Tightening margins and negative organic growth were the key takeaways for industrials in 2015, as treacherous economic conditions forced customers to rein in capital spending. That challenging backdrop subsequently prompted investors to take flight, in a moment of panic that suddenly made the sector's usually conservative dividends look very attractive.
Given the uninspiring outlooks that accompanied the worst set of results since the financial crisis, further sell-offs appeared imminent. But a repeat of last summer's wave of exits has yet to materialise, a trend that could be tied to the lure of cheap, inflated income on offer. With interest rates still at rock-bottom, hunting for healthy dividend stocks has never been so popular.
But are the dividends responsible for propping up share prices actually sustainable? Rather than take at face value the yields currently available, investors would be better advised to consider the likelihood of them actually getting paid out. Judging by the reaction to recent dividend cuts from the likes of Rolls-Royce (RR.), Dialight (DIA) and Chemring (CHG), most in the investment business have been guilty of burying their heads in the sand.
Extra caution required
As the two main causes of stagnant demand - the global economic slowdown and plummeting commodity prices - show little sign of easing, closer analysis is now even more necessary. An extra squeeze on profits in the year ahead is likely to further test free-cash-flow yields across the board, leaving those who were late to cut costs at risk of irking shareholders. With balance sheets coming under increasing pressure, poorly managed companies may have no option but to cull dividends in the near future.
One of the most effective metrics used to identify dividend stability requires dividing the total amount shelled out to shareholders by free cash flow. Apply this calculation and several names appear on the brink of breaching the recommended maximum payout ratio of 75 per cent.
Those most at risk
Investors convinced that Weir (WEIR) has the commodity downturn under control could be mistaken. The valve and pump manufacturer had a terrible 2015, marred by a 61 per cent fall in US rig counts and a 25 per cent drop in mining capital expenditure. In response, management outlined a series of cost-cutting measures, including the sale of non-core assets for up to £100m.
Judging by the spike in its share price since this news was announced, markets are content that these measures will prevent Weir from encroaching on its fast approaching debt covenant. We're less positive, particularly as trading conditions in the group's more resilient minerals after-market business have come under increased pressure of late. Recent negative commentary from customers such as Metso (FI:MEO1V), Rio Tinto (RIO) and BHP Billiton (BLT) add to this sense of gloom, suggesting that a dividend cut of Rolls-Royce proportions could be on the cards. Jack O'Brien at Liberum even thinks there may be a rights issue.
Analysts are generally more bullish about IMI's (IMI) prospects, owing more to the conglomerate's restructuring efforts than its trading patterns. The maker of valves for the oil and gas, nuclear and power industries blamed the economic slowdowns in Brazil and China, depressed energy prices and weak nuclear activity since the Fukushima disaster for a 34 per cent fall in pre-tax profit last year.
A repeat of this performance could have serious implications for shareholders attracted by its sizeable, and consistently growing dividend. And that's in spite of encouraging indications that management's 'lean' initiatives have substantially improved working capital. Reducing production process times helped to boost cash generation by a quarter to £192m. But calculations show the anticipated £105m of dividend payouts in 2016 could put a big strain on cover, particularly as free cash flow is forecast to drop by nearly a third.
