BHP downgrade a dividend red flag

BHP downgrade a dividend red flag

The decision by Standard and Poor’s to downgrade the debt rating of BHP is a wake-up call first to the Big Australian and also our banks. It’s time for BHP and most of the Australian banks to come to grips with the fact that the 2016 dividend game is totally different to past years.

BHP will now almost certainly reduce its dividend and all the banks will review their past dividend policies. It’s highly likely that one or two will cut their dividend in the current half year.

Directors of BHP and the banks have been petrified that if they lower their dividend their shares will be slashed in the market.

They can take comfort from the experience of Brazilian iron ore miner Vale, which last week announced that, given its problems and the Samarco disaster, it was suspending dividends. The shares responded by rising almost 8 per cent and last night they held most of that gain until a late fall evaporated about half Friday’s rise.

Of course, it’s true that Vale shares have fallen from an annual peak of above $US9 to around the current level of $US2.37.

BHP’s 2015 dividend rate involved a payout of around $US6bn and Citigroup estimate that if BHP’s capital expenditure is around the forecast level of $US8bn, then the company will need to borrow $US4bn in 2016 to pay dividends at the 2015 level.

If BHP continues to borrow big in order to pay dividends, in the absence of a jump in commodity prices and if it is not very careful, it will put itself into a downward debt ratings spiral.

In the case of the banks, they have had to raise capital to comply with regulatory requirements and its possible more capital may be needed. The extra shares lift the amount required to maintain bank dividends at last year’s per-share rate.

Around the world, bank shares have been hit hard in 2016. American financial stocks have fallen 9 per cent in January and are the main reason why the US S&P index fell 5 per cent in January. This year’s fall follows earlier declines in 2015.

The world understands that in the years ahead banking is not going to be the growth business that it once was and that banks face threats from high technology ‘disrupters’. And, of course, in the US there are fears of loan losses in energy and other high-risk areas, plus the fear that the problems in China and emerging countries could lead to nasty bank losses.

Most of the danger being focused on Australian banks is concentrated on housing, but our banks are part of the world scene. Globally, most strong banks payout in the vicinity of half their profits in dividends. Our banks are closer to 80 per cent. We got to that level because of the attractions of paying out high dividends to tap franking credits. When bank profits were skyrocketing and the regulations allowed banks to gear their housing portfolio to the hilt, Australian banks could argue their high-dividend case.

Now, the situation has changed and the high-dividend strategy carries much higher risk, although shareholders love it. But what is more important longer term is that the banks invest in lowering their cost base so they can compete with the disrupters. Lowering your cost base is not just about retrenching staff but rather doing things in a better fashion. And that requires investment.

If dividends are lowered at a time when bank profits are holding, I think the market reaction will be restrained, particularly as the high current dividend yields indicate that the market is expecting a dividend reduction.

However, the shares are unlikely to “do a Vale” and jump.