Are Dividends Built To Last At HSBC Holdings plc And National Grid plc?

Some dividends have staying power. Companies delivering enduring dividends tend to back such often-rising payouts with robust business and financial achievement.

Fragile dividends, meanwhile, arise because of weaker operational and financial characteristics. Those are the dividends to avoid. However, fragile dividends often tempt us because of high dividend yields.

How to tell the difference

Under the spotlight today, two FTSE 100 firms: HSBC Holdings (LSE: HSBA) the international bank and National Grid (LSE: NG) the gas and electricity transmission system operator.

These firms operate in different sectors, but they both have a high dividend yield. At the recent share price of 605p, HSBC Holdings forward yield for 2015 is 5.9%. At 878p, National Grids is 5%.

Lets run some tests to gauge business and financial quality, and score performance in each test out of a maximum five.

1. Dividend record

Both firms enjoy a decent dividend record:

Over four years HSBC Holdings dividend advanced 39%, delivering a compound annual growth rate of 8.6%. National Grids moved forward by 9%, scoring a modest growth rate of 2.2%.

For their dividend records, Im scoring HSBC Holdings and National Grid both 2/5

2. Dividend cover

HSBC Holdings expects its 2015 adjusted earnings to cover its dividend around 1.7 times. National Grid expects cover from earnings of about 1.3 times. My ideal dividend payer would cover its cash distribution with earnings at least twice.

Of course, cash pays dividends, so its worth digging deeper into how well, or poorly, both companies cover their dividend payouts with free cash flow thats cash flow after maintenance capital expenditure.

On dividend cover from earnings, though, HSBC Holdings scores 3/5 and National Grid 2/5.

3. Cash flow

Dividend cover from earnings means little if cash flow doesnt support profits.

Here are the firms recent records on cash flow compared to profits:

As we might expect, National Grids toll-bridge style regulated monopoly distribution business delivers rock-solid cash flow that supports profits like granite.

Then we have HSBC Holdings. Cash flow at banks is a less useful indicator of business health than that at other types of business. Banks cash flow tends to be noisy, as we see here. Accounting quirks such as how the banks classify their loans and investments, for example can bolster or lower a cash-flow number artificially. It all adds to the opaque, black-box feel that surrounds banks, rendering them almost uninvestable, in my view.

Im scoring HSBC Holdings a benefit-of-the-doubt 3/5 for its cash-flow record and National Grid 5/5.

4. Debt

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

Most banks carry big external debts and HSBC Holdings balance sheet entry for debt securities exceeds four times the level of its operating profit last year. However, bank debts come in many forms, so thats not HSBC Holdings only exposure.

National Grid is also a big user of borrowed money, with debts running in excess of five times the level of operating profit.

Arguably, utilities and banks run particular types of business that require, and can justify, high debt loads. That said, they would make more secure investments with lower levels of borrowed money. Im awarding both HSBC Holdings and National Grid 2/5.

5. Degree of cyclicality

We saw in the financial crisis of last decade how cyclical the banks are. Fluctuating share prices and valuations are the order of the day with banks such as HSBC Holdings, as macro-economic gyrations keep cash flows, profits and asset valuations bouncing around.

National Grid is far less cyclical. Domestically, we keep using gas and electricity no matter what the economic weather throws at us, although industrial and commercial demand can wane during recessionary periods.

HSBC Holdings scores 1/5 and National Grid 4/5

Putting it all together

Here are the final scores for these firms:

National Grid wins this face-off, but neither firm is perfect by these measures, so my search for a dividend champion continues.