Dividend Investors Find the GlaxoSmithKline Yield Hard to Resist

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Earlier this year, GlaxoSmithKline (GSK 0.12%) froze its dividend, electing to maintain its same dividend payout for the next few years, ending a string of 18 consecutive years in which the company increased its annual dividend payout. Typically, such an announcement might cause concern for investors, as a dividend freeze may be the first step toward a dividend cut, meaning the reduction or elimination of a dividend payout that many have grown to count on. However, the London-based pharmaceutical giant is still yielding about 5.6% -- a sizable and tempting distribution. The question is, though: is this dividend sustainable?

Glaxo has been in the news of late for the following reasons:

• the impending introduction of a malaria vaccine
• bribery allegations
• the recent shutdown and subsequent reopening of a plant due to the discovery of Legionella bacteria
• the CEO's bold prediction of double-digit growth as early as next year
• better-than-expected second quarter earnings
• rumors of potential suitors buzzing overhead, the latest being Pfizer
• the freezing of the company's dividend

For Americans investing in GlaxoSmithKline, the 18-year streak of consecutive annual dividend increases ended several years ago due to currency fluctuations. The charts below are presented in Great British pounds and U.S. dollars to illustrate the impact that exchange rates have had on dividends paid to American investors via the American Depositary Receipt for Glaxo.

Annual dividend payout and percentage change, in GB pounds

Annual dividend payout and percentage change, in U.S. dollars

When purchasing GSK on the New York Stock Exchange, investors purchase ADRs rather than actual shares of stock. ADRs allow Americans to buy and sell shares of foreign companies denominated in U.S. dollars rather than in foreign currencies. While ADRs may make it easier for U.S.-based investors to buy and sell shares of foreign companies like GSK, the U.S. dollar payment of these dividends is directly affected by the movement of currency rates. Additionally, taxes may be withheld by the ADR company's local government -- the U.K. in this case -- which could erode dividend payments, as well. 

Notwithstanding the currency impact on its ADR, the dividend for this London-based pharmaceutical giant has increased each year for nearly two decades. However, in recent years, the rate of increases has been steadily declining, until it came to an abrupt standstill earlier this year when the company announced that it elected to freeze its dividend payout, henceforth, through the end of 2017.

Assessing dividend sustainability
This is certainly a good moment for investors to consider how secure future dividend payouts appear. One of the key metrics that many investors use to evaluate the safety of a company's dividend is the dividend payout ratio. This calculation helps investors assess how well earnings support dividend payments.

The dividend payout ratio is calculated by dividing the dividends paid per share by earnings per share, expressed as a percentage. A low ratio indicates that a company retains much more of its earnings than it pays out to shareholders. Newer, less established companies tend to pay out less than older, more established companies, as they use more of their money to fund research and development in order to grow their businesses.

Typically, this ratio comes in around 25% to 50%. The average across all industries is about 37%, but the results vary across industries.

In January 2015, the average dividend payout ratio for the 151 companies in the pharmaceutical sector was 61.85%. This is considerably higher than the average payout ratio across all sectors since this cash-intensive, research-based sector has higher than average expenses, and tends to reward shareholders with dividend yields which, on average, are higher than 80% of all other sectors.  The dividend payout ratio for Glaxo has exceeded the pharma average, and has reached clearly unsustainable levels -- the company's payout ratio of 141% in 2014 indicates that the company paid out dividends which exceeded earnings by 41% that year. As the company's earnings have been choppy of late, it is easy to understand why GSK elected to curtail increases to its dividend for the next few years.

GlaxoSmithKline Dividend Payout Ratio

Dividend to free cash flow ratio
Another metric used by many investors when assessing the safety of a dividend payout is the dividend to free cash flow ratio. Free cash flow, or FCF, is the cash a company produces from its operations less the cost of expanding its asset base; FCF differs from earnings as it takes into account the consumption of capital goods. Without free cash, it's difficult to develop new products, make acquisitions, pay dividends, and pay down debt. The formula to determine the dividend to free cash flow ratio is: annual dividend per share divided by free cash flow per share. The lower the percentage, the more disposable cash a company has to spend elsewhere.

Most people want the results of this calculation to be 60% or below, irrespective of what industry they are researching. Again, Glaxo results are poor in this analysis:

GlaxoSmithKline Dividend to Free Cash Flow Ratio

I use both of these ratios when analyzing potential investments and monitoring those companies that I invest in, but I place greater emphasis on the results provided by the dividend to free cash flow ratio. I believe it's more important to know what portion of its cash a company is paying out via dividends, and understanding how much cash is still available for running the business. 

Is Glaxo's high yield worthy of your portfolio?
Despite Glaxo not stacking up in these two tests, its 5.6% yield may be difficult to pass up, especially for retirees seeking income. The average yield for all 151 companies in the pharmaceutical sector is 2.28%, which is less than half the yield which Glaxo currently sports, and much higher than the yield for the S&P 500, which is presently 1.95%. Nevertheless, while the above-average yield for GSK might be very tempting, a more thorough look shows that this payout may prove to be unsustainable.

As a dividend investor, I would prefer to invest in a company like Johnson & Johnson, which has been increasing its dividend every year for the past 53 years, with a 7.3% growth rate during the past five years. I also favor J&J because it has a dividend payout ratio of 48% and a dividend to free cash flow ratio of 54%, even if it is "only" yielding 3.00%.

Bottom line is, if you're looking to invest in Glaxo to get a 5.6% yield, you should understand that the yield could eventually be cut -- likely sooner rather than later -- and that could send the company's stock price into a rapid downward spiral. I would rather sleep well at night with the confidence that my dividend investments will likely grow year after year, for many years to come.