Following Pearson’s dividend cut announcement yesterday, I’m sure dividend investors are concerned about the safety of a few other high-yielding stocks.
The dividend coverage ratio is a key measure of dividend sustainability as it gauges the extent to which dividends are covered by a company’s earnings. It’s calculated by simply dividing the company’s net income by the amount of dividends paid to shareholders.
This means that a company with a dividend cover below one times is paying out more to shareholders than it earns in that year. And usually, this would mean the company would have to borrow money or sell assets to maintain the dividend, which may become difficult over the long term.
One company whose dividend cover has fallen short of that level for a number of years now is telecoms giant Vodafone (LSE: VOD). Ever since the sale of its 45% stake in Verizon Wireless, it has failed to generate sufficient earnings to cover its payout and has instead relied on the sale proceeds to maintain its generous progressive dividend policy.
Profits and free cash flow generation have been hobbled by stiff price competition in Europe. And looking forward, city analysts expect earnings will continue to fall short of dividends for at least another two years. Vodafone may be able to fund its dividends by raising debt, as it has done in the past three years, but it can’t do so indefinitely. Net debt has more than doubled since the sale of its stake in Verizon Wireless, and now stands at more than €40bn.
Falling dividend cover
At first glance, satellite communications services company Inmarsat (LSE: ISAT) appears to be in better shape as its dividends have consistently been fully covered in past years. But, when we dig deeper into its earnings outlook, its dividend sustainability doesn’t look all that secure.
Revenues from its new Global Xpress satellites have been growing much more slowly than earlier expected and the company’s profitability continues to be impacted by ongoing legacy issues. As such, City analysts have been busy reducing their profit forecast for the firm.
Currently, analysts expect underlying EPS would fall to 42.5p this year, which implies its dividend cover would fall just below the one times minimum sustainable level this year. However, Inmarsat may still avoid a payout cut as long as earnings don’t fall too far short of dividends for too long.
Challenging trading conditions
Engineering group Weir (LSE: WEIR) had dividend cover of 1.8 times last year, which doesn’t give too much cause for alarm. But because the company’s earnings outlook remains tied to upstream spending in the oil and gas sector, we ought to be vigilant.
Trading conditions remain challenging and another slump in commodity prices could hit the company hard. And although the industry’s fundamentals look a lot better than a year ago, I expect the recovery to be slow as capital spending by major oil and gas producers is unlikely to rebound back to pre-2015 levels.
The company is due to announce its full-year results in February and analysts currently expect underlying EPS to fall by 19% to 63.5p. This implies its dividend cover would have fallen to below 1.5 times in 2016, which could cause some concern for shareholders given the cyclical nature of its business.
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Jack Tang has no position in any shares mentioned. The Motley Fool UK has recommended Weir. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.