The new threat for big miners

The world's top advisers warn the big miners are on a high wire with unsustainable dividend promises.

Summary: Major miners are keen to maintain their progressive dividend policies. But falling commodity prices are weighing on miners’ profits. This means the majors are likely to lift their payout ratios to levels that are unsustainable over time, according to estimates from investment banks.

Key take-out: Investment banks and consultants are questioning whether major miners are able to maintain their dividend policies. Lower commodity prices could force miners to sell assets or raise debt to pay dividends – or miners could break their promises.

Key beneficiaries: General investors. Category: Mining stocks.

If you believe the consensus forecast of eight top investment banks BHP Billiton’s dividend payout ratio in the current financial year will rise to 126.2 per cent, a number which is unsustainable over time because it means the company will be paying out more than it’s earning.

A guide as to whether the company’s payout ratio will rise above 100 per cent will come next month when BHP Billiton releases its profit result for the financial year which ended on June 30 last week.

The consensus view of banks such as UBS, Morgan Stanley, Credit Suisse, Citi and JP Morgan is that dividend payments to shareholders from last year’s earnings will be 83.4 per cent, almost double the 46.5 per cent ratio of the 2013-14 financial year.

Rio Tinto, Australia’s second biggest resource company, is expected to have a payout ratio this calendar year (Rio Tinto has a December 31 balance date) of 87.6 per cent, also roughly double last year’s ratio of 42.7 per cent.

The payout ratio is the share of profits returned to shareholders and, by inference, a measure of the amount of money kept by the company for future growth. It is calculated by dividing the dividends paid per share by the earnings per share.

The reason the payout ratio has become one of the most closely watched measurements of big resource companies such as BHP Billiton and Rio Tinto is that they have become important “yield generators” for investors at a time of low interest rates and low yields on other asset classes.

Banks have been the traditional leading yield plays but the recent correction in bank share prices was a warning that investors had pushed bank shares too high, with some investors also worried about the need for banks to boost their balance sheets by raising more capital, possibly by issuing more shares.

As part of the wider hunt for yield in recent times investors have stuck with big miners on the basis they are now – in contrast to past times – committed to paying reasonable dividends.

But treating resource companies, with their exposure to commodity prices, as yield plays is a risky policy with a lot of faith being placed in promises from the directors of mining and oil stocks that they will do everything possible to defend “progressive” dividend policies.

This adherence to a progressive dividend policy, which means gradually lifting the annual dividend to shareholders, has become one of the major talking points about big resource companies given their exposure to the prices of commodities such as iron ore, coal and oil, which have all fallen sharply over the past 12 months.

PwC, an international consultancy, raised the question of dividend sustainability last month in a sharply-worded report on trends in the global mining industry titled “Mine 2015: The Gloves Are Off”.

One of the key comments in that report was that many of the world’s top 40 mining companies are “walking a fine line” with the dividend policies.

The firm, which is close to a number of the big miners either as an adviser or auditor, noted that last year dividends by the top 40 were covered by a microscopic 1.1 times, continuing a trend of thin dividend cover, or the negative dividend cover of 2013 when some miners were forced to borrow money to meet their dividend commitments.

PwC, in a significant understatement, warned that: “this practice isn’t sustainable in the long term” with dividends paid from 2014 earnings consuming most of the cash in the top 40.

Falling commodity prices, including this week's horror session on global markets, will be ringing alarm bells in boardrooms through the mining sector with iron ore back below $US50 a tonne, and with copper and nickel down to new six-year lows.

China, which ignited the resources boom in 2002, is now the bogeyman of the resources world with its increasingly troubled economy and stock market weighing heavily on the prices of most commodities, including minerals and food.

The profit-diluting effect of lower commodity prices is producing one of the biggest challenges for mining company chief executives with Andrew Mackenzie at BHP Billiton and Sam Walsh at Rio keen to maintain their company’s progressive dividend policies “through the commodity-price cycle”.

The problem is judging whether this is a normal downward leg in the cycle or something which will last longer, in the same way the upward leg lasted longer than many people expected – triggering the mine development boom which has flooded global markets with an excess of raw materials.

At a “roundtable” meeting with investment bank analysts in May, BHP's Mackenzie reinforced his commitment to a progressive dividend policy with reports from that meeting suggesting that the policy was regarded as so important that BHP Billiton might take on partners to fund some of its projects, or even sell assets to protect the policy.

Citi reported after the roundtable that it expected BHP Billiton’s payout ratio in the 2015-16 financial year to hit 138 per cent of earnings if the progressive dividend policy was to be maintained (which is above the consensus view).

The introduction of a share-issue component to the annual dividend was ruled out because of BHP Billiton’s complex dual-listed structure and because of its diluting effect on the share price without a corresponding share buy-back program.

Two weeks ago Citi re-visited the question of progressive dividend policies, describing them as “the Achilles heel” of the big mining companies.

“Dividend yield has become the dominant valuation metric for the major miners,” Citi said.

“The key question from investors is if the companies can defend their yield and if the dividend policies are immune.”

PwC in its Gloves Off report said that because the stock market value of the top 40 miners had fallen in line with commodity prices the average dividend yield had risen from 4.3 per cent to 5 per cent in 2014.

“This is the highest dividend yield in the history of Mine (the annual PwC report on mining which was launched in 2004) where the average is 2.8 per cent,” the consultancy said.

“Interestingly, for iron ore majors BHP Billiton, Rio Tinto and Vale, the dividend yield was 6 per cent, which suggests a desire to maintain their dividend policies.

“This is an attractive entry point for investors, assuming the dividends can be maintained.”

Last night’s commodity-price collapse back to prices last seen during the global financial crisis was a warning shot across the bows to those progressive dividend policies.

The challenge is that lower commodity prices mean reduced cash flow which, in turn, potentially means dipping into reserves, selling assets, or raising debt to meet dividend promises – or it means breaking promises made to shareholders.

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