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How Does AA plc (LON:AA.) Fare As A Dividend Stock?

Simply Wall St

Is AA plc (LON:AA.) a good dividend stock? How would you know? Dividend paying companies with growing earnings can be highly rewarding in the long term. If you are hoping to live on the income from dividends, it's important to be a lot more stringent with your investments than the average punter.

With a goodly-sized dividend yield despite a relatively short payment history, investors might be wondering if AA is a new dividend aristocrat in the making. It sure looks interesting on these metrics - but there's always more to the story . Remember though, given the recent drop in its share price, AA's yield will look higher, even though the market may now be expecting a decline in its long-term prospects. Some simple analysis can reduce the risk of holding AA for its dividend, and we'll focus on the most important aspects below.

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LSE:AA. Historical Dividend Yield, May 25th 2019

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Payout ratios

Companies (usually) pay dividends out of their earnings. If a company is paying more than it earns, the dividend might have to be cut. Comparing dividend payments to a company's net profit after tax is a simple way of reality-checking whether a dividend is sustainable. In the last year, AA paid out 29% of its profit as dividends. This is medium payout level that leaves enough capital in the business to fund opportunities that might arise, while also rewarding shareholders. Plus, there is room to increase the payout ratio over time.

We also measure dividends paid against a company's levered free cash flow, to see if enough cash was generated to cover the dividend. AA's cash payout ratio last year was 6.8%, which is quite low and suggests that the dividend was thoroughly covered by cash flow. It's positive to see that AA's dividend is covered by both profits and cash flow, since this is generally a sign that the dividend is sustainable, and a lower payout ratio usually suggests a greater margin of safety before the dividend gets cut.

Is AA's Balance Sheet Risky?

As AA has a meaningful amount of debt, we need to check its balance sheet to see if the company might have debt risks. A quick way to check a company's financial situation uses these two ratios: net debt divided by EBITDA (earnings before interest, tax, depreciation and amortisation), and net interest cover. Net debt to EBITDA is a measure of a company's total debt. Net interest cover measures the ability to meet interest payments on debt. Essentially we check that a) a company does not have too much debt, and b) that it can afford to pay the interest. AA has net debt of greater than 10x its earnings before interest, tax, depreciation and amortisation (EBITDA), which we think carries substantial risk if earnings aren't sustainable.

We calculated its interest cover by measuring its earnings before interest and tax (EBIT), and dividing this by the company's net interest expense. With EBIT of 1.47 times its interest expense, AA's interest cover is starting to look a bit thin. High debt and weak interest cover are not a great combo, and we would be cautious of relying on this company's dividend while these metrics persist.

We update our data on AA every 24 hours, so you can always get our latest analysis of its financial health, here.

Dividend Volatility

Before buying a stock for its income, we want to see if the dividends have been stable in the past, and if the company has a track record of maintaining its dividend. Looking at the data, we can see that AA has been paying a dividend for the past four years. This company's dividend has been unstable, and with a relatively short history, we think it's a little soon to draw strong conclusions about its long term dividend potential. During the past four-year period, the first annual payment was UK£0.09 in 2015, compared to UK£0.02 last year. The dividend has fallen 78% over that period.


Dividend Growth Potential

With a relatively unstable dividend, and a poor history of shrinking dividends, it's even more important to see if EPS are growing. In the last five years, AA's earnings per share have shrunk at approximately 27% per annum. Declining earnings per share over a number of years is not a great sign for the dividend investor. Without some improvement, this does not bode well for the long term value of a company's dividend.

Conclusion

When we look at a dividend stock, we need to form a judgement on whether the dividend will grow, if the company is able to maintain it in a wide range of economic circumstances, and if the dividend payout is sustainable. It's great to see that AA is paying out a low percentage of its earnings and cash flow. Second, earnings per share have been in decline, and its dividend has been cut at least once in the past. Ultimately, AA comes up short on our dividend analysis. It's not that we think it is a bad company - just that there are likely more appealing dividend prospects out there on this analysis.

Without at least some growth in earnings per share over time, the dividend will eventually come under pressure either from costs or inflation. Very few businesses see earnings consistently shrink year after year in perpetuity though, and so it might be worth seeing what the 5 analysts we track are forecasting for the future.

We have also put together a list of global stocks with a market capitalisation above $1bn and yielding more 3%.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.