Income investors should look beyond blue-chip stocks for high-yield opportunities. Some small-cap shares can provide safer and more stable dividend growth than commodities-exposed blue chip companies.
BP
BP (LSE: BP) has an attractive dividend yield of 5.7%, but neither earnings nor free cash flow is likely to cover dividend payments in 2015. Earnings coverage of the dividend is expected to fall just below 1.0x; but weak free cash flows are of greater concern.
Net operating cash flows after capital spending in the first quarter of 2015 was a negative $2.78 billion. Even after a 20% cut in its 2015 capital spending budget, BP will still spend $20 billion in capex. $10 billion worth of divestments booked for 2015 would reduce some pressure on cash flows, but its dividend will likely be funded mostly through debt. With oil prices likely to remain lower for longer, BP’s long term dividend sustainability is uncertain.
BHP Billiton
Mining giant BHP Billiton (LSE: BLT) pays a dividend yield of 5.7%. Although its 2015 dividend is covered on earnings by over 1.2x, it is unlikely to be fully covered on a free cash flow basis. Persistently high capital spending on increasing iron ore production would likely mean that its dividend will only be sustained through taking on more debt.
Even though BHP Billiton suffers from a weak outlook for most commodities, including iron ore and oil, its capex budget could be reduced further without hurting its extraction rate too much.
Chesnara
Chesnara (LSE: CSN), the closed book insurer, is attractive because of its strong cash generation capability. Gross cash generation fell 14.3% to £42.6 million in 2014, due to a fall in bond yields in the UK. But, the dividend is still safely covered by more than 2.0x gross cash generation. On earnings, the dividend is covered 1.2 times.
Its simple business model of acquiring and managing closed life insurance and pension books means that it can keep operating costs low. The life insurance market is highly fragmented, and further consolidation could lead to substantial savings. Running down old policies also allows it to release provisions, which makes the business highly cash generative.
Limited new customer business means that Chesnara needs acquisitions to sustain growth in operating cash flows in the long term. So far, the company has been able to acquire closed books at a sizeable discount to their embedded value, but increasing competition could lead to more expensive acquisitions or Chesnara could avoid acquisitions all together. But, both scenarios lead to reducing the cash available for distribution to shareholders.
Chesnara has limited capital appreciation potential, as the company trades at 0.95 times its embedded value. Embedded value is a commonly used valuation measure for life insurers, because it is an estimate of the present value of future profits and the sum of net asset value. Closed-end insurers are rarely valued above their embedded value. But, Chesnara does have a strong track record of growing its embedded value through opportunistic acquisitions and better than expected investment performances.
Chesnara’s dividend is set to grow another 3% this year. Its shares currently have an attractive indicative dividend yield of 5.9%.