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Does Metcash Limited (ASX:MTS) Have A Place In Your Dividend Portfolio?

Simply Wall St

Dividend paying stocks like Metcash Limited (ASX:MTS) tend to be popular with investors, and for good reason - some research suggests a significant amount of all stock market returns come from reinvested dividends. Yet sometimes, investors buy a popular dividend stock because of its yield, and then lose money if the company's dividend doesn't live up to expectations.

In this case, Metcash likely looks attractive to investors, given its 5.1% dividend yield and a payment history of over ten years. It would not be a surprise to discover that many investors buy it for the dividends. Some simple research can reduce the risk of buying Metcash for its dividend - read on to learn more.

Click the interactive chart for our full dividend analysis

ASX:MTS Historical Dividend Yield, March 11th 2020

Payout ratios

Dividends are typically paid from company earnings. If a company pays more in dividends than it earned, then the dividend might become unsustainable - hardly an ideal situation. As a result, we should always investigate whether a company can afford its dividend, measured as a percentage of a company's net income after tax. Although it reported a loss over the past 12 months, Metcash currently pays a dividend. When a company recently reported a loss, we should investigate if its cash flows covered the dividend.

The company paid out 80% of its free cash flow as dividends last year, which is adequate, but reduces the wriggle room in the event of a downturn.

Is Metcash's Balance Sheet Risky?

Given Metcash is paying a dividend but reported a loss over the past year, we need to check its balance sheet for signs of financial distress. A quick check of its financial situation can be done with 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. Essentially we check that a) the company does not have too much debt, and b) that it can afford to pay the interest. Metcash has net debt of 0.24 times its EBITDA, which we think is not too troublesome.

Net interest cover can be calculated by dividing earnings before interest and tax (EBIT) by the company's net interest expense. With EBIT of 12.20 times its interest expense, Metcash's interest cover is quite strong - more than enough to cover the interest expense.

Consider getting our latest analysis on Metcash's financial position 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. For the purpose of this article, we only scrutinise the last decade of Metcash's dividend payments. Its dividend payments have declined on at least one occasion over the past ten years. During the past ten-year period, the first annual payment was AU$0.24 in 2010, compared to AU$0.13 last year. The dividend has shrunk at around 5.9% a year during that period. Metcash's dividend has been cut sharply at least once, so it hasn't fallen by 5.9% every year, but this is a decent approximation of the long term change.

When a company's per-share dividend falls we question if this reflects poorly on either external business conditions, or the company's capital allocation decisions. Either way, we find it hard to get excited about a company with a declining dividend.

Dividend Growth Potential

Given that dividend payments have been shrinking like a glacier in a warming world, we need to check if there are some bright spots on the horizon. It's good to see Metcash has been growing its earnings per share at 20% a year over the past five years. A company paying out less than a quarter of its earnings as dividends, and growing earnings at more than 10% per annum, looks to be right in the cusp of its growth phase. At the right price, we might be interested.

Conclusion

Dividend investors should always want to know if a) a company's dividends are affordable, b) if there is a track record of consistent payments, and c) if the dividend is capable of growing. We're a bit uncomfortable with the company paying a dividend while being loss-making, although at least the dividend was covered by free cash flow. Next, earnings growth has been good, but unfortunately the dividend has been cut at least once in the past. Ultimately, Metcash 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.

It's important to note that companies having a consistent dividend policy will generate greater investor confidence than those having an erratic one. Meanwhile, despite the importance of dividend payments, they are not the only factors our readers should know when assessing a company. For instance, we've picked out 1 warning sign for Metcash that investors should take into consideration.

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

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.

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. Thank you for reading.