Is it time for BHP to rethink its dividend?

Some analysts are questioning whether BHP should be adding to its debt load while commodities are falling.

As BHP Billiton talks to investors to test appetite for a planned hybrid debt and equity raising to support its progressive dividend policy, some analysts are questioning whether it should be adding to its debt load while commodities are falling or cutting capital spending further.

BHP Billiton’s CFO and treasury team have met with investors in Europe, the US and Asia for a proposed debt and equity raising that could raise as much as $US3 billion ($4.1bn) according to Thomson Reuters, or $US5bn according to Bloomberg.

The two-week roadshow concluded last week and BHP is continuing to collect feedback as it considers whether to proceed with the new hybrid instrument.

The timing is not ideal, with volatility racking the shares of mining companies a week ago and corporate debt yields rising even for quality names in the wake of Glencore’s near-death experience.

BHP has said the final decision will be subject to market conditions.

The plan has revived discussion about the global mining giant’s commitment to maintaining a $US6.5bn dividend payout at the nadir of the commodities cycle after the iron ore price fell more than 70 per cent from its peak and earnings were slashed by two-thirds.

The outlook for China’s economy and hence demand for commodities has weakened again recently and prices for BHP’s iron ore and oil appear set to remain lower for longer.

“To have cast in stone a progressive dividend policy for what is a capital intensive business is sub-optimal,” says Pengana Capital portfolio manager Tim Schroeders.

He says while a dividend yield currently around 7 per cent makes the company attractive to equity investors, the payout should be reflective of the company’s earnings.

Instead, BHP is already paying out more in dividends than it is earning and that gap is forecast to widen, which makes some investors nervous that the miner will eventually have to borrow more heavily to fund the payout.

BHP’s interest in a hybrid instrument (a mixture of debt and equity) can be explained by the way such securities are viewed by the ratings agencies. Andrew Mackenzie has made clear he does not want to do anything that would jeopardise the company’s credit rating — the strongest in the sector (A+ with Standard & Poor’s).

Ratings agencies view hybrids as 50 per cent debt and 50 per cent equity, so if BHP uses the issue to replace maturing debt it can actually expand its balance-sheet capacity at the same time as protecting its credit profile. It has about $US24.4bn of net debt and strong liquidity of $US12.8bn at June 30.

According to estimates by Credit Suisse analyst Paul McTaggart and colleagues, dividend coverage for BHP has declined from 123 per cent of free cashflow in 2014 to 89 per cent this year, and is forecast on their numbers to fall to 67 per cent of free cashflow in 2016.

They believe commodity prices are likely to remain well below the levels seen in the past 10 years. “With this backdrop, we’d prefer to see BHP cutting capital expenditure and operating expenditure to hold debt levels, rather than issue a hybrid debt instrument to support the dividend,” McTaggart says.

If dividend payout ratios were cut to match 100 per cent of free cashflow, next year’s dividend yield would shrink to 4.9 per cent — a level that would send a shiver down the spine of yield-besotted equity investors.

Two more years of trimming controllable costs and deferring some planned capex at Escondida would help balance the books, but it might just be easier to rebase the dividend downwards, Credit Suisse suggests, although that would be a decision for the board.

BHP has already nearly halved capital expenditure from the peak of the boom and has taken an aggressive stance on costs, reaching a $US4bn productivity target two years ahead of schedule, even as it ramped up production.

However, with the pace of global growth once again under a dark cloud and no recovery for commodities in sight, it might be a prudent time for the board to revisit the progressive dividend policy regardless of what the ratings agencies think.