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, there's 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 U.K.'s biggest listed companies, to see whether their dividends are being funded in a sustainable way, from genuine spare cash. Today, I'm looking at Spain's largest bank, Banco Santander (LSE: BNC ) (NYSE: SAN ) , whose 50 billion-pound market capitalization and 10% dividend yield make it a very unusual investment opportunity.
Does Banco Santander 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 Santander's cash flow from the last five years:
|Free cash flow (millions of euros)
|Dividend payments (millions of euros)
|Free cash flow / Dividend*
*A value of >1 means the dividend was covered by free cash flow.
In the U.K., we have adjusted to receiving low or zero dividends from our troubled banks -- Barclays, RBS, and Lloyds. However, more than half of Santander's profits come from its Latin American operations (mainly Brazil), and it also has substantial operations in the U.K. and U.S. This means the majority of the bank's profits come from outside the eurozone, which has enabled Santander to manage the rising tide of bad property loans it faces in Spain, and remain profitable.
In its fourth-quarter results for 2012, Santander reported a 59% fall in full-year profits to 2.2 billion euros, after it set aside a further 18 billion euros last year to cover non-performing (bad) loans and losses on properties it owns and needs to sell.
The majority of Santander's bad debts in Spain relate to loans made to property developers during the boom, not to personal mortgages, and worryingly, the level of bad debt is still rising, several years after the market crashed. In 2012, bad debt levels in Santander's Spanish loan book rose from 5.49% to 6.74%, although the bank did manage to halve its real estate exposure by selling 33,500 properties from its books, and from those of real estate developers who owe money to the bank.
On a more positive note, Santander's non-performing loan levels are 4% below the Spanish average, and the bank's market share in Spain rose by 2.1% last year, with deposits rising by 12%, thanks to Santander's apparent stability -- many of Spain's regional savings banks have come close to bankruptcy and are only being kept afloat with state assistance.
Is Santander's dividend safe?
Santander's chairman, Emilio Botín, believes that 2012 will prove to be a "turning point," after which earnings will begin to recover. It's too early to say whether he is right, but Santander's shares currently trade at about 510 pence, at which level they offer a 10% yield, based on the 0.60 euro per share payout the bank has maintained for the last three years.
Abnormally high dividend yields like this normally indicate an above-average level of risk, and Santander currently trades at a price to book ratio of just 0.75, suggesting that the financial markets believe there is still a lot of risk attached to the bank's assets. The ultimate risk is that Spain will be forced out of the eurozone, but I think a more realistic risk is that the current situation -- where Spain is in a deep recession -- will continue for much longer than expected, depressing Santander's earnings and increasing its bad debts still further.
If this happens, there is a real risk that Santander might be forced to cut its dividend at some point in the next two years, but it's worth noting that even if the dividend halved, the shares would still offer a prospective yield of 5% -- well above the FTSE 100 average of 3.3%. I think Santander's shares are a fairly attractive purchase at present, but it would be rash to rely on the dividend remaining uncut.
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