Where Next for Aviva's Dividend?

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 high-yielding insurance giant Aviva  (LSE: AV  ) (NYSE: AV  ) .

Aviva's 7% Yield
Like its insurance peers RSA Insurance and Resolution, Aviva offers a remarkably high yield -- at today's prices, Aviva shares yield a juicy 7%, and while the final dividend for 2012 has yet to be confirmed, last year's interim dividend was held and brokers' forecasts are for the final dividend to also remain unchanged. The financial and eurozone crises have left the general insurance sector firmly out of favour and Aviva has come under particular suspicion due to its large exposure to eurozone sovereign debt -- the bonds issued by cash-strapped countries such as Spain.

Many people, including me, think that this risk is overdone and have purchased Aviva for both its income and value qualities. However, such a high yield inevitably implies a certain amount of risk and raises two questions; is Aviva's underlying business sound, and will it be forced to cut its dividend? In this article, I'm going to look at Aviva's dividend, and ask whether it is properly supported by the company's cash flow.

Does Aviva 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 Aviva's cash flow from the last five years:

Year 2007 2008 2009 2010 2011
Free Cash Flow (millions of pounds) 2,628 6,163 1,984 1,460 -972
Dividend Payments (millions of pounds) 517 749 493 489 448
Free Cash Flow / Dividend* 5.1 8.2 4.0 3.0 -2.2

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

Aviva's free cash flow figures suggest that its dividends have been comfortably affordable over the last five years -- with the exception of 2011, when dire market conditions meant that it generated very little cash. The firm hasn't published its 2012 results yet, but to get some clues as to the likely outcome, I took a look at Aviva's interim results for 2012, covering the six months to June 30, 2012.

Aviva's interim results suggest that 2012 was a good period in terms of cash flow. During the first half of the year, Aviva generated 3,221 million pounds of free cash flow, using my measure -- an impressive figure that was helped by the company's ongoing program of disposals and by a fall in interest payments, which may have been due to the company refinancing some of its debt at more favorable rates.

Is Aviva's dividend safe?
Although 2011 was a difficult year, 2012 looks likely to have been a return to previous form for Aviva, with ample free cash flow to fund shareholders' dividends. Looking ahead, some risks remain. Aviva is mid-way through a program of changes intended to focus the business on its most profitable divisions and remove its least profitable. In time, this strategy should make Aviva more robust, less indebted and more profitable -- but it's too early to say how successful it will be, or how long it will take.

I believe that Aviva's underlying business is solid and that this strategy should work, not least because the company has an able management team with previous experience of transforming large insurance operations. Institutional investors seem confident, too -- Aviva's share price has risen by 30% over the last six months, compared to an 8% gain for the FTSE 100.

Overall, I think that Aviva's dividend looks fairly safe, but is likely to be held at its current level for at least another year.

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 fifteen years to October 2012, during which time the FTSE All-Share index managed a gain of only 125%.

Mr. 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 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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