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Where Next for the BT Group Dividend?

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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 BT Group  (LSE: BT-A  ) (NYSE: BT  ) .

BT's new direction
BT has made good progress in rolling out its fiber-based BT Infinity super fast broadband service, and the company remains the U.K.'s primary provider of telephone and broadband services, through its retail and wholesale arms. However, BT is not content with this, and is seeking to gain access to the potentially lucrative triple-play market: telephone, television and Internet.

To do this, BT has revamped and expanded its little-known BT Vision television service, spending 890 million pounds over the last year to acquire football and rugby broadcasting rights that it hopes will be enough to attract customers who would formerly have remained loyal to British Sky Broadcasting's Sky service, which is home to much of the U.K.'s live sport.

If this strategy succeeds, it could drive significant growth for the company -- but if not, it will place pressure on BT's dividends, add to its interest payments and dampen the effects of growth elsewhere in the business. BT did recently expand in a different direction by acquiring Tikit -- a provider of IT solutions to legal firms -- but Tikit's pre-tax profits were just 2.4 million pounds in the first half of 2012 -- small beer compared to the money being spent on BT Vision.

Does BT 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 BT's cash flow from the last five years:

Year 2008 2009 2010 2011 2012
Free cash flow (in millions of pounds) 980 796 1,094 1,410 -183
Dividend payments (in millions of pounds) 1,236 1,221 265 543 590
Free cash flow/dividend* 0.8 0.7 4.1 2.6 -0.3

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

Although these figures don't look too bad when averaged across a five-year period, it is worth noting that for the last three years, BT's interest payments have been greater than its dividend payments. In effect, shareholders have slipped into second place behind the company's lenders, who were collectively owed 10.9 billion pounds at the end of September 2012. There's also BT's 4 billion pound pension deficit to consider -- this is a company with a lot of calls on its spare cash.

Is BT's dividend safe?
Although you might expect BT to be one of the safest income shares in the FTSE 100, it isn't! In fact, BT's dividend history is somewhat erratic, and the last 20 years have seen a mixture of big hikes, big cuts and even one year -- 2001 -- when no dividend was paid at all. BT cut its dividend by nearly 60% in 2008 and last year's dividend payout of 8.3p per share was just over half the 2008 payout of 15.8p.

BT shares do currently offer a forward yield of 3.8%, which is above the FTSE 100 average of 3.3%, but when BT announced in May 2012 that it would increase its dividend by 10%-15% per year for the next three years, it got a lukewarm response. Investors were hoping for something closer to 20% per year, in order to make up lost ground.

Overall, I think that BT's dividend is pretty safe at current levels, and I expect that it will deliver on its promise of substantial increases over the next few years. However, I believe that BT's dividend will remain under pressure from debt and pension obligations, and should the company's BT Vision experiment fail, further dividend disappointment could be in store for the company's long-suffering shareholders.

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 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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