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Not All Dividends are Created Equal

Dividends are a great source of return for investors – just ask Warren Buffett, Chairman of Berkshire Hathaway (NYSE: BRK-A).

In 2011 Berkshire received US$376m in dividends from Coca-Cola (NYSE: KO) from its US$1.3b investment in the fizzy drinks maker dating back to 1995. That’s a whopping 29% dividend yield on Berkshire’s investment.

Just like the soft drink, those dividend returns are sweet, but not easy to achieve if you don’t look in the right places. Berkshire’s fantastic dividend returns from Coke come from a long holding period – 18 years and counting – and an investment made in a capital un-intensive business that has generated increasing free cash flow (FCF) slowly but steadily.

Thing is, the financial media tends to focus on the Income Statement and, perhaps, not enough on the Cash Flow Statement, which records the actual cash brought in and paid out by a business.

Meanwhile, the Dividend Payout Ratio (dividends per share divided by earnings per share) is often used to gauge whether a company’s dividend payout is sustainable. However, the safest and most reliable dividends generally come from companies that generate gobs of free cash flow.

The simplest form of Free Cash Flow is given by the formula:

Free Cash Flow = Operating Cash Flow – Capital Expenditures

So, FCF is the cash leftover after a company has reinvested the cash generated from its normal business operations to sustain its competitive position. Any cash that is left can then be used to do a number of things that include: growing the business, buying back shares, improving the balance sheet and paying out dividends.

Let’s take a look at a company that has a patchy dividend record. Pacific Andes (SGX: P11) is a global frozen-fish supplier whose dividends have been erratic even though net income has been relatively steady.

So why has the payout been uneven?

The table below shows how its Net Income, Operating Cash Flow, Free Cash Flow and Dividends have changed over the last seven years. Note how FCF has been negative in six of the seven years.

Without the ability to generate excess cash, Pacific Andes has to borrow to grow, to maintain the business and to pay dividends. Currently, Pacific Andes is carrying HK$9.9b in debt and has HK$340m in cash.

Pacific Andes

2006

2007

2008

2009

2010

2011

2012

Net Income ($HKm)

559

946

825

1,317

1,101

964

887

Operating Cash Flow  ($HKm)

(545)

436

105

917

657

(877)

(1,047)

Free Cash Flow ($HKm)

(630)

338

(571)

(236)

(596)

(2,044)

(1,727)

Cash Dividends Paid ($HKm)

50

103

37

55

13

73

212

**Note: There was a change in the Financial Year 2009, so the results for 2009 consisted for 18 months instead of the usual 1 year of operations.

Compare Pacific Andes with Kingsmen Creatives (SGX: 5MZ), a leading player in Asia’s Meetings, Incentives, Conventions and Exhibitions (MICE) industry.

The table shows how Kingsmen’s FCF has roughly tracked its Net Income. What’s more dividends can be comfortably paid from its FCF without having to take on debt to grow the business. It has S$48m in cash and S$4.6 million of debt.

In fact, dividends have been growing steadily along with improving Net Income and FCF. Interestingly, the dip in FCF in 2009 did not diminish Kingsmen’s ability to reward shareholders thanks to its cash hoard built up over previous years.

Kingsmen Creatives

2006

2007

2008

2009

2010

2011

2012

Net Income ($Sm)

4.9

9.4

14.2

14.9

15.1

16.3

16.7

Operating Cash Flow ($Sm)

9.0

12.7

25.7

1.3

20.3

12.8

26.7

Free Cash Flow ($Sm)

7.8

11.9

14.5

0.02

14.1

10.0

24.5

Cash Dividends Paid  ($Sm)

1.0

2.4

6.6

5.6

6.6

7.6

7.6

**Note that results for 2012 are actually Trailing Twelve Month figures for 3Q 2012

A good dividend yield is always welcome but as Foolish investors we should be mindful of how dividends are funded because not all dividends are created equally.

Motley Fool’s purpose is to help the world invest, better. Click here now for your FREE subscription to Take Stock Singapore, The Motley Fool’s free investing newsletter. Written by David Kuo, Take Stock Singapore tells you exactly what’s happening in today’s markets, and shows how you can GROW your wealth in the years ahead. 

 

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.  Motley Fool Singapore Contributor Chong Ser Jing owns shares in Berkshire Hathaway and Kingsmen Creatives.