Are Dividends Built To Last At Royal Bank of Scotland Group plc, J Sainsbury plc And British American Tobacco plc?

If you’re looking for dividends, there are those with staying power from companies with robust business and financial achievements. Or there are more fragile dividends that arise because of weaker operational and financial characteristics. Those should be avoided even though their high dividend yields can be tempting. But how to tell the difference?

Let’s look at three FTSE 100 firms: Royal Bank of Scotland Group (LSE: RBS), J Sainsbury (LSE: SBRY) and British American Tobacco (LSE: BATS).

They operate in different sectors, but all look set to pay a dividend for 2016. At the recent share price of 234p, Royal Bank of Scotland’s forward yield for 2016 should be 0.5%. At 246p, J Sainsbury’s is around 4.3%. At 3765p, British American Tobacco’s is 4.4%.

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

1. Dividend record

Here are the firms’ dividend records:

RBS paid zero dividends over the period. Sainsbury saw a dividend contraction of 33% and BAT boosted its dividend by 23% so I’m scoring RBS 0/5, Sainsbury 1/5, and BAT 4/5.

2. Dividend cover

RBS expects forward earnings to cover its modest dividend in 2016 almost 20 times. Sainsbury expects earnings to cover its dividend payout just over twice, and BAT anticipates cover around 1.35 times.  

I feel earnings should cover the dividend payout at least twice in my dividend investments, but as cash pays dividends, dig deeper into how well (or poorly) these companies cover their dividend payouts with free cash flow too. 

On dividend cover from earnings, I’m awarding RBS 5/5, Sainsbury 4/5, and BAT 2/5.

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:

Royal Bank of Scotland’s record of profits and cash flow looks disastrous. When cash flow fails to support profits, firms must make up the shortfall elsewhere, such as investing or fundraising. Such reliance on activities other than straightforward banking is part of what makes banks such as RBS cyclical and prone to the volatility that exaggerates macroeconomic and financial market wobbles.

Meanwhile, Sainsbury displays robust positive cash flow that supports profits, and BAT’s performance on cash generation is steady, despite a trend towards cash flow lagging operating profits.

I’m playing safe, scoring RBS 0/5 for its record on cash flow from operations. Sainsbury gets 5/5 and BAT 3/5.

4. Debt

Interest payments on borrowed money compete with dividend payments for incoming cash flow, making big debts undesirable in dividend-led investments.

RBS’s external borrowings are at least 10 times 2015’s pre-tax profits and maybe more. Sainsbury’s gross debt runs at around 3.7 times 2015’s pre-tax profit and BAT’s at 2.75 times profits for 2015.

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 borrowing. Indeed, the need for high exposure to debt in order to turn a profit seems to be a key reason banks get in trouble when economies tank.

I’m ‘awarding’ RBS 0/5, Sainsbury 2/5, and BAT 3/5 for their approach to borrowings.

5. Degree of cyclicality

Recent weakness in share prices of banks and commodity firms teaches me not to become complacent about their inherent cyclicality. 

Cyclical firms make poor choices for dividend-led investors and RBS operates with hair-trigger cyclical characteristics. And while investors once prized supermarkets for stability and lack of cyclicality, Sainsbury currently faces a discounter-led structural challenge to its industry that could see the firm in long-term decline.

BAT has almost zero cyclicality due to its product — consumable goods with addictive ‘qualities’.

I’m scoring RBS 1/5, Sainsbury 4/5, and BAT 5/5 for cyclicality.

Putting it all together

Here are the final scores:

BAT wins here but none of the trio are perfect by these measures, so I continue to seek a dividend champion.