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Where Next for HSBC's Dividend?

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LONDON -- Many investors focus on earnings per share when judging a company's performance. However, earnings can be manipulated and adjusted in all sorts of ways, meaning they don't tell you a lot about how much spare cash a company has generated. Similarly, since dividend cover is calculated using earnings, a good level of dividend cover doesn't necessarily mean the payout is actually being funded from a company's profits.

A company's cash flow can tell you a lot about a firm's financial health. Is the company burning up its cash reserves on interest payments and operating expenses, or does it generate spare cash that can fund dividends or be retained for future investment? If a dividend isn't funded by cash flow, then there is a greater chance the payout will become unaffordable and be cut, which is bad news for shareholders like you and me.

In this series, I'm going to take a look at the cash flow statements of some of the biggest names in the FTSE 100 (UKX) to see whether their dividends are being funded in a sustainable way, from genuine spare cash. Today, I'm looking at HSBC Holdings  (LSE: HSBA  ) (NYSE: HSBC  ) .

Profits vs. the Law
HSBC's global banking business is in good health. Its large presence in Asia has helped to protect it from the U.S. and European recessions, and pre-tax profits are expected to be around 13.5 billion pounds this year, with a 5.5% dividend increase to keep shareholders happy.

Despite this, the U.K.'s biggest listed bank hasn't escaped the scandals that have tarnished the reputations of its U.K. peers. HSBC is under investigation for its involvement in the LIBOR-rigging scandal, and it also set aside $353m in the third quarter to address Payment Protection Insurance claims -- although this is a trivial amount for the bank, and much less than RBS and Lloyds have paid out. HSBC's biggest problem is in the U.S., where it faces possible criminal charges relating to laundering Mexican drug money. News reports this week suggest that HSBC will manage to settle these claims by paying a $1.8 billion fine and promising to fix its internal compliance problems. If this turns out to be true, then it will be a good outcome -- HSBC can afford it, and it could have been much worse.

HSBC's current 4% dividend yield is the highest of any U.K. bank, making it attractive to dividend investors seeking a diversified income. Let's take a closer look.

Does HSBC have enough cash?
As private investors, we want to back businesses that are able to pay their dividends out of free cash flow each year. I define free cash flow as the cash that's left over after capital expenditure, interest payments, and tax deductions. With that in mind, let's look at HSBC's cash flow from the last five years:

Year 2007 2008 2009 2010 2011
Free cash flow ($m) 70,760 5,327 -50,179 20,769 69,831
Dividend payments ($m) 6,721 8,017 5,235 4,449 6,155
Free cash flow/dividend* 10.5 0.7 -9.6 4.7 11.3

Source: HSBC annual reports. *A value of >1 means the dividend was covered by free cash flow.

Is HSBC's dividend safe?
HSBC reported solid annual profits every year through the financial crisis -- in 2009, it made pre-tax profits of $7.1 billion. Yet a glance at the table above shows that its free cash flow was -$50 billion in the same year! This is a great example of why it is important to look at companies' cash flow statements, not just their income statements: Profits don't necessarily mean positive cash flow, and this can sometimes be a problem.

In HSBC's case, I don't think it is a problem -- the company delivered positive cash flow in the years before and after 2009 and looks to be in robust health. Its cash balance will be getting a further boost following the recently announced sale of its 15% stake in China's Ping An Insurance company, which will net HSBC $9.4 billion. This includes a healthy $2.6 billion post-tax profit on the original price it paid for Ping An.

I think that HSBC's dividend looks pretty safe and confidently expect it that it will continue to rise over the next few years. However, it's worth noting that HSBC's longer-term shareholders haven't escaped unscathed from the financial crisis -- the bank cut its dividend in 2008 and 2009, and this year's total dividend is only expected to be around 55% of the total dividend paid in 2007.

Top income tips
One man who really understands how to assess the quality of a company's dividends is legendary City fund manager Neil Woodford, whose High Income fund grew by 342% over the 15 years to October 2012, during which time the FTSE All-Share index managed a gain of only 125%.

Woodford selects stocks that he believes are undervalued and likely to deliver strong dividend growth. His record is one of the best in the City and at the end of October 2012, he had 21 billion pounds of private investors' funds under management -- more than any other City fund manager.

You can learn about eight of Neil Woodford's largest holdings and how he generates such fantastic returns in this exclusive Motley Fool report. It's completely free, but is available for a limited time only. I strongly suggest you click here and download the report today to avoid missing out.

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