Taking comfort in the dividend

Thursday, 25th February 2016 09:36 - by David Harbage

It has been a busy week for equity analysts and institutional investors as they digest a plethora of trading results from UK stock exchange listed companies.

These range from the largest bank - HSBC - to a range of AIM listed minnows. Excepting any special news (such as management change or the announcement of an acquisition), investors' focus has typically been on the outlook statement. The magnitude of the dividend payout is also a useful indication of management's confidence in future earnings. A share price's immediate response to the announcement of trading results may reflect an up or downside surprise (on an exceptional development or, more typically, on whether the numbers match forecasts). But, after that knee jerk movement, progress or a retreat in the equity valuation will largely be determined by the answer to the question,"How confident can one be that these profits (and, by implication, dividend payout) will be maintained and, hopefully, grown?"

This week will see announcements from companies across almost every sector of the UK equity market, some of which have little control of the price of their key product. BHP Billiton, one of the world's biggest owners of mineral and natural resources, is a prime example of such a business and yesterday they announced a 74% cut in its dividend. The prospects for a wider raft of firms is also largely determined by commodity prices, even if they are not the extractors. These include oil service companies, like FTSE250 constituents Petrofac and Wood Group, who have reported a downturn in 2015 earnings but - in anticipation of a recovery in profits, confidence in a large backlog order book or more simply in appreciation of the existing dividend being sufficiently well covered - are able to maintain, or increase (in Wood Group's case), their respective dividend payments.

Other companies may have different factors exercising an adverse or beneficial impact within their recently declared interim or final results. GKN manufactures components for the automotive and, increasingly, aerospace industries - making the company something of a proxy on global demand. 2015 was a tough year in trading terms, with profit margins being squeezed by 40 basis points (from 9.2% to 8.8%) but, despite slippage in earnings, the board hiked the 3 times covered dividend by 4% to offer a 3.25% yield. Going forward, the shares are likely to reflect the strength of global GDP on a macro basis as well as integration benefits arising from the recent £480m acquisition of Fokker.

Croda International is a specialist chemical company making innovative, high margin products for a number of different industries (personal care, pharmaceutical life sciences, performance technologies - including the oil industry - and, to a very small extent, industrial chemicals). Much of its new product is identified, and R&D (research and development costs) in part paid for, by existing customers. Earnings per share rose 7.8% last year and, in addition to a 5.3% increase in dividend payout, the company plan to return another £136m to shareholders as a special £1 per share special dividend - alongside a share consolidation. This was driven by an efficient balance sheet, where leverage of 1.0 to 1.5 times net debt to EBITDA (earnings before interest, tax, depreciation and amortisation is expensed) is targeted.

Drax Group, owner of the largest power generation plant in Western Europe and famous for burning low carbon emitting wood and vegetation-based biomass (rather than solely coal, making it a favourite of environmentally friendly funds) is subject to significant industry regulation. Lower commodity prices, exceptional external factors (notably the removal of levy exemption certificates) and ongoing heavy capital expenditure to complete the transformation to biomass fuel resulted in earnings falling by 52% in 2015. In accordance with company strategy, the dividend was cut from 11.9p per share in 2014 to 5.7p. Government and EU directives appear likely to continue to cast a pall over this stock in the short term.

Despite regulators increasingly influencing and some would say 'putting the boot' into banks, with more fines and financial penalties - which often seem to reflect their ability to pay, rather than reflect the crime - banks proffered mixed news on their dividend payouts and others like Lloyds (if not RBS) appear set to announce distributions after a lengthy absence. While HSBC's 1% pre-tax profit advance fell short of expectations, its strong capital base (tier 1 ratio improved from 11.1% to 11.9%) enabled a 2% hike in the dividend for 2015. One of the biggest banks in the world, with diverse operations in both the developed and emerging economies, HSBC represents another core play on global GDP. By contrast, Standard Chartered has a greater bias to the emerging markets - especially in Asia - but at the end of last year had to recapitalise (£3.3bn rights issue), which included a cancelled final distribution. Currently refreshing its management - in particular looking for a new chairman - the group appears somewhat in 'limbo', but a healthier balance sheet (tier 1 is 12.6%) is set to mean the dividend will be restored in 2016.

The most encouraging news on historic trading and income returns for investors, this week, came from the construction and property sectors. Looking forward, house builders Bovis, Persimmon and Barratt Developments expressed confidence in their ability to secure new land (with higher margin potential), keep build cost inflation below 4% per annum and sell higher volumes at higher prices (anticipate 10% top line advance). The FTSE100 builders have followed Berkeley Group's lead in returning cash to shareholders - with big jumps in normal dividends enhanced by special payments. Most obvious was Persimmon, who increased the terms of their original capital return plan by 45% to £2.76bn - via 110p per share annual payments over the next 5 years. A policy rewarded by the shares advancing to within touching distance of their 25 September all time high. 

Although some press commentators have speculated on a property 'bubble' (especially in London) set to burst, and suggested house builders are overvalued, the evidence for a 'stronger for longer' domestic housing cycle remains. Affordability is being eased by government measures and further easing in medium term interest rates. Demand is not in doubt: last year the ONS (Office for National Statistics) predicted population growth in the UK to be 500,000 per annum - or 4.4m over the next 8 years - to reach 69m by 2024. 

Beyond the home builders, real estate group Unite - which provides accommodation for university students - announced healthy trading and prospects for 'more of the same' in 2016, with confidence evidenced by a 34% jump in its final dividend. EPRA adjusted (includes placing a fair current value on properties and excludes items not expected to crystallise in a long term business model) net asset value of 579p, (up from 434p in the previous year), was aided by 3.8% rental growth in its portfolio. Management flagged that new entrants into this niche sector, increasing competition, could put pressure on margins over the medium term; which prompted a little profit taking in the shares. 

Bottom line, investors must have confidence in the sustainability of future profits - which could mean looking through temporarily depressed earnings being announced by some of the FTSE100's mega caps - and their hopes of sharing them, via higher dividends and an appreciation in share prices. Consideration of the differing risks, and the extent of those risks, which could lead to an adverse surprise in profits is an ongoing essential exercise. Investors should try to establish a reasonable level of base dividend that could be paid - especially for companies within cyclical industries - and allow such an income yield to inform their view of a stock. While a strong balance sheet can enable businesses to maintain a dividend payment, a view can be taken in these times of relatively low growth (revenue and profit) of what would constitute an acceptable level of profit and payout or dividend. It may be that a judgement can then be made on the market's expectation - as reflected in current valuation - and your own. 

For example, based on broker projections for Barratt Developments who announced impressive interim results today, earnings per share (EPS) are forecast to be 54p for their full year to 30 June 2016 with 30p of that profit paid out as a dividend. At today's closing price of 571p, that equates to a PE ratio of 10.6 and a dividend yield of 5.2%. While consensus estimates to June 2017 anticipate a 10% advance in EPS and a 20% jump in dividend payout (with further, but slowing, growth expected in the 2017/18 year), a conservative investor might say that the June 2016 forecasts represent a more sensible base upon which to judge Barratt's appeal to investors today.

Written by David Harbage for lse.co.uk on the 24th February 2016

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.