Are Dividends Built To Last At ARM Holdings plc, BAE Systems plc And WM Morrison Supermarkets PLC?

Some dividends have staying power. Companies delivering enduring dividends tend to back such often-rising payouts with robust financial achievement. Fragile dividends, meanwhile, arise because of weaker operational and financial characteristics. Avoid them, even though they often tempt with high yields.

Telling the difference

Under the spotlight today, three FTSE 100 firms: chip designer ARM Holdings (LSE: ARM), weapons and aviation company BAE Systems (LSE: BA) and retailer WM Morrison Supermarkets (LSE: MRW).

They operate in different sectors, but all pay a dividend. At the recent share price of 931p, ARM Holdings’ forward yield for 2016 is 1.1%. At 473p, BAE Systems’ is 4.5%.  At 172p, WM Morrison’s is 3.2%.

Here are some tests gauging business and financial quality, scoring each out of a maximum five.

1. Dividend record

Each has maintained at least some dividends.

ARM’s dividend grew 138% over the period shown. BAE rose 11%, but Morrison’s dividend slipped 52%. I’m scoring ARM 5/5, BAE 3/5 and Morrison 1/5.

2. Dividend cover

ARM expects adjusted earnings for 2016 to cover its dividend around 3.4 times. BAE expects earnings to cover the  firm’s dividend payout 1.8 times, and Morrison to cover its dividend two times.

I like earnings to cover the dividend payout at least twice in my dividend investments, but cash pays dividends, so it’s worth digging into how well companies cover their dividend payouts with free cash flow too. 

On dividend cover from earnings though,  ARM gets 5/5, BAE 3/5, and Morrison 4/5.

3. Cash flow

Dividend cover from earnings means little if cash flow doesn’t support profits.

Here are the companies’ recent records on operational cash flow compared to profits:

ARM displays the most robust cash flow, comfortably exceeding operating profits every year. Morrison’s cash flow is also steady, but BAE’s seems volatile.

I’m scoring ARM 5/5, BAE 2/5, and Morrison 4/5 for this.

4. Debt

Interest payments on borrowed money compete with dividend payments for incoming cash flow, making big debts undesirable in dividend-led investments.

ARM has zero borrowings and a large pile of free cash. BAE’s borrowing is around 2.75 times the level of annual operating profit. Morrison is the most indebted with borrowings at almost seven times anticipated earnings for 2015.

I’m giving ARM 5/5, BAE 3/5, and Morrison 0/5 for their approaches to borrowing.

5. Degree of cyclicality

Recent share price weakness of London-listed banks and commodity firms teaches me not to become complacent about cyclicality. 

Of these three firms, perhaps BAE has the most cyclicality inherent in its business model. However, Morrison is facing a structural challenge to its industry led by low-price competition. Traditionally though, supermarkets were prized by investors for defensive qualities and lack of cyclicality. Indeed, Morrison’s cash flow performance remains strong despite its recent problems.

ARM’s position in consumer electronics must have a cyclical element to it, but the firm is locked into some of the most powerful and enduring trends of our time.

I’m scoring ARM 4/5, BAE 3/5, and Morrison 4/5 for cyclicality.

Putting it all together

Here are the final scores:

ARM wins with ease, and is one of the highest-scoring firms I’ve encountered. However, its dividend yield is low, albeit well-covered. BAE and Morrison achieve low-looking scores by these measures. So my search for a dividend champion continues…