LONDON -- Many investors focus on earnings per share when judging a company's performance. However, earnings can be manipulated and adjusted in all sorts of ways, meaning they don't tell you a lot about how much spare cash a company has generated. Similarly, since dividend cover is calculated using earnings, a good level of dividend cover doesn't necessarily mean the payout is actually being funded from a company's profits.

A company's cash flow can tell you a lot about a firm's financial health. Is the company burning up its cash reserves on interest payments and operating expenses, or does it generate spare cash that can fund dividends or be retained for future investment? If a dividend isn't funded by cash flow, then there is a greater chance the payout will become unaffordable and be cut, which is bad news for shareholders like you and me.

In this series, I'm going to look at the cash flow statements of some of the biggest names in the FTSE 100 (UKX), to see whether their dividends are being funded in a sustainable way, from genuine spare cash. Today, I'm looking at the U.K.'s second-largest pharmaceutical company, AstraZeneca .


The story so far
Recent years have seen AstraZeneca offering investors a high dividend yield but lackluster share-price performance -- the company's share price has risen by just 4% over the past three years. Underlying this dull performance has been the patent cliff -- a looming drop-off in earnings caused by the expiry of key patents on some of AstraZeneca's drugs, enabling other companies to make them as cheap generics.

The main problem is that companies like AstraZeneca should have a pipeline of new drugs to replace those on which patents are expiring, but in reality this hasn't happened, leaving investors anxious about a shortfall in future earnings. As a result, former CEO David Brennan quit last year, to be replaced by Pascal Soriot, the former chief operating officer of Swiss pharmaceutical firm Roche. Soriot's first public action was to cancel the multibillion-dollar program of share buybacks that have absorbed much of Astra's cash in recent years in an effort to prop up its share price.

The move suggested that Soriot is serious about making acquisitions to fill the void in AstraZeneca's drug pipeline. He's in a strong position to do so, too -- at the end of last June, AstraZeneca had $7.5 billion in cash and cash equivalents on its balance sheet, so the company should be able to make some substantial deals without having to raise or borrow too much new money.

Does AstraZeneca have enough cash?
As private investors, we want to back businesses that are able to pay their dividends out of free cash flow each year. I define free cash flow as the cash that's left over after capital expenditures, interest payments, and tax deductions. With that in mind, let's look at AstraZeneca's cash flow from the past five years:

Metric

2008

2009

2010

2011

H1 2012

Free cash flow ($ millions)

4,846

9,263

8,454

5,799

1,438

Dividend payments ($ millions)

2,739

2,977

3,361

3,764

2,505

Free cash flow/dividend*

1.8

3.1

2.5

1.5

0.6

Source: AstraZeneca company reports.
*A value of >1 means the dividend was covered by free cash flow.

AstraZeneca may not have invested sufficiently in new drugs, but its existing products have been something of a cash cow in recent years. The company has had ample free cash flow to cover its generous dividends (the current yield is around 5.7%), and liquidity has definitely not been a problem.

A new broom sweeps clean
Earlier this week, AstraZeneca announced a reorganization that saw both the head of research and development and the company's commercial head lose their jobs. Soriot has reorganized the company's R&D and commercial functions and introduced a new strategy role intended to bridge the gap between R&D and sales. According to Soriot, these changes will "bring an even sharper management focus to key pipeline assets, key brands, and key markets, and helps us further accelerate decision-making."

Investors will be hoping he's right and will be looking forward to the next stage of his makeover, which is widely expected to include the acquisition of one or more companies with attractive new drugs that will be ready for marketing in the next couple of years. It's this element that poses the only imminent threat to AstraZeneca's dividend -- should Soriot decide to make a really ambitious acquisition, the company might need to load up on debt, stretching its existing cash flow to the point where the dividend looks overly generous.

Is AstraZeneca's dividend safe?
Overall, I don't expect AstraZeneca to be pushed into cutting its dividend, and I think the existing payout is likely to remain safe. However, I think dividend increases are likely to be very modest indeed over the next couple of years, as the firm diverts most of its cash into acquisitions and new R&D programs.

Top income tips
One man who really understands how to assess the quality of a company's dividends is legendary City fund manager Neil Woodford, whose High Income fund grew by 342% over the 15 years to last October, during which time the FTSE All-Share index managed a gain of only 125%.

Woodford selects stocks that he believes are undervalued and likely to deliver strong dividend growth. His record is one of the best in the City, and at the end of October, he had 21 billion pounds of private investors' funds under management -- more than any other City fund manager.

You can learn about eight of Woodford's largest holdings and how he generates such fantastic returns in this exclusive Motley Fool report. It's completely free, but it's available for a limited time only. I strongly suggest you click here and download the report today to avoid missing out.

The article Where Next for AstraZeneca's Dividend? originally appeared on Fool.com.

Roland Head and The Motley Fool have no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright © 1995 - 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.


Increase your money and finance knowledge from home

Investment Strategies

What's your investing game plan?

View Course »

Basics of Diversification

Learn one of the fundamental concepts of building a portfolio.

View Course »

Add a Comment

*0 / 3000 Character Maximum