividend yield of 5.8%, covered just 0.94 times. Despite its sub-par dividend cover, I suspect that Standard Life will not cut its dividend in 2012. After raising its dividend every year since it floated in mid-2006, I imagine that Standard Life's board has a point to prove and, therefore, won't trim this payout.

3. Man Group

The least-known name of my three is Man Group (LSE: EMG), the world's largest listed manager of hedge funds. Three weeks ago, I wrote about Man's fat dividend, which, at 10%, was the highest in the FTSE 100.

Unfortunately, Man's dividend is only two-thirds covered by earnings, with dividend cover of just 0.66. However, it does have $550 million of surplus capital which it could use to keep its dividend high while it waits for financial markets and its earnings to recover.

As I write, Man shares trade at 136p, valuing the group at £2.6 billion. Man aims to pay out 22 cents (13.8p) in dividends in 2012, for a dividend yield of just over 10%. However, for this payout to be fully covered, Man's earnings would have to soar by 50% this year.

Hence, of these three Footsie firms, I consider Man's payout to be shakiest.

In summary, while it's all very well banking a high dividend today, what matters most is what the payout will be next year, the year after, and beyond. By paying close attention to companies' dividend cover, you can steer clear of those firms most at risk of cutting their cash payouts in the coming years!

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Comments

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MagicalBeaker 22 Mar 2012 , 3:08pm

Interesting that none of the high yielding insurance companies are listed here, when perceived risk is seems to be the biggest reason for their low P/E and high yield...

psatek 22 Mar 2012 , 3:39pm

At the other end of the spectrum I'd like to know which company has a yield of 4.5% or above and dividend cover of 4.5 times.

Hannibalis 22 Mar 2012 , 3:44pm

This highlights the difficulty with dividend investing - by rights these companies can't really afford to maintain such high dividends but they can be seen to cut them - until other bad news hits the fan and the share price plummets. So not only do you lose your dividend but the floor has fallen on the share price. What to do then?

A surprisingly high number of dividend payers cut or reduced dividends earlier in the financial year
http://www.the-diy-income-investor.com/2011/10/chopped-13-of-uk-dividend-payers-cut.html

Best to play safe and avoid those with dividend coverage less than 1.5 or other bad news in the pipeline.

Crawfish123 22 Mar 2012 , 3:49pm

Bp is my guess, around 18.7p in divs and 85.7p eps, but that's only a 3.8% yield...

CunningCliff 23 Mar 2012 , 11:10am

Hi psatek,

I think the firm you're looking for is Resolution, but please check using this stock screener:
http://www.digitallook.com/cgi-bin/dlmedia/stock_screener.cgi

Regards,

Cliff

jasonjarvisgbr 23 Mar 2012 , 12:33pm

Is there any precendent for a FTSE 100 firm not covering a dividend ? I mean completely not just cutting by 1.0%.

Surely it would be calamitous to extent that they would rather quietly aquire debt to cover the payout, rather than risk the consequence and wrath of the City ?

JJ

RobinnBanks 23 Mar 2012 , 4:31pm

Aviva is paying a 7.5% dividend of 26p on EPS of 5.8p; or on 17p without the discontinued operations; which is dividend cover of 0.22x or 0.65x depending on which figures you use.
Although they have over £23bn in cash, how did these worse than bland results not come up on your screener Cliff?

performer777 23 Mar 2012 , 5:11pm

Hi Robin,

Those figures are historical. Indeed last year the dividend was uncovered as you point out. The forecasts are for a dividend of 27.5 and EPS of 57p giving cover of just over 2, which is fine.

Hi Psatek,

I have just ran your criteria through the dividendmax 3 dividend optimizer and lots of companies come close to your criteria but only 2 meet it going forward 3 dividends

BP yields 5.12% and has cover of 4.1
African Barrick Gold yields 5.19% and has cover of 7.7

Benatar 23 Mar 2012 , 6:02pm

United utilities latest full year results had a dividend of 30p & EPS of 67.2, so not sure how you get such a low cover figure. Also it has a stated dividend policy of growing the dividend year on year by RPI + 2%, so I think it very unlikely they will diverge from that policy if nothing was said at the trading statement.

Arborbridge 26 Mar 2012 , 7:50am

United's 2011 year end normalised eps was 40.7p. Dividend cover of 1.2 is forecast to drop to 1.10 for 2012 and pick up again to 1.18x in 2013, so wafer thin. On the other hand, it's improved from being uncovered in 2007 and 2008! Definitely all a bit marginal, but it will just scrape through in the next couple of years without a cut - then all bets are off unless matters improve.

Arb.

norgler 26 Mar 2012 , 3:28pm

You say for UU "thanks to higher capital spending ... lower forecast underlying operating profit "
Boring as it is, I feel I have to point out that Capital spending does not in itself reduce profits ( Capital v Revenue ) It's the Depreciation that us accountants calculate to write off the capital spending , over the estimated life of the asset . Maybe everybody knows that, but just in case .
So spend 1M in the second half , depreciation at say 10% , or 5% for half year , gives deduction from profits of 50K .
Otherwise useful article . ( i couldn't find any spelling mistakes either ! )

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