GlaxoSmithKline (LSE: GSK) currently supports one of the largest dividend yields in the FTSE 100.
At present, the company’s shares yield just under 6%, around double the market average, making them extremely attractive in the current interest rate environment.
However, it is often the case that a higher-than-average dividend yield like Glaxo’s reflects the market’s belief that the company is sick and will have trouble maintaining its dividend payout.
That said, Glaxo’s management has stated that the group’s dividend payout will remain at 80p per share for the next three years. This indicates that the company will yield 5.9% for the next three years based on the current price.
But how realistic is management’s outlook? It’s not uncommon for companies to guarantee their dividend payouts, only to backtrack and slash the payout a few months later.
So, will Glaxo’s management stay true to their word?
According to my figures, it looks as if Glaxo will be able to maintain a payout of 80p per share for the next few years.
Last year the company generated £5.2bn in cash from operations. Meanwhile, the group’s capital spending totalled £1.7bn, giving a free cash flow of £3.5bn. During the past five years, on average Glaxo has reported a free cash flow of approximately £4.4bn.
Free cash flow gives a much clearer view of a company’s ability to maintain its dividend payout. Indeed, without cash, it’s tough to invest without borrowing, pay dividends and reduce debt. Earnings can often be clouded by accounting gimmicks, but it’s tougher to fake cash flow.
Funding the payout
With around 4.9bn shares in issue, a dividend of 80p per share per annum will cost Glaxo around £3.9bn per annum to maintain. According to last year’s figures, Glaxo’s dividend payout of 80p per share cost the company a total of £3.8bn.
Unfortunately, this figure of £3.8bn is only just covered by Glaxo’s free cash flow based on the five-year average. With this being the case, Glaxo doesn’t have much room for manoeuvre and if things don’t go to plan the company could struggle to make ends meet.
Still, these figures are based on historic numbers and don’t take into account the initiatives Glaxo has in place to improve profit margins.
Specifically, the group is on track to achieve annualised cost savings of £3bn by the end of 2017. Also, Glaxo is set to receive £3bn from its recent asset swap deal with Novartis. As part of this deal, a further £1bn will be returned to investors via a special dividend.
Moreover, Glaxo’s management believes that the company’s earnings will expand at a compound annual rate in the mid-to-high single digits from 2016 onwards, further boosting group cash flow.
All in all, Glaxo’s lofty dividend yield seems to be safe for the time being. The dividend is covered by free cash flow at present and cost-saving initiatives, coupled with earnings growth should only help improve dividend cover.
Rupert Hargreaves owns shares of GlaxoSmithKline. 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.