Are Dividends Built To Last At GlaxoSmithKline plc And BHP Billiton plc?

Dividend investing can be a minefield, just as any other kind of investing — make no mistake about that.

Dividends have different characters. Some dividends have staying power. Companies delivering enduring dividends tend to back those often-rising payouts with robust business and financial achievement.

Fragile dividends, meanwhile, arise because of weaker operational and financial characteristics. Those are the dividends to avoid. However, fragile dividends often tempt us because of high dividend yields.

How to tell the difference

Under the spotlight today, two FTSE 100 giants: GlaxoSmithKline (LSE: GSK) the pharmaceutical provider and BHP Billiton (LSE: BLT) the diversified commodity producer.

These firms operate in different sectors, but they both have a high dividend yield. At the recent share price of 1519p, GlaxoSmithKline’s forward yield for 2015 is 5.3%. At 1470p, BHP Billiton’s is 5.4%.

Let’s run some tests to gauge business and financial quality, and score performance in each test out of a maximum five.

1. Dividend record

Both firms enjoy a decent dividend record:

Over four years GlaxoSmithKline’s dividend advanced 23%, delivering a compound annual growth rate of 5.3%.  BHP Billiton moved forward by 39%, scoring a growth rate of 8.5%.

Both firms notched up a consistent record on dividends over the last few years although their rates of dividend growth are modest.

For their dividend records, I’m scoring GlaxoSmithKline 2/5 and BHP Billiton 3/5

2. Dividend cover

GlaxoSmithKline expects its 2015 adjusted earnings to cover its dividend around 1.14 times. BHP Billiton expects cover from earnings of about 1.23 times.

Both firms are running thin cover from adjusted earnings. I’m more comfortable with cover of around two times earnings. Thin cover means both companies return most of their annual gains to shareholders. However, a firm giving it all away like that suggests growth opportunities — where the firm reinvests earnings — remain scarce. That implies low future dividend growth, as a slow-growing business can’t help but offer a slow-growing dividend at best.

Of course, cash pays dividends, so it’s worth digging deeper into how well, or poorly, companies cover their dividend payouts with free cash flow — that’s cash flow after maintenance capital expenditure. For large, mature firms like these two, though, we can be reasonably confident that adjusted earnings represent a reasonable test of a firm’s ability to afford its dividend.

On dividend cover both GlaxoSmithKline and BHP Billiton score 2/5

3. Cash flow

Dividend cover from earnings means little if cash flow doesn’t support profits.

Here are the firms’ recent records on cash flow compared to profits:

Generally, both businesses see there cash flow support profits well. I’m scoring both firms 4/5 for cash flow.

4. Net cash or debt

Interest payments on borrowed money compete with dividend payments for incoming cash flow. That’s why big debts are undesirable in dividend-led investments.

At the last count, BHP Billiton’s borrowings were around one-and-a-half times the size of its operating profit, which seems reasonable. GlaxoSmithKline’s, though, were around five times its last-reported operating profit, which appears high unless profits are set to recover.

For their debt positions, BHP Billiton gets 4/5 and GlaxoSmithKline scores 1/5

5. Degree of cyclicality

GlaxoSmithKline’s share price moved from around 1260p at the beginning of 2011 to 1519 or so today, handing investors a 21% capital gain over the period to add to income from dividends.

BHP Billiton moved from 2600p at the start of 2011 to around 1470p today, erasing investor dividend gains, and then some.

Those share-price movements act as a clue to the degree of cyclicality inherent in each sector. At one end of the cyclicality scale, we have BHP Billiton, a business joined at the hip with macro-cycles and with little control over its own selling prices as commodity rates dance up and down to the tune of supply and demand.

At the other end of the cyclicality scale sits GlaxoSmithKline, a firm well placed in a consumable market with high barriers to entry, and a structural trend locked on a course of rising demand, thanks to demographics and evolving affluence (indigestion formulations when once just water would do!). Patent expiry issues move in cycles, but they are cycles the firm may control by keeping up investment in research and development.

It’s clear that, of the two firms, in terms of cyclicality GlaxoSmithKline best supports a long-term dividend-led investment strategy. BHP Billiton scores 1/5 and GlaxoSmithKline 4/5

Putting it all together

Here’re the final scores for these firms:

Neither firm is perfect by these measures. However, I’m inclined to put greater weight on some factors over others. For example, BHP’s finances look good after a period of relative prosperity, which boosts some of the scores. It may be a different story following leaner years, after a period of lower commodity prices perhaps. The figures look good over the period, but look at BHP Billiton’s share-price performance — the effects of cyclicality are difficult to predict.

GlaxoSmithKline on the other hand saw a profit dip, which makes debts look high when compared to earnings. Yet, the dynamics of the sector give GlaxoSmithKline a fair chance of restoring its profitability, which could work well for a long-term, dividend-led investment in the firm over the coming years.