Many investors rely on dividends to bulk up their income or accelerate returns from their portfolio. However, choosing dividends you can trust for the long term is tough.
Indeed, some dividend companies that look steady on the outside are often hiding brewing problems. I believe BT (LSE: BT.A) and Marks and Spencer (LSE: MKS) are two such companies.
Falling out of fashion
Marks and Spencer is one of the most widely held public companies in the UK. Tens of thousands of investors rely on Marks’ shares to provide them with an income boost every few months, and the company’s management is well aware of this.
Still, while management has been increasing the company’s dividend payout to shareholders every year, earnings have been falling. Dividend cover is set to drop to 1.4 times next year from 2.1 times for 2012.
Unfortunately for dividend investors, this trend looks set to continue. The company has been struggling to turn around its legacy clothing business for years to no avail and market trends now look set to accelerate the decline of the business. According to researcher Kantar Worldpanel, data for the year to September 25 showed that the UK fashion industry has seen four consecutive months of decline. The fashion market is now £700m smaller than it was this time last year.
For a company such as Marks that has been struggling to compete against online and low-cost peers for many years, the rapidly shrinking UK fashion market could become a huge problem and is likely to weigh on the company’s sales growth.
If the company’s earnings continue to fall, and management continues to increase the company’s dividend payout faster than earnings, the Marks dividend is on a collision course.
Pension problems
BT’s growing pension deficit is probably the biggest issue facing the company today. At the end of May City analysts calculated that pension deficit had hit £10bn, which is an enormous sum — more than three times the company’s pre-tax profit for fiscal 2016.
And the pension black hole is only going to become more troublesome for BT going forward. Indeed, according to analysts at Australian bank Macquarie, to be able to fill its pension shortfall BT will have to increase its pension payments by £1bn a year until 2030. There’s no other way of putting it, this is a huge commitment.
Last year BT generated £5.2bn cash from its operations. Of this total, the company spent £5.1bn on developing its network leaving almost nothing for dividends and debt repayment. For the past five years, BT’s capital spending has consumed an average of 78% per annum of cash from operations, leaving little room for manoeuvre. Borrowing has filled the company’s spending gap.
But not only is BT facing a larger pension bill, the company is also facing huge new tax demands from the government. A proposed fourfold rise in business rates could see BT’s annual bill rise from £158m to £715m over five years, putting still further pressure on the company’s cash flows.
Overall, BT’s dividend payout no longer looks as safe as it once was.