Where Next for Marks & Spencer'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, to see whether their dividends are being funded in a sustainable way, from genuine spare cash. Today, I'm looking at Marks & Spencer Group (LSE: MKS.L  ) .

Does Marks & Spencer 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 Marks & Spencer's cash flow from the last five years:

Year 2008 2009 2010 2011 2012
Free cash flow (in millions of pounds) 14.7 496.6 536.0 563.0 309.3
Dividend payments (in millions of pounds) 343.6 354.6 236.0 247.5 267.8
Free cash flow/dividend* 0.04 1.4 2.3 2.3 1.2

Source: Marks & Spencer annual reports. *A value of >1 means dividend is covered by free cash flow. 

Pension problems
Marks & Spencer's dividends have been covered by free cash flow for four of the last five years, suggesting the company's payouts are sustainable and affordable.

However, while poring over the company's accounts, I noticed that M&S has been making some pretty hefty extra cash payments to make good its pension scheme deficit. In 2010, the firm agreed to make additional payments of 800 million pounds into its UK Defined Benefit Pension Scheme in order to help make good a 1.3 billion pound deficit. This funding plan includes additional cash payments of 35 million pounds per year from 2010 until 2012, and then 60 million pounds per year from 2013 until 2018. That means that a big chunk of the company's free cash flow is going to be absorbed by extra pension scheme contributions over the next five years -- which could put pressure on dividends.

Marks & Spencer's free cash flow dipped in 2012, as its clothing retail business -- which accounts for almost half its revenue -- struggled. After total pension-related cash contributions of 71.9 million pounds were accounted for, it was left with negative cash flow for the year. This could happen again this year -- in its half-yearly report, published at the start of November, M&S revealed that its cash balance has dropped from 195.8 million pounds at the start of the financial year to just 140.5 million pounds six months later.

Is Marks & Spencer's dividend safe?
Shareholders will need to hope that Marks & Spencer's free cash flow will soon return to 2010/2011 levels, so that the company can fund both its dividends and its additional pension contributions without dipping into its reserves too often.

I think that Mark & Spencer's dividend is safe, but is likely to be held for at least one more year. The company has not increased its dividend for the last two years, and its payout remains lower than it was in 2008. While analysts are pencilling in an increase from 17 pence to 17.06 pence for the year ending March 2013, I think that even this nominal increase could stretch the company's free cash flow as it faces the ongoing challenges and costs of rejuvenating its flagging clothing business.

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.

Roland Head does not own shares of any companies mentioned. The Motley Fool has a disclosure policy.
We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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