Is Rio's dividend in trouble too?

BHP Billiton's dividend, and the potential for it being cut, has been making news for weeks but it might soon be sharing the headlines with another mining company with an emerging dividend problem: Rio Tinto.

While the challenge for Rio Tinto to maintain its generous annual payout of $US2.15 a share is not as acute as BHP Billiton retaining its $US1.24 per share there are similar pressures building in each company.

The directors of both are not required to reveal their dividend plans for 2016 until February but the market already appears to be assuming a reduction by BHP Billiton and a chance of Rio Tinto following the leader.

Recent events at Rio Tinto, which have not attracted the same attention as those at BHP Billiton, are pointing to there being more than a chance that an industry-wide dividend reduction trend could be on the way, in keeping with the “lower-for-longer” theme gripping the mining industry.

The latest sharp fall in commodity prices, which has taken iron ore below $US44 a tonne and copper to $US2.12 a pound, will hurt both miners. But the dividend issue is far deeper than daily commodity price movements: it goes to the heart of managing cash reserves to achieve a balance between rewarding shareholders and funding future growth.

The nature of financial markets is that companies in the same industry tend to not drift too far apart in the way they run their businesses or the way they treat their shareholders with a common bond being that both have “progressive” dividend policies, which is effectively a promise to not cut payouts.

Other connections include the way both big mining companies which have followed each other into similar commodities (iron ore, coal and copper), similar jurisdictions with a preference for assets in Australia, Canada, Chile and the US, and similar customers, China, Japan and Korea.

There are differences, such as BHP Billiton having an oil division and Rio Tinto a big bauxite and aluminium operation – a business they once had in common until BHP Billiton offloaded its aluminium assets into South32.

The reason for comparing the commodities to which both are exposed is to demonstrate that the factors which affect one invariably affect the other and while one might be the leader (or the loser) at any time in the cycle the other quickly catches up.

In BHP Billiton's case the bad news has been dominated by problems in the Samarco iron ore joint venture in Brazil.

But that single event masks deeper issues such as falling revenue from oil, copper, coal and iron ore production which is likely to see annual profit slide from $US6.4 billion to $US3bn in the current financial year, according to the latest analysis from investment bank UBS.

Rio Tinto's profit is expected to fall from $US9.3bn last calendar year to $US5.2bn this year, and then down again to $US3.9bn in 2016 with most of that likely to be absorbed by dividend payments if the $US2.15 payout is maintained.

It's the potential for a big profit fall, and the prospect of a dividend cut, which has caused the 36 per cent drop in BHP Billiton's share price this year and lifted the yield on its shares to an eye-catching 8.6 per cent – substantially higher than the big four banks which currently yield around 5.8 per cent.

Rio Tinto's problems have not been as obvious as those dogging BHP Billiton but that's largely a result of BHP Billiton having so much go wrong at the same time whereas Rio Tinto's problems are yet to make headlines or attract the attention of investment analysts.

Falling iron ore revenue is a common problem as is trouble at an iron ore project. In BHP Billiton's case it's the Samarco joint venture. In Rio Tinto's case it's the Simandou project in Guinea where a recent legal setback, coupled with the lower iron ore price, might have laid the groundwork for a showdown with the government of Guinea which wants the project developed as quickly as possible while Rio Tinto is not as keen to see more ore hit an over-supplied market.

A hint of what might be on the way for Rio Tinto can be seen in its 6.3 per cent dividend yield which is less than BHP Billiton but more than most banks. The yield is a key pointer to what shareholders expect to receive as well as being a guide to the risk profile of a company.

Analysts at investment bank Goldman Sachs have been concerned about the dividend policies of both companies for some time pointing out that both are unsustainable in the long term.

The bank's latest view of the dividend question contained in a research paper sent to clients two days ago reinforced a convincing argument that the era of generous dividend payments by the big mining companies is coming to an end.

Using cash flow analysis Goldman Sachs noted how dividends as a percentage of cash flow have doubled over the past decade, from 11 per cent in 2006 to 29 per cent in 2015.

Both big miners have the financial firepower to maintain their current dividend policies, even if it means using debt, in the short term but without a big boost in earnings the dividends are not sustainable in the long run.

The most interesting comment from Goldman Sachs was that an analysis of dividend sustainability over a 42-year period from 1970 to 2012 showed that dividends represented 20 per cent of a company's earnings before interest, tax, depreciation and amortisation with EBITDA a proxy for cash flow.

On that basis an implied dividend from BHP Billiton at 20 per cent of EBITDA is US60c a share with Rio Tinto's implied dividend on the same basis being $US1.40 a share.

If correct, shareholders in both companies could be looking at a reduction of at least 50 per cent in their annual dividend.

No other investment bank has followed the gloomy projection of Goldman Sachs and most are sticking with management forecasts of steady dividends from both companies in future years.

But with commodity prices under intense pressure as over-building in the boom maintains a flood of commodities into a slowing global economy, the prospect of dividends becoming part of the “lower-for-longer” trend should not be ignored.