When a company’s earnings don’t cover its dividend, the situation can’t persist for long without a cut to the payout. That’s bad news for shareholders, particularly those who need the income.

Dividend cover of two — or, a 50% payout ratio — is a healthy level. This means the company is passing half its earnings to shareholders and retaining half to invest in the business for future growth. It also gives leeway to maintain, or even modestly increase, the dividend should the company go through a few lean years of earnings.

Alarm bells have been ringing for some time on the dividend outlook for the FTSE 100. Cover declined from 2.9 five years ago to 1.9 a year ago, and has since plunged to a diabolical 0.75.

HSBC (LSE: HSBA), Vodafone (LSE: VOD) and Pearson (LSE: PSON) are three companies on the dividend danger list. Are their payouts set to crash?


HSBC’s dividend cover has fallen from a healthy 2.2 five years ago to just 1.3 last year. While the board defiantly raised the 2015 payout by 2%, chairman Douglas Flint explicitly warned that future dividend growth is “dependent upon” overall profitability, asset sales and meeting regulatory capital requirements.

There was none of this “dependent upon” business at the AGM a couple of years ago, when the company “continued to demonstrate our ability to generate enough capital to deliver a progressive dividend” and “cemented our status” as a high dividend payer.

So, the board’s change in tone from two years ago has been rather dramatic, and clearly signals that HSBC’s status as a high dividend payer is now somewhat less than “cemented”. A deteriorating revenue and earnings outlook has seen the market move to price-in a dividend cut, pushing the share price down and lifting the trailing yield to a staggering 8%.

It strikes me that the risk of a cut is significant, and heightened for HSBC because meeting regulatory capital requirements isn’t something the bank can dodge. Contrarian investors may take the view that a 50% dividend cut would still leave a decent yield and that the company is worth buying for its long-term prospects, and I wouldn’t argue with that


We’ll have a much better idea about the outlook for Vodafone’s dividend after the company releases its results for the year ended 31 March this coming Tuesday (17 May).

As things stand, Vodafone increased its interim payout by 2.2%, following last year’s rise of 2% when the board said: “Our intention to continue to grow dividends per share annually demonstrates our confidence in strong future cash flow generation”.

Dividend cover last year was just 0.5. If the analyst consensus is on the mark, expect to see a further decline to 0.45 in next week’s results. Vodafone yields 5.2%, but we’re at a critical juncture, and the market will be watching carefully for what the company has to say on the dividend, future capital expenditure and cash flow.


Pearson is another company whose dividend cover has fallen markedly over recent years — from a healthy 2.1 five years ago to 1.35 last year. Earnings have declined by getting on for 20% over the period, and the company has guided on a further fall in excess of 20% for 2016, which would put dividend cover at 1.05 at best.

Pearson is going through a major restructuring and in light of this and the low level of cover, many were expecting a dividend cut to be announced when the company released its annual results in February. Indeed, some shareholders were actually calling for a reduced payout in order to conserve cash through this difficult period.

However, Pearson said it would maintain the dividend at the 2015 level, giving a current yield of 6.5%, while it rebuilds cover “reflecting the board’s confidence in the medium-term outlook”. However, a business in transition is always more unpredictable, and if the board’s confidence proves even moderately over-optimistic, the dividend would soon come under pressure with cover being so precarious.

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