Stingy miners not playing fair with shareholders

The post-global financial crisis era has been the age of the dividend. As investors have realised that those capital gains they enjoyed so much in the boom were no longer a sure thing - and capital losses a distinct possibility - attention has turned back to dividends.

And why not? Unlike capital growth, dividends are money in your pocket. They provide a degree of certainty in an uncertain investment climate and companies with a track record of improving their dividends tend to do better in recoveries than those with more question marks hanging over them.

As conditions in Europe look increasingly uncertain, the focus on dividends will intensify.

Not even a solid dividend will protect investors from potential market falls but it will reduce the impact.

A recent report by the head of equities research at Morningstar, Peter Warnes, has questioned whether many leading Australian companies are playing fair with their shareholders in terms of dividends.

Warnes says shareholders are often at the bottom of the food chain when companies decide what to do with their free cash flow and deserve better treatment.

Ironically, in this age where dividends are king, this could also be working against both companies and their shareholders by limiting potential share-price growth.

The main companies in Warnes's firing line are resource stocks, which have always tended to think they have better things to do with their cash than pay high dividends and traded on lower yields than the average industrial stock.

Their argument is that their return on equity is much higher than a shareholder could get on a sustained basis somewhere else, so it makes sense to keep the money and reinvest in the company's future. Maybe so.

But as Warnes points out, this attitude has persisted through one of the greatest commodities booms in decades, when companies have been generating so much cash that they could afford to increase their dividends while still having plenty to invest for future growth.

There's not a lot companies can do with their excess free cash flow.

Warnes says it comes down to three "buckets". They can reinvest in the business they can reduce their gearing or they can give money back to the people who ultimately own the company. That's the shareholders, not management, though sometimes you'd wonder.

Overall, Australian companies have record levels of cash and low gearing levels, so debt is not an issue for many. Yet shareholders have not been harvesting the results of the boom. Warnes points to Iluka Resources, which recently enhanced its dividend policy and committed to paying out at least 40 per cent of free cash flow, provided the outlook is reasonably predictable. The share price, Warnes says, has outperformed other mining stocks since.

Is this a coincidence? He thinks not. He also cites the example of the US gold miner, Newmont Mining Corporation, which has a policy of paying an "enhanced" dividend when the realised gold price is more than $1700. So at a $1700 gold price, the normal 40? quarterly dividend becomes 42.5? and as the gold price rises further, the dividend increases significantly. If the gold price is $2000, the old 55? dividend is enhanced to 67.5?. Warnes says it has also outperformed other stocks.

Eldorado Gold also introduced a gold-price linked dividend policy in October and seen its share price benefit.

BHP has recently come under fire from its institutional shareholder, BlackRock, which has challenged the group's distribution of free cash flow to expansion rather than dividends. BHP has a progressive dividend policy, where dividends increase by a small amount each year rather than rising and falling with market conditions.

That's arguably a good thing, as it gives certainty to shareholders and to management, which can continue to invest through the full market cycle. But Warnes says that may not be a good thing.

"It could pay to be a bit more circumspect on how it's spending its money and the bang it gets for its buck, especially when capital costs have gone through the roof to get projects up and running," he says.

"Olympic Dam is a classic example. When BHP acquired WMC six years ago, the capital costs for that project were $6 billion. They're now $20 billion-plus. When you push the button, you want to be very sure you'll get the return on investment you're looking for."

Warnes reckons that if BHP embraced the Iluka policy of paying out 40 per cent of its free cash flow in dividends, it would have still had $17 billion of free cash flow to invest in 2011. But it would have paid out about double the amount in dividends, lifting its fully franked yield from about 2.8 per cent to 5.6 per cent.

If that happened, Warnes asks, would its share price still be languishing at about $35?

In an age of super mining profits, shouldn't shareholders be entitled to a super dividend?

But it is not just the miners that Warnes says need to clean up their dividend act. He says timing of dividend payments is also an issue.

Why, for example, does Harvey Norman pay its December dividend in May? And Woolworths at the end of April?

As Warnes points out, in an uncertain world, many things are beyond the control of company management. But dividend payments are not.

In the post-GFC era, he says people are not going to invest in assets that don't pay a reasonable and efficient rate of return on their investment. Companies need to catch up with that.

* The author owns shares in BHP and Woolworths.

Twitter: @sampsonsmh