Philip O'Sullivan's Market Musings

Financial analysis from Dublin, Ireland

Dividend Yields: Hunting High and Low

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With markets as volatile as they have been of late, the arrival of the weekend has finally provided me with the breathing space to do some meatier analysis. Dividends are the main focus of this entry, for a variety of reasons. Firstly, over the long-run, dividends make up a huge chunk of total returns. For example, between 1950 and 2000, some 72% of the total return an investor achieved in the U.S. market was delivered via the dividend yield. In Europe ex U.K. the average contribution of dividend to total return has been 62% over the same time period. Secondly, in these extremely volatile markets, with portfolio values swinging violently from one day to the next, having the comfort of stable dividends to look forward to can help soften the “gulp” that comes from watching how much your shares are worth on a down day!


In over a decade as an active investor, I’ve learned, sometimes the hard way, about the importance of the sustainability of dividends above all else. I’ve seen dividends dry up from the banking stocks I’ve held over the years, while in my greener days I also made the mistake of simplistically assuming that “things will eventually go back to the way they were” for distressed firms that have suspended their payouts (one particularly disastrous trade during my undergraduate days in Waterford Wedgwood comes to mind!). So, I look for companies with stable cashflows, proven track records and strong balance sheets.


For me, companies that tick the box as potential dividend yield plays have to have net debt/EBITDA of below 2 times, cashflow dividend cover (which I define as free cashflow per share / dividend per share) of at least 1.5x and a dividend yield (dividend per share / share price) of 5%  or more. Anything below 5% doesn’t really interest me, mainly because the risk/reward trade-off isn’t as compelling when compared to less risky investments. With all of this in mind, I dug out this month’s “Rolling Agenda” publication from Goodbody Stockbrokers to help run a screen over the Irish market, and it threw up some interesting results. There are a few health warnings on this – firstly, Goodbody’s estimates are correct as at July 29, so no doubt some of their estimates will have changed in the period since it was published; secondly, screens are in my view only a useful “first look”, meaning that they only throw up what’s worthy of doing more in-depth analysis on; thirdly, these are Goodbody’s estimates – not market consensus, which may differ significantly in some cases; and finally, I should disclose that I am a shareholder in both ICG plc and CRH plc.


Stock    Price       EPS       Free Cashflow Per Share    DPS    Div Yield    Div Cover    Net Debt/EBITDA

ICG        1475     131.8             145                         100         6.8%                1.5                  Net Cash

FBD         625       140.1           n/m                         33.1        5.3%               n/m                      n/m

CRH       1210       94.1           124.8                       62.7        5.2%                2.0                        1.7

Notes: All figures are for the current financial year. Prices in cent. Share prices correct as at 12/8/11.


To return to something I mentioned above, stability of cashflows is very important. If companies fail to generate decent recurring cashflows, this raises obvious question marks about the sustainability of the dividend. Let’s look at the track record of the three companies listed above. In the case of ICG, its free cashflow per share (FCF) slipped markedly from the 2009 out-turn (187.0c) in 2010 (105.4c). This move is almost entirely explained by an unwinding of 2009’s large working capital inflow in 2010, with all of the other main cashflow headings reasonably stable last year. Despite this decline, its free cashflows more than covered its dividend outlay of €1 a share that year. Looking ahead, the broker sees a gradual improvement in cashflow, with 2009’s levels reached once more in 2013, which looks a conservative assumption given Ireland’s improving external trade figures and reduced competition for Irish Ferries on the Irish Sea. Moreover, with ICG likely to be debt free by the end of 2011, the possibility of special/enhanced dividends in the medium term looks good to me.


In the case of FBD, as an insurance company when it comes to gauging the stability of its cashflows it’s probably more instructive to look at its gross written premium, which stabilised in 2010 (+0.3% yoy) after a 7% decline in 2009. In the first quarter of 2011 the company reported that its GWP was “down marginally“, and we’ll get an update on more recent trends in its interim results later this month. It should be noted that the well-publicised difficulties Quinn Insurance found itself in should help FBD both in terms of better pricing in the insurance market generally and customer acquisition. Dividend cover, defined here as operating EPS / DPS rose from 2.5x in 2009 to 3.3x last year, and is expected to improve further to 4.2x in 2011. So, a very well-covered dividend.


Turning to CRH, a heroic drive to squeeze as much cash as possible out of working capital, along with good work on cutting costs, have seen it generate a remarkable €3bn in free cashflow in the past two financial years, while paying out cash dividends of only €550m over the same period. Its balance sheet is the strongest in the materials sector, and the operating leverage that will arise once economic conditions globally turn for the better will drive enhanced profits that will result in a marked improvement to its already solid dividend cover.


So, overall this screening exercise has thrown up three financially strong companies with strong market positions that pay out chunky, well-covered dividends. Obviously, given the extreme volatility at this time, choosing the right entry level for any of these stocks is going to be tricky to say the least, but income investors who take a longer-term view are unlikely to go wrong with any of the above names.


Finally, as an aside, regular readers will recall that I mentioned Cyprus’ problems last month. S&P placed it on credit watch negative on Friday, meaning that a downgrade is likely in the not too distant future.


Written by Philip O'Sullivan

August 14, 2011 at 9:03 am

Posted in Sector Focus

One Response

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  1. People spend so little time on div sustainability that it is alarming. A very timely piece. There are some fantastically undergeared companies with long term sustainable cash-flow paying well covered divs at present.
    Slow and steady wins the race.


    August 15, 2011 at 8:11 am

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