Dividend dream is torn to shreds

COMPANY profits are plunging faster than at any time since the Gulf War in the early 1990s and now the downturn is, for the first time in recent memory, taking a severe toll on dividends.

In recent weeks, household names that have slashed payments, or warned of cuts to come, include ICI, EMI, Corus, Kingfisher, Royal & SunAlliance, United Business Media, Scottish Power, Reuters and CGNU. The signs are this will become a much more noticeable trend later this year, due to the sharp slide in profits and a troublesome new accounting rule - FRS 17.

Dividends had been falling out of fashion anyway in recent years, due to the upsurge of loss-making hi-tech companies, which were bought only for capital gain. There had also been sharp cuts in payments from a handful of giant companies such as Marconi, British Airways and Invensys.

Falling profits are serious enough in themselves. Until recently, brokers were looking for nearly 10% growth in average earnings this year. But that dream has disappeared in a barrage of terrorism, global economic slowdown and profit warnings. A drop of 10%-20% is more likely.

A Evening Standard Business Day survey of profits from more than 50 of the top 100 companies to have reported 2001 figures shows nearly 60% posted a drop in earnings. Moreover, the falls reported were generally steeper than the gains and many defensive industries such as banks, drugs, insurance, transport, mining and oil have joined their hi-tech counterparts in telecoms, media and computer services in announcing shock setbacks.

Companies have a lot of fat to live off from 10 years of plenty and can hope for recovery from the worst this year and next when the economies of Europe and the US may be revived. So dividends have still been raised by the majority of big companies reporting so far this year. But FRS 17 threatens to end that trend.

This little-known rule requires companies to show changes in the market value of their pension funds as they happen, rather than smoothing them out over many years, as they have in the past. The trouble is that shares are the bedrock of most pension schemes and have tumbled more than 20% in the past two years.

FRS 17 could cut top company pension fund surpluses from 25% to a wafer-thin 5% on average and in some cases is exposing deficits. It has already been blamed for causing a number of companies, such as Marks & Spencer, Sainsbury's, BT and ICI to switch employees from guaranteed final-salary pension schemes to money purchase schemes, dependent on the performance of a fund of investments, and is affecting the way companies think about dividends.

Merrill Lynch UK equity strategist Khuram Chaudhry believes a weak trading outlook and the new accounting rule could result in up to a third of Footsie companies cutting dividends this year, putting further pressure on pension schemes. Alastair Darling, the Work and Pensions Secretary, is disturbed enough about FRS 17 to have called in the Accounting Standards Board, led by Mary Keegan, to press for a rethink on this damaging rule.

Dividends are a matter of vital concern to investors and to anyone with an interest in a pension scheme, life insurance policy or charity project because all have traditionally used shares to fund payments. This is doubly the case because dividends traditionally account for two-thirds of long-term returns on shares and play a crucial role in creating capital gains.

Many investors treat capital gains and income from shares as two separate objectives, with the former preferred because it attracts better tax treatment. But in reality they are as closely interlinked as Siamese twins.

High income shares have outperformed 'growth shares' with low dividend yields on the key test of capital gains over periods ranging from five to 10 years and have outperformed them in four of the past five years.

In the past year, the Financial Times Higher Yield index has edged up 5% whereas its Lower Yield index has tumbled 15%. The latest trend in profits and dividends will not do much to underpin share ratings.

Although average price-earnings ratios have eased to 22 from alltime peaks of 23 to 27 a year ago, current trends suggest PE multiples will edge back up to 24 or 25 this year, while the average dividend yield of around 2.75% could fall to around 2.5%.

Early in 1999, when profits were last falling, the prospective PE ratio was a heady 31. But a sharp recovery was virtually assured then. This time, it seems more a hope than a prospect.