Where Next for ARM Holdings' 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 FTSE 100 tech star ARM Holdings (ARM) (ARMH), whose microprocessor chip designs power many smartphones and tablets.

ARM's dividends
Although ARM does pay dividends, it's not an income share -- at least not for recent investors. ARM's share price has risen by 600% over the last five years, massively outpacing its growth in profits and giving rise to a dizzying price-to-earnings ratio of 73, according to data from Thomson Reuters. Although ARM pays out around 25% of its earnings per share in dividends, the stock's high price means that this only equates to a current yield of around 0.5%.

It's a different story for long-term shareholders -- back in 2008, you could have purchased ARM shares for less than 100 pence, which would give you a 3%-4% yield on cost today.

Does ARM Holdings 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 ARM's cash flow from the last five years:

Source: ARM Holdings annual reports. *A value of >1 means the dividend was covered by free cash flow.

At first glance, the figures above suggest that ARM is paying out dividends it cannot afford -- but nothing could be further from the truth. A look at ARM's cash flow statements reveals that from 2009-2011, the vast majority of its capital expenditure was actually used to purchase short and long-term deposits. In other words, ARM was generating so much spare cash it didn't have any use for it -- so it has been invested for safekeeping until the firm needs it.

ARM's balance sheet confirms this version of events. At the end of 2011, ARM had 319 million pounds of short-term deposits and 83 million pounds in long-term deposits. It also had 26 million pounds in cash and cash equivalents -- enough to meet operating requirements without being inefficient.

Is ARM's dividend safe?
Whatever the future holds for ARM, it's unlikely to threaten the safety of the company's dividend. Not only does it have several years' dividend payments held in cash or short-term deposits, but its licensing and royalty-based business model means it isn't burdened with costly factories, has relatively few employees and isn't directly exposed to the risk of rising input costs, such as raw materials and energy.

I expect ARM's growth rate and P/E ratio to moderate over the next couple of years, but I don't think that this will threaten its dividend growth; I'm pretty confident that ARM's dividend is safe and will continue to increase over the next couple of years.

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 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.

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.

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