Are Dividends Built To Last At Tesco PLC And Standard chartered 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 me because of high dividend yields.

How to tell the difference

Under the spotlight today are two FTSE 100 firms: supermarket chain Tesco (LSE: TSCO)  and international banking company Standard Chartered (LSE: STAN) .

These firms operate in different sectors, but they both pay a dividend. At the recent share price of 173p, Tesco’s forward yield for year to February 2017 is just 1%. At 450p, Standard Chartered’s is around 2.7%.

Here are some tests gauging business and financial quality, and scoring performance in each test out of a maximum five

1. Dividend record

Both firms have maintained at least some dividends.

Tesco’s dividend collapsed with its earnings and Standard Chartered’s dividend has recently fallen to half its previous level.

For their dividend records, I’m scoring both firms 1/5.

2. Dividend cover

Tesco expects its adjusted earnings for year to February 2017 to cover its dividend more than five times. Standard Chartered expects earnings to cover the payout for its 2016 trading year almost four times.

I like earnings to cover the dividend payout at least twice in my dividend investments, but cash pays dividends, so it’s worth digging deeper into how well, or poorly, both companies cover their dividend payouts with free cash flow, too. 

On dividend cover from earnings, though,  I’m awarding both firms 5/5.

3. Cash flow

Dividend cover from earnings means little if cash flow doesn’t support profits.

Here are the companies’ recent records on operational cash flow compared to profits:

Volatile cash flow such as Standard Chartered’s is a common feature with large banking firms. Their arcane accounting practices can make the measure less useful for investors than it might be for firms in other sectors. However, periods of negative cash flow from operations are always undesirable in my book, whatever the company.

When cash flow persistently fails to support profits, firms must make up the shortfall from other financial activities, such as investing or fund raising. Such reliance on activities other than straight-forward banking is a big part of what makes banks such as Standard Chartered so cyclical and prone to harsh volatility that often exaggerates macro-economic wobbles and financial market undulations.

Meanwhile, Tesco displays robust positive cash flow that supports its profits — to the point of following them down when they collapsed!

I’m playing it safe and scoring Standard Chartered 2/5 for its record on cash flow from operations. Tesco gets 5/5.

4. Debt

Interest payments on borrowed money compete with dividend payments for incoming cash flow. That’s one reason I think big debts are undesirable in dividend-led investments.

Tesco’s borrowings run around 20 times the level of this year’s anticipated pre-tax profit and Standard Chartered’s external debts look like they stand in excess of 60 times this year’s anticipated earnings.

Most banks carry big debts, arguably banking businesses require, and can justify, high debt-loads. But I reckon banks would make more secure investments with lower levels of borrowed money. Indeed, the need for high exposure to debt in order to turn a profit seems to be one of the main reasons banks tend to get in trouble when economies tank.

 I’m ‘awarding’ Tesco and Standard Chartered 0/5 each for their approach to borrowings.

5. Degree of cyclicality

Recent weakness in the share prices of the London-listed banks and commodity firms, teaches me not to become complacent about the cyclicality inherent in their businesses.  

Cyclical firms make poor choices for a dividend-led investing strategy, I would say, and Standard Chartered operates with hair-trigger cyclical characteristics. The supermarket, sector on the other hand, was once prized for its stability and lack of cyclicality. However, Tesco currently faces a structural challenge to the industry that could see the firm in long-term decline.

I’m scoring Tesco 4/5 and Standard Chartered 1/5 for their cyclicality.

Putting it all together

Here are the final scores for these firms:

Tesco wins this face-off, but both firms are far from perfect by these measures, so my search for a dividend champion continues.