Dividend Report Card: UPS

All dividends are not created equal.

We learned this lesson the hard way in recent years. In the first quarter of 2009, a record 367 firms cut their dividend payouts only to be followed by another 250 in the next quarter. Because dividends are paid at the board of directors' discretion, when times get tough, a firm's dividend payout can meet the corporate chopping block.

Avoiding the executioner
Certainly things have gotten better since those dark days, but with many concerns remaining about the global economy, investors would be wise to ask the following three questions of their companies' dividends:

1. Over time, has this company steadily increased its payouts?
2. How sustainable is the dividend?
3. Does the company have room to further increase the dividend?

To help you out, I've created a proprietary dividend report card, which seeks to answer these questions by analyzing a company's financial statements. It's not intended to be a Magic Eight-Ball, but it will hopefully get you pointed in the right direction.

Today's pupil is United Parcel Service (NYSE: UPS).

Dividend history
Income-minded investors prefer a good track record of rising dividend payouts. Not only is it a sign that management is dedicated to returning shareholder value, but also that the board of directors expects future profitability.

Let's see how well UPS has increased its dividend over the past five years, relative to its earnings growth:

Data provided by Capital IQ, as of July 20, 2010.

You've got to credit UPS for raising its dividend despite declining earnings, but you'd prefer both of those figures to be positive. Given the cyclicality of UPS's business, a little lumpiness is to be expected, but revenues were actually up over the same period. In other words, UPS hasn't been able to maintain the same profit margins it did in 2005 -- that's something to keep an eye on going forward.

Past returns don't guarantee future results, however, so dividend history is only 10% of the final grade. That said, for this category, UPS scores a 4 out of 5.

Sustainability
Finding companies with solid financial footing, backed by a strong balance sheet, sufficient profitability, and plenty of free cash flow is at the root of successful dividend investing. There's no point buying a stock yielding 5% if you don't believe the dividend is sustainable. For this reason, sustainability gets a 50% weighting in my formula.

To analyze dividend sustainability, I look at three factors:

1. Interest coverage ratio (EBIT / interest expense)
2. Earnings dividend payout ratio (dividend per share / earnings per share)
3. Free cash flow dividend payout ratio (dividends paid / free cash flow to equity)

It's worth noting that in my definition of free cash flow to equity, I also back out any acquisitions the company's made over the past 12 months. Hey, that's cash that could have been paid out as a dividend! Plus, serial acquirers may reduce a dividend to help fund a new acquisition, so we want to be sure there's still plenty of cash to go around after all investments have been made.

For UPS, the results are:

Data provided by Capital IQ, as of July 20, 2010.
NM = Not meaningful.

These are all encouraging signs that the current dividend level is sustainable, and the free cash flow payout ratio has been trending down in recent years, as well. At the same time, though, the interest coverage ratio has decreased, which is not such a good sign.

UPS has taken on a lot more debt since 2005: Its long-term debt to equity ratio has increased from 19.6% in March 2005 to 113.4% in March 2010. None of this is to say that UPS can't pay its bills -- it most certainly can -- but because creditors must be paid before equity holders, dividend investors will want to see this trend begin to reverse.

Growth
Once you know that a dividend is sustainable, you'll want to see how much room the company has to raise its payout. It may not be quite as important as dividend sustainability, but it's still an essential factor for income-minded investors who want their payouts to increase at rates well above inflation.

For this reason, growth makes up the last 40% of the final grade.

In this section, I once again use the earnings and free cash flow payout ratios. Only this time I'm not just looking to see if there's more than enough profit and cash to sustain the dividend; I want to see how much the payout can grow, so the lower the payout ratios, the better.

I also consider a firm's implied sustainable growth rate, defined as return on equity times its retention ratio (the percentage of profits it keeps to reinvest in the business). This is the highest achievable growth rate the company can have without changing its capital structure.

Here's how UPS scored on these metrics:

This is where UPS gets dinged for increasing its dividend at a high rate while earnings declined. The earnings payout ratio on a trailing twelve month basis, for example, was 37.3% in March 2005 and it's doubled since then. Unless UPS can resume growing earnings at a faster pace than dividends, the payout ratio will remain high. Based on this data, and without resurgence in earnings growth, it appears UPS may struggle to raise its dividend at a 9%-plus clip again over the next five years.

Bonus factor
An "ungraded" section of the dividend report card is to see how a stock's current yield stacks up against direct competitors'. If it's too high relative to competitors' yields, the board could be tempted to slow the growth rate, or vice versa, to bring it more in line with the industry average.

Dividends in the air freight and logistics industry, with the exception of UPS's 3.2% yield, are quite low, though CH Robinson and Expeditors have grown their dividends at 25%-plus annualized rates since 2005. Unlike UPS, FedEx pays out very little of its earnings as dividends (around 12%), so it can keep more to reinvest in the business. As a result, UPS may have less incentive to boost its dividend at high rates.

Pencils down!
With all the numbers in, here's how UPS's dividend scored:

UPS's dividend seems to be sustainable and to have modest room for growth. However, given recent trends of rising payout ratios and debt levels, I would keep UPS's dividend on "watch" in the next few quarters until it begins to reverse them.