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This article appeared in the October 2013 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Can CBA, Wesfarmers, Woodside and Harvey Norman keep delivering on the dividend front?

Photo of Christine St. Anne By Christine St Anne, Morningstar

Despite a tough environment, more companies lifted, rather than cut, their dividends in the most recent earnings season. This was a key finding of CommSec's earnings season wrap-up, which found interim dividends were higher in aggregate by 8.5 per cent.

Although dividends are "the new black", investors should not focus on a company's yield in isolation. They should look at a number of measures that will determine the viability of a company's yield.

Standard measures such as the payout ratio and history of dividend per share can give investors an idea about a company's ability to pay its dividends.

A company that records a jump in its payout ratio (that is, it pays out a large proportion of its earnings as dividends) may, in fact, be struggling to maintain its dividend at current levels.

For Morningstar's head of equities research, Peter Warnes, it is very simple: companies that can support their dividends are the ones still able to grow their earnings during the bad times.

As for the recent earnings season, let's take a closer look at a number of companies that lifted dividends and assess the viability of the increases.

In addition to the dividend payout ratio and dividend per share measures, we have also used the annual growth rate of earnings per share (EPS) to gauge the profitability of a company.

The Commonwealth Bank of Australia (CBA) not only announced a record $7.82-billion profit, but also declared a fully franked final dividend of $2 a share. This took the total dividend for the year to $3.64, up 9 per cent.

Graph 1 shows CBA has consistently grown its earnings, even through periods of subdued credit growth. The bank ticks all the boxes - maintaining a payout ratio of between 70 to 80 per cent and consistently increasing its dividends.

Graph 1: Commonwealth Bank of Australia (CBA)

Commonwealth Bank of Australia (CBA) earnings bar chart - 2011 to 2013

Source: Morningstar

Morningstar's head of financial services, Asia Pacific, David Ellis, believes CBA's fully franked dividends are sustainable. He said in a report: "Earnings momentum and chief executive Ian Narev's relatively positive outlook supports our long-argued position that the major banks can deliver solid dividend growth despite moderate credit growth and soft economic conditions."

Wesfarmers (WES) made a splash in the recent earnings season when it announced a $579-million capital return to shareholders. The return of 50 cents a share was the result of strong earnings growth and cash flow generation, said Wesfarmers' finance director, Terry Bowen.

The company also declared a fully franked final dividend of $1.03, taking the full-year dividend to $1.80, a rise of 9.1 per cent on the previous year.

Graph 2 illustrates that Wesfarmers, like CBA, has managed to consistently grow its earnings through a challenging economic environment of low GDP growth and weak consumer sentiment.
Again, its payout ratio has remained consistent at around the 90 per cent level and dividends have grown steadily.

Graph 2: Wesfarmers Limited (WES)

Wesfarmers earnings bar chart - 2011 to 2013
Source: Morningstar

On the other side of the market spectrum is Woodside Petroleum (WPL). The oil and gas major managed to lift dividends despite a fall in underlying profit. It announced a fully franked half-year dividend of 83 US cents a share, up from 65 US cents a share in the same half of the previous year.

Graph 3 reflects the uncertainty surrounding the earnings of companies operating in the resources sector.

Graph 3: Woodside Petroleum Limited (WPL)

Woodside earnings bar chart - 2010 to 2012

Source: Morningstar

Earnings have recently improved for Woodside. As Graph 3 suggests, EPS increased from 201 cents in 2011 to 247 cents in 2012.

A recent research note from UBS suggests the company is "making dividend hay while the sun shines". UBS sees a solid yield ahead for Woodside on the back of higher oil production.

However, like many companies in the resources sector, Woodside's focus will be on growth and UBS does not expect the high dividends to last as oil production declines and LNG is eventually re-priced.

Nevertheless, Morningstar notes that Woodside's cash flows remain strong and its debt levels relatively low. The company also manages a large proportion of Australia's long-life, low-cost, export-oriented and expandable gas projects. "These ensure low-cost supply - the foundation for competitive advantage in the resources space," Morningstar says.

Graph 4: Harvey Norman Holdings Ltd (HVN)

Harvey Norman bar chart - 2011 to 2013

Source: Morningstar

A surprise result this earnings season came from embattled retailer Harvey Norman (HVN). Although it announced a 3.3 per cent decline in net profit after tax to $183 million, the business recorded a sales lift across a number of its divisions. Fourth-quarter like-for-like sales rose 2.6 per cent, up from 1.5 per cent in the third quarter. Dividends remained fully franked at 9 cents a share.

The same-store sales increase reflected an improved housing market, which triggered demand for household furniture. UBS noted in a research report that Harvey Norman is the Australian retailer most leveraged to housing.

Positives aside, Morningstar's senior equities analyst, Tim Montague-Jones, has highlighted a number of issues confronting the group, including the consumer shift to online shopping. "We view the fourth-quarter result as pedestrian and fail to deduce any material turnaround in momentum," he says.

Graph 4, above, shows that although Harry Norman's headline sales numbers look good, its earnings remain weak.

Going beyond the numbers

Although EPS and dividend payout ratios are good measures of a company's earnings viability, it is also important to look behind the numbers.

As is the case with Woodside, while EPS may not have been consistent with a company like CBA, investors need to consider other factors when assessing resources and energy companies, such as cash flow and debt levels.

Morningstar's report on Woodside noted that its balance sheet is strong, with US$3.4 billion in cash and gearing levels at 13 per cent.

Investors should also look at outlook statements, which can give a clearer picture of the challenges ahead for companies. For example, the outlook for commodity prices is obviously critical for the profit outlook of resources companies.

A good illustration is Fortescue Metals Group (FMG). The "third force in iron ore" also surprised the market, announcing a 12 per cent rise in headline profit to US$1.7 billion. Full-year dividends of 10 Australian cents a share, fully franked, were declared, up 25 per cent.

However, Morningstar's sector head of basic materials and energy, Mathew Hodge, pointed out in a report that while a strong iron-ore price may have boosted Fortescue's results, it also hid its business flaws.

The most notable flaw is the debt of US$30 billion, and although Hodge noted that the dividend was a surprise, it may not be prudent, given the miner's debt and the outlook for iron ore prices. "With or without the dividend, Fortescue's fate hinges on the iron ore price, over which it has no control," Hodge says.

About the author

Christine St Anne is Morningstar's online editor.

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