Are Dividends Built To Last At Lloyds Banking Group plc And Unilever 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: Lloyds Banking Group (LSE: LLOY) the bank, and Unilever (LSE: ULVR) the consumer goods company.

These firms operate in different sectors, but they both have decent forward dividend yields. At the recent share price of 77.5p, Lloyds’ forward yield for 2015 is 3.7%. At 2774p, Unilever’s is 3.3%.

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

Unilever has a good dividend record and Lloyds hasn’t.

Over four years Unilever’s dividend advanced 27%, delivering a compound annual growth rate of 6%.

For their dividend records, I’m scoring Unilever 3/5 and Lloyds Banking Group 0/5

2. Dividend cover

Lloyds expects its 2015 adjusted earnings to cover its dividend around 2.8 times that year and its 2016 earnings to cover the dividend twice. The reinstatement and building up of a dividend payout is an encouraging sign as the bank continues its recovery.  

Unilever expects cover from earnings of about 1.45 times. I lke to see firms cover their dividends with earnings at least twice, so Lloyds is heading in the right direction.

But 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, Lloyds scores 4/5, on the assumption that it will follow through with its dividend-paying plans, and Unilever scores 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:

Unilever’s consumer-products-driven cash flow follows profits to a large extend, although it has tailed off a bit in the last two years.

Lloyds’ cash flow, in common with many 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, all helping to fuel the black-box feel that surrounds banks, rendering them almost uninvestable to the non-specialist investor, in my view. 

I’m scoring Lloyds Banking Group 2/5 for its cash-flow record and Unilever 3/5.

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 Lloyds recent balance sheet entry for debt securities is more than ten times the level of estimated 2014 operating profit. However, bank debts come in many forms, so that’s not Lloyds’ only exposure to borrowed money. Meanwhile, Unilever runs borrowings at around 1.6 times the level of operating profit.

Arguably, banks have particular types of business that require, and can justify, high debt loads. That said, they would make more secure investments with lower levels of borrowed money. I’m awarding Lloyds 1/5 and Unilever 4/5.

5. Degree of cyclicality

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

Unilever is far less cyclical. We tend to keep buying consumer products such as food, detergent and personal care items no matter what the economic weather throws at us, although Unilever’s customers probably cut back during recessionary times.

For the degree of cyclicality inherent in their businesses Lloyds scores 1/5 and Unilever 3/5

Putting it all together

Here are the final scores for these firms:

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