At first glance, it may seem strange to suggest GlaxoSmithKline (LSE: GSK) is a better dividend stock than BP (LSE: BP), as GSK’s dividend yield of 5.7% is significantly lower than BP’s 6.6%. However, the best dividend stocks are not necessarily the highest yielding ones. A high yield may be tempting for income investors, but dividend sustainability and the potential for capital growth should be just as important for dividend investors.
In this article, we will take a look at what makes GSK a better dividend stock than BP.
GSK has better dividend sustainability. Its dividend cover in 2014 is 1.2x, whilst BP’s is 0.5x. But, whilst it is important to look at coverage ratios to evaluate the dividend sustainability of these stocks, a qualitative evaluation of the underlying fundamentals is just as important.
Although BP remains committed to maintaining its dividend even with lower oil prices, its operating cash flow in the near term will fail to cover its capital spending budget and its dividend payments. Operating cash flow in the first six months of 2015 had almost halved to $8.1 billion, from $16.1 billion last year. BP is selling assets and taking on more debt to maintain the dividend, but this is not a sustainable strategy in the long term. Investors and analysts seem to expect oil prices will bounce back to above $80 within a few years, but there are growing concerns that this seems to be becoming less likely.
GSK’s revenue base is far more stable, as the demand for drugs are non-cyclical. The non-cyclical nature of the healthcare sector means that GSK can reliably generate stable earnings and cash flow to pay its dividends. Although the loss of patent expiration does lead to intense competition from generic manufacturers, the volatility of GSK’s earnings is much lower than it is for BP. This is because the overwhelming majority of GSK’s earnings is derived from products that still enjoy patent protection or products that rely more heavily on its branding, such as its consumer healthcare business.
Both companies have seen earnings decline in recent quarters, but it seems that GSK will bounce back more quickly. GSK, which has seen the expiry of blockbuster drugs lead to shrinking revenues, benefits from a strong pipeline of 40 new drugs that should soon allow the company to return to growth. Its management is confident that earnings per share will grow in the double digits on a constant currency basis in 2016. GSK’s dividend has been fixed at 80 pence annually until 2018, but a return to growth is likely to lead to an uprating in GSK’s shares long before that.
BP, whose earnings depend heavily on the oil price, is likely to freeze its quarterly dividend at $0.10 per share, unless the oil price recovers to at least $80 per barrel for a sustained period of time. With production from Iran flowing back into the international market, the prospects of a sustained rise in oil prices just seems unlikely. And, if the price of Brent crude oil stays near today’s level of around $50 per barrel, BP would need to consider cutting its dividend to conserve cash. If that happens, shares in BP have a long way to fall.
Although GSK is far from being a perfect stock, its stronger dividend sustainability and the greater visibility over its earnings and cash flows justify its lower dividend yield.
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Jack Tang 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.