Are Dividends Built To Last At Barclays PLC And Diageo plc?

Some dividends have staying power. Companies delivering enduring dividends tend to back such 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 firms: Barclays (LSE: BARC) the bank and Diageo (LSE: DGE) the alcoholic beverage provider with well-known brands.

These firms operate in different sectors, but they both have a reasonable dividend yield. At the recent share price of 260p, Barclays’ forward yield for 2015 is 3.6%. At 1867p, Diageo’s is 2.9%.

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

Barclays struggled to maintain its dividend, and didn’t raise it in recent years, and Diageo has a decent dividend-raising record:

Over four years Barclays’ dividend advanced 18%, delivering a compound annual growth rate of 4.3%. Diageo’s moved forward by 36%, achieving a growth rate of 7.9%. 

For their dividend records, I’m scoring Barclays 2/5 and Diageo 3/5.

2. Dividend cover

Barclays expects its 2015 adjusted earnings to cover its dividend around 2.7 times. Diageo expects cover from earnings of about 1.7 times. My ‘ideal’ dividend payer would cover its cash distribution with earnings at least twice.

However, cash pays dividends, so it’s worth digging into how well, or poorly, both companies cover their dividend payouts with free cash flow — that’s cash flow after maintenance capital expenditure.

On dividend cover from earnings, though, Barclays scores 4/5 and Diageo 3/5.

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:

As we might expect, Diageo’s consumer goods business, with its repeat-purchase credentials, delivers steady cash flow that generally supports profits. Over the last three years, though, the cash supply from operations dwindled a bit.

Then we have Barclays. Cash flow at banks is a less useful indicator of business health than that at other types of business. Banks’ cash flow tends to be ‘noisy’, as we see here. Accounting quirks–such as how the banks classify their loans and investments, for example–can bolster or lower a cash-flow number artificially. It all adds to the opaque, black-box feel that surrounds banks, rendering them almost uninvestable, in my view. 

I’m scoring Barclays a benefit-of-the-doubt 3/5 for its cash-flow record and Diageo 3/5 also.

4. 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.

Most banks carry big external debts and Barclays’ balance sheet entry for debt securities exceeds thirteen times the level of its estimated operating profit this year. However, bank debts come in many forms, so that’s not Barclays’ only exposure to borrowed money.

Diageo also uses a fair amount of other-people’s money, with debts running in excess of four times the level of operating profit.

Arguably, banking businesses require, and can justify, high debt loads. That said, they would make more secure investments with lower levels of borrowed money. I’m awarding Barclays 1/5 and Diageo 2/5 for their approach to borrowings.

5. Degree of cyclicality

We saw in the financial crisis of the last decade how cyclical the banks are. Fluctuating share prices and valuations are the order of the day with banks such as Barclays, as macro-economic gyrations keep cash flows, profits and asset valuations bouncing around.

Diageo is far less cyclical. We keep consuming our favourite tipple no matter what the economic weather throws at us, although some cash-strapped customers probably switch to cheaper brands when the economic climate is tough.

Barclays scores 1/5 and Diageo 4/5.

Putting it all together

Here are the final scores for these firms:

Diageo wins this face-off, but neither firm is perfect by these measures, so my search for a dividend champion continues.