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Where Next for HSBC's Dividend?

Roland Head
December 7, 2012

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 (UKX) to see whether their dividends are being funded in a sustainable way, from genuine spare cash. Today, I'm looking at HSBC Holdings (LSE: HSBA) (NYSE: HBC).

Profits vs. the Law
HSBC's global banking business is in good health. Its large presence in Asia has helped to protect it from the U.S. and European recessions, and pre-tax profits are expected to be around 13.5 billion pounds this year, with a 5.5% dividend increase to keep shareholders happy.

Despite this, the U.K.'s biggest listed bank hasn't escaped the scandals that have tarnished the reputations of its U.K. peers. HSBC is under investigation for its involvement in the LIBOR-rigging scandal, and it also set aside $353m in the third quarter to address Payment Protection Insurance claims -- although this is a trivial amount for the bank, and much less than RBS and Lloyds have paid out. HSBC's biggest problem is in the U.S., where it faces possible criminal charges relating to laundering Mexican drug money. News reports this week suggest that HSBC will manage to settle these claims by paying a $1.8 billion fine and promising to fix its internal compliance problems. If this turns out to be true, then it will be a good outcome -- HSBC can afford it, and it could have been much worse.

HSBC's current 4% dividend yield is the highest of any U.K. bank, making it attractive to dividend investors seeking a diversified income. Let's take a closer look.

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

Year 2007 2008 2009 2010 2011
Free cash flow ($m) 70,760 5,327 -50,179 20,769 69,831
Dividend payments ($m) 6,721 8,017 5,235 4,449 6,155
Free cash flow/dividend* 10.5