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Are Dividends Built To Last At GlaxoSmithKline plc And Diageo plc?

Photo: Ian Wilson. Cropped & adjusted. Licence: https://creativecommons.org/licenses/by/2.0/

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 me because of high dividend yields.

How to tell the difference

Under the spotlight today, two FTSE 100 firms: GlaxoSmithKline (LSE: GSK) the pharmaceutical giant and Diageo (LSE: DGE) the premium drinks provider.

These firms operate in different sectors, but they both have attractive dividend yields. At the recent share price of 1393p GlaxoSmithKline’s forward yield for 2016 is 5.9%. At 1852p, Diageo’s yield for year to June 2016 is 3.2%.

Here are some tests to gauge business and financial quality. Each test scores a maximum five.

  1. Dividend record

Both firms enjoy a record of rising ordinary dividends:

Ordinary dividends

2011

2012

2013

2014

2015

GlaxoSmithKline (pence)

70

74

78

80

80(e)

Diageo (pence)

40.4

43.5

47.4

51.7p

56.4

Over four years GaxoSmithKline’s dividend advanced 14%. Diageo’s moved forward by 40%.

For their dividend records, I’m scoring GaxoSmithKline 3/5 and Diageo 4/5.

  1. Dividend cover

GlaxoSmithKline expects adjusted earnings to cover its dividend around once for the year to June 2016. Diageo’s earnings look set to cover the firm’s dividend around 1.5 times.

However, cash pays dividends, so it’s worth looking at how well, or poorly, both companies cover their dividend payouts with free cash flow too.

On dividend cover from earnings, I’m scoring GlaxoSmithKline 2/5 and Diageo 3/5. 

  1. 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:

GlaxoSmithKline

2010

2011

2012

2013

2014

Operating profit (£m)

3,783

7,807

7,300

7,028

3,597

Net cash from operations (£m)

6,797

6,250

4,375

7,222

5,176

Diageo

 

 

 

 

 

Operating profit (£m)

2,595

3,158

3,380

2,707

2,797

Net cash from operations (£m)

2,183

2,093

2,033

1,790

2,551

GlaxoSmithKline displays a consistent ability to support profits with cash flow. Diageo’s cash flow, although steady,  tends to fall below reported profits.

I’m scoring GaxoSmithKline 4/5 and Diageo 3/5.

  1. Gross 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.

GlaxoSmithKline’s debt load runs at almost five times the level of its annual operating profits. Diageo’s borrowings are about 3.5 times annual operating profits.

For their debt positions, I’m scoring GlaxoSmithKline 1/5 and Diageo 2/5.

  1. Degree of cyclicality

GlaxoSmithKline and Diageo operate similar consumer-product-driven businesses characterised by stable demand and reliable cash flows. As such, they stand among the least cyclical firms listed on the London market.

However, to get full marks in this category I like to see a faster rate of growth in earnings than these two slow growers offer, so I’m awarding both GlaxoSmithKline and Diageo 4/5.

Putting it all together

Here are the final scores for these firms:

 

GlaxoSmithKline

Diageo

Dividend record

3

4

Dividend cover

2

3

Cash flow

4

3

Debt

1

2

Degree of cyclicality

4

4

Total score out of 25

14

16

Diageo wins this contest, but neither firm is perfect by these measures, so my search for dividend champions continues.

If you're looking for strong dividend-led investments too, you may wish to consider a company uncovered by one of The Motley Fool's top investors. He believes the best days for the business featured in this free report still lie ahead.

Overall, turnover has been growing at around 10% a year for this business, with profit growth not far behind. The firm has a decent record of rising dividends that looks set to continue, given its clearly identified path to growth. If the dividend keeps rising, share-price appreciation could follow.

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Kevin Godbold has no position in any shares mentioned. The Motley Fool UK has recommended GlaxoSmithKline. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.