Some thoughts on GlaxoSmithKline’s 5.3% dividend

GlaxoSmithKline Pfizer dividend cut

GlaxoSmithKline’s (LON: GSK) (GSK.L) share price has endured a rough few months. Trading above 1,700p in late June, the shares now change hands for around 1,515p. That share price decline has pushed Glaxo’s dividend yield up to an attractive 5.3%. But is the dividend safe? Will the payout grow going forward? Here are some of my thoughts.

I can see both a bull case and a bear case for GlaxoSmithKline as a dividend stock. I hold the stock in my personal dividend portfolio right now, but I’m far from convinced about the company’s dividend prospects.

Frozen payout

For a start, Glaxo has paid the same dividend payout of 80p for three years now. That’s not good. Tesco did the same thing between 2012-2014, before slashing its payout in 2015. A frozen payout is also a negative for investors who rely on dividends for income, as with inflation running at 2%-3% per year, the purchasing power of the dividend diminishes over time.

New dividend policy

In its July half-year report, Glaxo made several references to the dividend. The company stated:

GSK recognises the importance of dividends to shareholders and aims to distribute regular dividend payments that will be determined primarily with reference to the free cash flow generated by the business after funding the investment necessary to support the Group’s future growth.

The Board intends to maintain the dividend for 2018 at the current level of 80p per share, subject to any material change in the external environment or performance expectations. Over time, as free cash flow strengthens, it intends to build free cash flow cover of the annual dividend to a target range of 1.25-1.50x, before returning the dividend to growth.

I like the wording “recognises the importance of dividends to shareholders.” That’s what a dividend investor wants to hear. However, that statement also suggests that we won’t see dividend growth any time soon.

Free cash flow coverage

Looking at free cash flow over the last three years, the picture doesn’t look great.

2014 2015 2016
Free Cash Flow (m) 3,322 265 3,320
Dividends Paid (m) 3,869 3,871 3,892
Free Cash Flow to Dividends 0.86 0.07 0.85

 

We can see that the free cash flow to dividends ratio is quite a long way off the target ratio of 1.25-1.50.

The most recent half-year didn’t see any improvement, with the company generating free cash flow of £368m, vs half-year dividends of £1,857m.

Dividend coverage

Turning to dividend coverage, the table below shows that dividend coverage has been thin in recent years. City analysts do expect coverage to improve a little this year, however.

2014 2015 2016 2017E
Core Earnings Per Share 95.4 75.7 102.4 110.8
Dividends Paid Per Share 80.0 80.0 80.0 80.0
Dividend Coverage Ratio 1.19 0.95 1.28 1.39

 

Putting this all together, my conclusion is that GlaxoSmithKline is far from the perfect dividend stock. Dividend coverage has been thin over the last three years, and free cash flow will have to increase significantly before shareholders see any dividend growth.

Having said that, the company looks to be a more balanced business after the 2015 asset swap with Novartis, and City analysts expect revenue to rise by a healthy 8.3% this year. With the world’s ageing population likely to boost demand for healthcare in coming years, healthcare stocks should benefit. With that in mind, I’m going to hold on to my GlaxoSmithKline shares for now, but I’ll certainly be keeping a close eye on the company’s free cash flow and dividend coverage going forward.

Disclosure: Edward Sheldon, CFA owns shares in GlaxoSmithKline. 

This article is provided for general information only and is not intended to be investment advice. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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