With interest rates falling to 1.5% this week, higher yielding shares such as Telstra Corporation Ltd (ASX: TLS) and Commonwealth Bank of Australia (ASX: CBA) are likely to become more popular among investors. However, there is more to income investing than a high yield and while Wesfarmers Ltd (ASX: WES) currently yields 4.7% versus 4.3% for the ASX, should investors avoid it because of concerns about its business performance?
Financial standing
In terms of Wesfarmers' financial standing, its dividend outlook is relatively bright. For example, its capital expenditure was slashed by 25% in the first half of financial year 2016 and it is expected to amount to no more than $1.4 billion in FY 2016, which would be a significant reduction on FY 2015's capex of $2.2 billion. This should free up a greater proportion of net operating cash flow which can be used to pay dividends. With greater discipline on capex expected to follow in FY 2017 and over the medium to long term, Wesfarmers's dividend could become more affordable.
Further, Wesfarmers has an A3 credit rating with a stable outlook from Moody's and an A- credit rating with a negative outlook from S&P. When combined with its net gearing level of 25% and the reduction in Wesfarmers' cost of debt from 5.5% to 4.4% from FY 2015 to FY 2016, its ability to pay a growing dividend in the long run seems sound.
Strategy
Wesfarmers' strategy also supports a bright growth outlook, with its investment in better merchandise offers, store network improvement and greater customer value helping to drive return on capital for the company's retail portfolio higher. In fact, return on equity (ROE) in the first half of FY 2016 increased by 30 basis points to 10%.
In addition, Wesfarmers is seeking to improve the efficiency of its retail supply chain as well as deliver operational simplification. It is also investing in customer service levels and in my view this could prove to be key regarding its future profitability and its ability to pay a growing dividend. That's because improved customer service could lead to greater customer loyalty and the potential for relatively higher margins.
Potential challenges
While Wesfarmers' retail operations are performing relatively well, its industrials segment is enduring a tough period. That's largely because of commodity price falls, but with Wesfarmers having a strong focus on cost reduction and it restructuring its industrial and safety business, its group cash realisation ratio of 118.3% remains high.
In terms of its newly-acquired UK operations, challenges could lie ahead due to the UK economy being forecast to grow by just 0.8% in 2017 by the Bank of England. This is down from the previous forecast of 2.3% and with sterling forecast to weaken yet further versus the Aussie dollar, a negative currency impact seems inevitable.
Dividend prospects
However, Wesfarmers has a sound balance sheet, strong cash flow, capital discipline and the right strategy to post inflation-beating dividend growth over the medium to long term. Therefore, when combined with its high yield, it seems to be a stock to buy rather than avoid in my view.
