Morton, who is the longest serving manager in the IA UK Equity Income sector as he has headed up the £170m Franklin UK Equity Income fund since January 1995, says that the four companies are examples of stocks which offer attractive yields for investors, but at this point in time look to have challenged dividends over the coming years.
Performance of fund versus sector and index since Jan 1995
Source: FE Analytics
While the manager says the mega-caps won’t definitely have to cut the amount they pay out, he warns that their dividends aren’t as covered as he would like and is therefore becoming increasingly concerned about their outlook.
“What is scary about those four companies – BP, Shell, GlaxoSmithKline and Vodafone – is when you put them together, they make up around 25 to 30 per cent of all the dividends the UK market pays,” Morton said.
“We [UK investors] basically have 30 per cent of our pension funds’ dividend payments in these four companies which, arguably, have dividends that are challenged.”
We will take a closer look at the funds which have the highest portfolio and, more importantly, income exposure to GlaxoSmithKline, Shell, BP and Vodafone in an article later this morning.
However, in the meantime and to just show how important their dividends are to the UK market, data from FE Analytics shows 23.8 per cent of funds in the UK income sector hold all four of the above companies in their top 10, while 45.2 per cent currently hold at least three or more of them as top 10 positions.
Furthermore, FE Analytics shows only 17.8 per cent of funds hold none of those companies in their top 10.
In this article, however, Morton runs through each of the four companies and tells FE Trustnet why he is concerned about their future income-paying capabilities.
Royal Dutch Shell & BP
First on the list are the two oil majors Shell and BP, which are top 10 holdings with 58.3 per cent and 45.2 per cent IA UK Equity Income funds respectively.
Morton does currently hold the two companies in his fund, but is now debating whether he should sell given that the oil price has fallen 40 per cent over the past six months, which has hurt the two companies’ share prices.
“[BP and Shell] are two I’m genuinely concerned about on a medium-term view. That’s the huge thing for me at the moment: what am I going to do with these two companies?”
Performance of stocks versus indices over 6 months
Source: FE Analytics
He says the positives for the two firms is that they have entered the recent oil price collapse in “strong financial shape” as Shell has balance sheet gearing of just 12 per cent while BP’s is slightly higher at 15 per cent.
The manager also points out that the two companies have been able to borrow money at an unbelievably low rate over recent years.
“From that point of view, they are in pretty good positions. The problem will be if the oil price stays low for any length of time, as these companies will be paying the dividend out of the balance sheet,” he said.
“At the moment, I’m willing to give them the benefit of the doubt that these dividends are absolutely safe, certainly for 2015 and probably 2016, unless there is another massive collapse in the oil price.”
Morton says that due to increased cost-cutting in the oil supply industry, BP and Shell don’t need oil at $100 a barrel as they could still function well if the price were rebound back to between $70 and $80.
However, he says the two companies’ dividends – which both currently have a yield of close to 6 per cent – could be at risk if the oil price stays at its current level of $60.
GlaxoSmithKline
“GlaxoSmithKline is another one I’ve got concerns about,” Morton said.
“They said they are going to pay that dividend this year, but have got this big asset swap with Novartis going on and if the business doesn’t start improving operationally, they will be consuming all of the cash flow to pay the dividend.”
Our data shows that pharmaceutical company GlaxoSmithKline is a top 10 holding in a staggering 66.6 per cent of IA UK Equity Income funds, as a result of its size in the index and the perceived stability of its earnings and business model.
The stock has lost money over the last 12 months, which has contributed to its current dividend yield of 5.84 per cent.
Performance of stock versus index over 1yr
Source: FE Analytics
Like with the two oil majors, Morton still believes GlaxoSmithKline won’t have to cut its dividend, but it is a stock he is keeping a very close eye on.
“I think [the dividend] is safe for the time being and there are things with Glaxo which I think are very valuable. It’s got a fantastic vaccines business which is going to be even better when they do this Novartis swap, they are going to have a very good consumer healthcare business and they have a very good respiratory business.”
“At the moment, however, the current dividend level is not covered as much as I would like. If the business doesn’t improve or if things significantly worsen for them over the next year or two that is something I would say is definitely a risk.”
He added: “It’s certainly not a dividend you can sit and feel comfortable about.”
Vodafone
“The other one, I would argue, is Vodafone nowadays,” Morton said.
Vodafone has been one of the best holdings for income investors over recent years as due to factors such as the sale of its stake in US company Verizon, the management have paid out a number of special dividends.
Even though its share price has fallen recently, there are still 46.4 per cent of UK income funds which have the telecom giant as a top 10 holding, according to FE Analytics.
Performance of stock versus index over 3yrs
Source: FE Analytics
While Morton hopes the management’s recent capital investment plans will help the business in the long run, he is concerned about the lack of dividend cover left.
“It’s another stock yielding around 5 per cent but Vodafone are doing this thing called ‘Project Spring’, which is basically means that they are investing billions into capex over the next two to three years in order to make them best in class for connectivity and 4G service,” he said.
“The risk of that is the dividend they are committed to paying. They are paying out of their balance sheet for the next two years, so there won’t be any free cash flow. The market knows this – it is a stated aim of the company – and we won’t get that dividend covered until 2017.”
“Hopefully, at the same time though, we will start seeing the benefits of this coming through in terms of cash flow.”