Dividend dopes?

It’s a long time since resource companies were seen as yield plays because of their generous dividend policies. But that’s the way some investors see companies such as BHP Billiton, Rio Tinto and Woodside Petroleum in what is an unnatural and unsustainable situation.

Woodside is the best example of a resource company that has dramatically changed focus from investing for future growth to one of immediate shareholder gratification, with an investment in its shares today yielding 5.4%. This is more than the 5.1% available from an investment in Westpac Bank.

The Woodside switch, which has involved shelving several oil and gas projects and the reallocation of funds to shareholder dividends, has done little for the company’s share price. It was $36 at this time last year and is now trading above $38.40, a rise of almost 7% – slightly less than the 7.63% rise in the All Ordinaries index over the past 12 months.

BHP Billiton, at its current share price, is yielding a dividend return of 3.6%. Rio Tinto’s yield is 3.4%. Both big miners, which were once seen as growth stocks, are now competing with low-growth stocks such as Woolworths, a food retailer, which is yielding 3.8%.

Share price movements also reveal how the big miners have been doing little more than track the wider market since they dropped growth as an option, with BHP Billiton’s share up by 9.8% over the past 12 months. Rio Tinto is up by 10.8%.

A simple test of share price movement is not enough to prove that investors are unimpressed with the resource companies shifting from growth into yield stocks by the payment of generous dividends, but it is a question which is starting to be asked.

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The changing mining landscape

What’s happened over the past few years is that management at resource companies over-invested in new projects, or lost control of construction budgets, because of an overblown belief in the now discredited commodity super cycle.

Watching their money wasted on projects that might never generate a reasonable return triggered an investor revolt, with mining and oil companies forced to abandon new projects, severely prune exploration efforts, and crank up dividend payments to silence shareholders.

The change has seen the big resource stocks flick from growth orientation into limited-growth cash cows with an annuity-type appeal rather than as the generators of future capital gains through increased production of minerals and oil.

Some investors, especially institutional funds in need of cash because their other investments have not performed well in recent years or because fixed interest investments are yielding ultra-low returns, are delighted with the big dividend policies of the resource companies and the promise of share buybacks that could come as soon as late this year.

Other investors are wondering whether such a fundamental shift by mining and oil companies from growth into cash generators has destroyed their long-term appeal and whether the “cash now” policy is sustainable given the nature of all geological resources requiring replacement through exploration and project development.

Imagine, for example, if a technology giant such as Apple slashed spending on research because management believed all that could be invented had been invented. It’s a fair bet that if Apple did that, and became a cash generator rather than a growth-focused technology leader, some investors would sell their shares.

Investor backlash?

It is possible that some investors are already trimming their exposure to big mining companies because of decisions to scale back exploration (the mining world’s equivalent of research and development), defer project development, and profoundly change the way they operate from a focus on growth for the future to short-term shareholder rewards today.

The real test of the miner’s new-found policy of shareholder appeasement will come over the next 12 months as the cost-cutting policies reach their targets and managements are forced to consider an expanded asset sales program and share buybacks as the next step in boosting returns to investors.

Asset sales, while sounding appealing to investors who want cash now, have the effect of shrinking a business, as do share buybacks. Yet, while it is fashionable today to quit assets regarded as surplus to requirements because of low commodity prices, there is risk of cutting too far and selling assets too cheaply.

Forgetting long-term growth in favour of short-term gain was a topic addressed last week by the chief executive of Australian Foundation Investment Company, Ross Barker.

He warned that companies needed to “strike the right balance” between capital release and parking funds aside for future growth.

“Income is still very important to people, but when companies spend more of their profits on dividends, they are not seeing much opportunity to invest in longer-term growth,” Barker said.

A number of big-name investors and investment banks have added their concerns to the debate about how excessively generous shareholder rewards might damage the long-term performance of a business.

Larry Fink, chief executive of the world’s biggest investment-fund manager, New York-based BlackRock, said in a television interview with Fox Business Network in the US that “the narrative of activist investors has grown too loud”.

Fink also warned in a private letter to a number of big companies that too much focus on dividends and share buybacks “comes at the expense of long-term investment”.

That view was picked up by Sydney-based analysts at the Macquarie investment bank who said in a note to clients on Wednesday that buyback run the risk of leaving limited funding flexibility to insulate against unexpected downturns.

Macquarie said that the two biggest miners, BHP Billiton and Rio Tinto, had already cut deeply into their costs, adding that “under-spending in a downturn may be just as damaging” as over-spending in a boom.

The hunt for yield

The push for more generous dividends is not confined to resource companies, with a recent survey of 130 companies in the ASX 200 index by the Bloomberg information service finding that collective revenue grew by 4.8% in the six months to December 31 while dividend payouts increased by 7.2%.

In the case of the big resource companies, the shift towards dividend payments over investment in growth projects can be measured by analysing forecast future profits and dividends.

According to an assessment of BHP Billiton by the investment bank J.P. Morgan, the resource company’s annual dividend is expected to rise from $1.20 a share this year to $1.26 a share next year and then up to $1.32 in 2016.

As a share of BHP Billiton’s profits, the rising dividend rate will consume 41.4% of earnings this year rising to 46% next year and then up to 52.8% in 2016.

Higher dividends are one way of rewarding shareholders. Share buybacks are the next step in pacifying investors after a period of waste and poor investment decisions, and buybacks might seem like an admission by management that it has run out of growth ideas they expected to start soon.

The investment bank, Credit Suisse, believes buybacks will come after the big resource companies cut their debt levels to new targets which, in the case of BHP Billiton, is said to be $25 billion. In the case of Rio Tinto is said to be $15 billion.

By tracking the effect of reduced spending on projects, asset sales and deep cost cutting, Credit Suisse sees BHP Billiton having around $12.5 billion available for distribution to shareholders by the end of 2017, while Rio Tinto should have $14.6 billion available by the end of 2016.

Long-term sustainability

It is the prospect of so much cash being returned to shareholders that will cause some investors to ask whether either company will retain sufficient funds to pay for future growth, or whether growth has ceased to be fashionable.

The cash now vs future growth debate is undoubtedly favouring higher dividends and share buybacks today, but expect that to change as the resource companies shrink and investors question the sustainability of minimal exploration and limited project investment.