With investors guessing which bluechip will cut its dividend next, we recently asked three experts how they measure the sustainability of a company's dividend. In this wire, they each share a stock example that passed their tests.
Don’t overlook Woollies
Neil Margolis, Lead Portfolio Manager, Merlon Capital Partners
Woolworths (ASX:WOW) is an example of an investment offering a sustainable and growing dividend.
For starters, the current payout ratio is only 65% and earnings are depressed after significant investment in price and service to arrest market share declines.
Supermarkets are less macro-sensitive than the typical listed company. The industry structure is concentrated and suppliers and customers are fragmented. As cash-flow investors, we are also attracted to cash-flows exceeding accounting earnings as cash is collected from customers long before it is paid to suppliers.
The demerger of Coles, and change in leadership, is likely to result in less discounting than recently experienced, which is important as the number two operator typically determines industry structure.
Woolworths also has clear competitive advantage in cost and product range, including the manufacture of private label products to compete with Aldi.
Management has done a good job turning market share losses into gains and shown capital discipline exiting the ill-fated Masters, attempting to divest the petrol businesses and stabilising BigW.
We value Woolworths at between $24 and $40 per share on the basis of its sustainable free cash flow, under a range of sensible scenarios. The stock is currently trading in the middle of this range as market concerns about irrational price competition and ongoing price deflation have eased.
Woolworths also has $2 per share in surplus franking credits that is not factored into our valuation but may be distributed in the form of special dividends or an off-market buyback.
Double-digit cashflow growth for Transurban
A company that has a great dividend pedigree is Transurban. The business converts a high proportion of revenue into cash flow with strong operating margins and minimal requirement to reinvest in the existing asset base.
Transurban will generate strong double digit operating cash flow growth over the next few years as solid trend growth is supplemented by the completion of several key projects. This includes the Citylink widening in Melbourne, tolling benefits in Queensland following the investment in Gateway North and the Logan widening project, as well as the completion of North Connex in Sydney during 2020.
The likely equity raising and dilution following the potential acquisition of Westconnex will likely reduce dividend per share growth below cash flow growth in the near term. That said, consensus appears to be factoring this in to some degree and Westconnex should increase Transurban’s longer term distribution growth profile.
While some have pointed to Transurban’s elevated gearing levels, we note several points that ameliorate this issue. Firstly, the nature of Transurban’s assets mean the company has far greater gearing capacity than most businesses. Secondly, the company is currently investing in a number projects that are not yet in operation and producing cash flow. Finally, a long debt maturity profile, which greatly increases flexibility.
Amcor: Ticking many boxes
Hugh Dive, Chief Investment Officer, Atlas Funds Management
Amcor offers a 4.6% yield and ticks all of the boxes we discussed in ‘How to identify a sustainable dividend’, being dividend payout ratio, leverage, and earnings and cash flow growth. Looking at Amcor on this basis:
- It has a dividend payout ratio is 70% with an extensive history of providing growing dividends.
- The company has an interest cover of 7.5 times and net debt divided by earning of 2.9 times, which indicates that the company does not face any imminent balance sheet stress.
- Continued growth in flexibles packaging in the US and Europe as well as the developing markets for this market leader will allow Amcor to continue to grow the dividend for shareholders.