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 pharmaceutical and consumer goods giant GlaxoSmithKline (LSE: GSK ) (NYSE: GSK ) .
Stormy waters ahead?
GSK's recent third-quarter results revealed that its sales revenue fell by 5% over the last three months, raising fears that the company could be forced to cut back in order to maintain its profitability. However, the company said that the fall was broadly expected and related to a few key drugs and product disposals, along with the impact of austerity measures in Europe.
In its defense, GSK pointed out that it is expecting to have completed phase 3 trial programs for 6 new medicines in 2012 and is expecting clinical trial results from 14 new drugs over the next two years, which should help to boost future sales prospects.
GSK is planning to pursue a broader drug development policy than in the past, trusting that some drugs will become "blockbusters" without trying to identify these too far in advance. This is one of the measures being taken to deal with the patent cliff -- where sales of patent-protected drugs plummet after their patent protection expires -- because generic drug companies can copy the formula and produce much cheaper clones. GSK's goal is to have a pipeline of new, patent-protected drugs that will replace the ex-patent drugs, ensuring that futures sales and profits are protected.
Does GlaxoSmithKline 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 GlaxoSmithKline's cash flow from the last five years:
|Free cash flow (in millions of pounds)
|Dividend payments (in millions of pounds)
|Free cash flow/dividend*
Source: GlaxoSmithKline company reports.*A value of >1 means the dividend was covered by free cash flow.
Is GlaxoSmithKline's dividend safe?
GSK is considered to have handled the patent cliff far more successfully than its U.K. peer AstraZeneca, and GSK also has a thriving consumer goods business that provides it with attractive emerging market exposure -- the firm's Horlicks brand outsells Coca-Cola in India, for example.
Although GSK's free cash flow is quite volatile from year to year, it's important to remember that its business involves periodic acquisitions and considerable investment in research and development, all of which can cause big fluctuations in cash flow. This is why it's important to look at several years' results when assessing a company's cash flow situation -- one year, looked at in isolation, can provide a very misleading picture.
Over the last five years, GlaxoSmithKline's dividend payments have been covered by free cash flow an average of 1.29 times. As a GSK shareholder myself, I find this reassuring, as it suggests that the company will be able to maintain or grow its current dividend levels in the years to come. I think that GSK's dividend looks pretty robust, and I expect it to rise further over the next few years.
Top income choices
Interestingly, GlaxoSmithKline is one of the eight biggest holdings of 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%.
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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