BHP looking at a dividend cut?

If the mining giant’s board was looking for an excuse to drop its progressive dividend, it’s just arrived.

Summary: For BHP Billiton, loss of cash flow from the Samarco iron ore mine following a ruptured dam and mudslide will add to the potential need to cover this year’s dividend with debt. This would raise a red flag at ratings agencies, which are already concerned about the company’s rating because of low commodity prices. Investors are increasingly confident the company’s promise of a progressive dividend will be dropped.

Key take-out: BHP shareholders have been more concerned than directors about unsustainable dividends and might even welcome the announcement of a more realistic dividend policy.

Key beneficiaries: General investors. Category: Mining stocks.

If the board of BHP Billiton was looking for an excuse to drop its promise of a progressive dividend it’s just arrived in the form of a Brazilian mine disaster.

Whether costs associated with the ruptured dam and mudslide which killed at least six people (with 21 still missing and 631 displaced) as well as closing the Samarco iron ore mine will prove to be as financially punishing as feared is uncertain a week after the event.

But that’s not stopping speculation that the company’s directors have been shown an exit route from a pledge which had placed excessive, and perhaps unnecessary, pressure on BHP Billiton at a time of low commodity prices and falling profits.

Concern about the progressive dividend, which means steadily increasing the annual payment to shareholders (or at least not cutting the dividend), was a hot topic at the first round of the company’s annual meeting in London last month.

The dividend will be an even hotter topic at the second phase of the meeting process scheduled for Perth next week (Thursday, November 19).

What particularly worried some BHP Billiton shareholders in London was a suggestion from the company’s chairman, Jac Nasser, that he was not opposed to using debt in the short term to keep the progressive dividend intact, but not if such a move damaged the company’s balance sheet.

“Over a short period of time we would look at it and consider borrowing to cover the dividend but if it risks the balance sheet over the long cycle we will not do it,” Nasser said in response to a series of shareholder questions.

Losing cash flow from its 50 per cent stake in Samarco will punch a relatively small hole in BHP Billiton’s annual profit, but a much bigger hole in the company’s credibility even if it did not have day-to-day control over the Brazilian mine.

Estimates of the costs associated with the event vary from hundreds of millions of dollars to more than $US1 billion, with half attributable to BHP Billiton and half to Brazil’s big iron ore miner, Vale.

The problem for the board of BHP Billiton is that any loss of cash flow adds to the potential need to cover this year’s dividend with debt, a step which if taken would certainly raise a red flag at ratings agencies which already have the company on negative watch because of low commodity prices.

Both Fitch Ratings and Standard & Poor’s are concerned about BHP Billiton being able to retain its A rating with both citing “headwinds” from commodity markets and China’s economic slowdown as the key factors.

Short sellers had already been busy in the market before the Brazilian accident because of concern over the company’s earnings and doubts about the ability to maintain the progressive dividend.

While not traditionally a heavily “shorted” stock the percentage of BHP Billiton shares being shorted rose from 0.17 per cent of the company’s issued capital in March to 0.84 per cent at the end of last month.

Given that BHP Billiton’s share price fell by 23.3 per cent from $28.11 at the end of March to $21.57 at the close of trading yesterday some short-sellers will have pocketed handsome profits.

The effect of the Samarco dam burst and closure of the mine can also be seen in the rapid acceleration of BHP Billiton’s price decline coming in the days after the event and in a comparison with its traditional rival, Rio Tinto.

Since the end of March Rio Tinto’s shares have declined by 13.7 per cent (versus BHP Billiton’s 23.3 per cent) with Rio Tinto’s shares falling by 1.5 per cent in the days after the Samarco incident (vs BHP Billiton’s 7.3 per cent fall).

Investors, if not yet the board of BHP Billiton, are increasingly confident that the company’s promise of a progressive dividend will be dropped.

A test of that view is the notional yield on BHP Billiton shares at their current price blowing out to 8 per cent, substantially higher than leading bank stocks such as Commonwealth Bank which is yielding 5.6 per cent.

Credit Suisse, an investment bank, said in a note sent to clients earlier today that the effect of the Samarco incident on BHP Billiton was “meaningful” because it meant that free cash flow had been reduced by 5 per cent this year and 6 per cent next year.

If correct, the Credit Suisse cash flow forecast means that BHP Billiton will suffer a substantial shortfall between free cash flow of around $US3.6 billion this year and a dividend commitment of $US6.6bn.

That dividend gap can only be plugged by further cuts to capital expenditure or debt or a miraculous recovery in commodity prices.

Two days ago another investment bank, Goldman Sachs, raised similar concerns as Credit Suisse about the generous dividends proposed by BHP Billiton and Rio Tinto.

According to a Goldman Sachs calculation dividends by both companies are sustainable at around 20 per cent of earnings before interest, tax, depreciation and amortisation (EBITDA).

On a 20 per cent EBITDA basis the implied dividend from BHP Billiton is US60c a share (versus the promised progressive dividend of $US1.24) and Rio Tinto’s implied dividend is $US1.40 (versus $US2.15).

In simple terms the dividend policies of both companies in the current commodity price environment do not add up.

Goldman Sachs reckons that on current commodity prices: “both companies would be approximately $US500 million light on their cash flow requirements” to meet their dividend commitments.

A third investment bank, Investec, was reported overnight by London’s Financial Times newspaper to have told clients that that BHP Billiton’s free cash flow was already appearing inadequate before the loss of Samarco.

“A reduction in the otherwise sacrosanct dividend may prove a pragmatic response to this tragic accident,” Investec was reported to have said.

Most other mining companies have already been forced to cut their dividends thanks to falling profits.

Vale, BHP Billiton’s partner in the Samarco mine, has already announced a cut of more than 50 per cent in its annual dividend, reducing the return to shareholders from $US4.2bn last year to a proposed $US2bn this year.

While the facts behind the Samarco incident are still to be collected, and the death toll remains uncertain, BHP Billiton and Vale are highly unlikely to announce any changes to the way they do business, at an operational or financial level.

But, once the dust settles a lot will change to placate government regulators, who control the licence of mining companies to operate; ratings agencies, which determine the cost of capital and debt; and shareholders, who have been more concerned than directors about unsustainable dividends – and might even welcome the announcement of a more realistic dividend policy.

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