Where Next for Lloyds Banking Group's Dividend Hopes?

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 taking a look at the cash flow statements of some of the biggest names in the FTSE 100 (UKX), to see whether they can afford to pay dividends from their free cash flow. Today, I'm going to take a look at Lloyds Banking Group (LSE: LLOY  ) (NYSE: LYG  ) -- after four years without dividends, can it now afford to restart dividend payments?

The story so far
Lloyds' shares have rallied impressively over the last six months, rising by 82% to their current price of about 55 pence. Of course, this is a far cry from the 440 pence or so they were worth at the beginning of 2008 -- and remains below the 73.6 pence average paid by the government for its 40% stake in the bank.

Since then, Lloyds has been focused strengthening its balance sheet and completing its divestment of non-core assets. Like Royal Bank of Scotland, Lloyds was banned from paying dividends until April 2012 because of EU rules on state aid. It has yet to confirm when it will restart dividend payments, but hopes are growing that the bank might declare a dividend some time in 2013. An average of analysts' forecasts indicate a dividend of 1 pence per share could be declared this year, equivalent to a yield of 1.8% at the current share price.

Given these growing expectations, now seems a good time to take a look at Lloyds' accounts, to see whether these hopes could become reality, or whether investors will have to wait a little longer.

Does Lloyds 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. Lloyds hasn't had much free cash flow over the last few years, but is that changing now that many of its problems have been addressed, and its business is returning to normal?

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 Lloyds' cash flow from the last four-and-a-half years:

Year 2008 2009 2010 2011 2012 (H1)
Free cash flow* -2,016 14,466 -6,377 24,699 23,260
Pre-tax profits* 760 1,042 281 -3,542 -439
Cash/cash equivalents at period end* 32,760 65,690 62,300 85,889 109,108

Source: Lloyds Banking Group reports. *in millions of pounds.

Can Lloyds afford a dividend?
Lloyds' cash balance has risen by more than 230% over the last five years, growing from just 32.7 billion pounds at the end of 2008, to 109 billion pounds at the end of June 2012. There's no doubt that the bank is in a far stronger position than it was five years ago, thanks to a concerted effort to ditch non-core assets, write down bad loans, and take the necessary impairments to deal with the Payment Protection Insurance scandal and other such disgraces.

A key measure of banks' financial strength is their Core Tier 1 capital ratio, and Lloyds' ratio has risen from a relatively puny 6.4% at the end of 2008 to a far more regulator-friendly 11.5% at the end of September 2012.

Although Lloyds has continued to posted pre-tax losses or tiny profits over the last three years, this has been due to the various impairments and writedowns it has been taking -- not to its cash position, which is strong. These impairments should now almost be finished, and according to Morningstar, analysts expect Lloyds to post a pre-tax profit of around 2.7 billion pounds for 2012 and 4.3 billion pounds for 2013.

This suggests to me that the bank's management will be keen to declare a dividend in 2013, as the resumption of dividend payments could be the trigger for big institutional shareholders like pension funds to buy back into the stock. In turn, this could lift the bank's share price and make it possible for the government to sell its stake in the bank at a modest profit, returning it to private ownership. However, any dividend policy will have to be very cautious, as a generous dividend would lead to Lloyds being accused of putting shareholders' enrichment ahead of its responsibility to fund new lending and strengthen its balance sheet.

In conclusion, I think Lloyds' is likely to declare a small dividend this year, unless any new problems arise that make it politically unacceptable to do so.

Top income tips
One man who was smart enough to get out of banking shares before they crashed is legendary City fund manager Neil Woodford. Woodford is a dividend specialist 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.

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