Following the release of GlaxoSmithKline's (LSE: GSK) third-quarter figures last week, shares in the company have crumbled due to rising concerns about the company's dividend payout.
This isn't the first time the company has faced such concerns. Several years ago the shares took a beating as the City proclaimed that falling earnings per share, a result of patent expirations, would force the company to slash its shareholder distribution.
This cut never materialised. Instead, management promised to hold the payout at 80p per share until at least 2018.
Unfortunately, it's now looking increasingly likely that the firm will slash its payout next year.
Turning the business around
Over the past few years, Glaxo's business has been through a rough patch. Luckily, the firm has been able to recover from its problems, and thanks to new treatments, as well as weak sterling, earnings have ticked higher. After earnings per share hit a low of 75p in 2015, this year the company is on track to earn 110p.
EPS of 110p easily cover the 80p per share dividend payout. However, on a cash basis, the payout looks vulnerable. Indeed, for the first nine months of this year, the company produced just over £4bn in cash from operations and spent £1.5bn on capex, giving a free cash flow of £2.5bn before dividends. Dividends for the period amounted to £3bn leaving a gap of £500m.
Going forward, the cash squeeze might get even tighter if the company chooses to pursue growth. Glaxo is eyeing potential acquisitions from Pfizer in the US and Merck in Germany to boost its consumer division. The Pfizer business is estimated to be worth $14bn.
Meanwhile, the firm is apparently preparing to buy out the 36.5% stake in its joint venture with Novartis for $10.3bn. These are some sizable figures, and Glaxo's balance sheet can't take on much more debt to fund acquisitions. So, it's entirely reasonable to assume that the firm could cut its dividend by 50% or more to save a few billion a year and fund expansion.
This is a delicate trade-off. On the one hand, a dividend cut will help reignite earnings growth. On the other hand, a reduction will make the stock less appealing to dividend hunters who are currently attracted to the near 6% dividend yield.
To cut or not to cut
In my view, Glaxo will reduce its dividend yield. Maintaining the payout at 80p per share has really taken its toll on the business as net debt has risen from £9bn to £14bn over the past six years. Shareholder equity (total assets minus total liabilities) has collapsed from £8bn to £1.1bn over the same period. If this trend continues, and growth remains sluggish, sooner or later the company will have to make some tough decisions.
I believe management should act before it is pushed. A 50% cut would reduce the payout to 40p per share, that's still a yield of around 3% at current prices, which is only just below the market average. Yet it may be too low for some investors.
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Rupert Hargreaves owns shares in GlaxoSmithKline. The Motley Fool UK owns shares of and has recommended GlaxoSmithKline. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.