Income-seeking investors love high yielding shares, but a very high yield could be seen as a warning that the dividend is at risk of a cut or that the share price will fall back.
BP
Shares in BP (LSE: BP) have long been a favourite for income seekers, as its shares typically yield 4%–6%. But shares in BP currently yield 7.8%, as the deteriorating outlook for the oil price has crushed analysts’ estimates of future earnings and free cash flow.
Expectations that BP could become a takeover target are also diminishing, as BP’s own cost cuts and asset disposals mean there are now fewer possible synergies that could be gained from a merger. On top of this, there seems to be mounting political opposition against the deal on both sides of the Atlantic.
By staying away from any major M&A activity — unlike big oil peer Shell — BP faces fewer execution risks with corporate integration and will benefit from a stronger balance sheet. BP has the financial flexibility to maintain the dividend at current levels in the short term, as it has plans to divest some $10bn worth of assets and net debt is relatively low.
Looking ahead, BP would likely need crude oil prices to stay above $70 per barrel to ensure that it breaks even on a free cash flow basis, after making dividend payments, and to avoid the need to make further divestments or curtail capital spending.
BHP Billiton
Share prices have also been falling in the mining sector, too, and shares in BHP Billiton (LSE: BLT) currently yield 8.1%. BHP has been hit harder than the shares of rival Rio Tinto, having fallen 30% over the past six months, compared to Rio’s fall of 19%.
Although BHP is more indebted than Rio, with a net debt to EBITDA of 1.11, compared to Rio’s 0.64, it still has one of the strongest balance sheets in the sector. In addition, its free cash flow shortfall (after dividend payments) in 2014/5 was less than $200 million.
Anglo American
Anglo American has one of the weakest balance sheets in the large-cap diversified mining sector, with a net debt to EBITDA of 1.99. Free cash flow (after interest costs but before dividend payments) was almost non-existent in the first half of 2015. By the second half of 2015, this could fall significantly below zero, and, if that happens, its entire dividend would need to be financed by new borrowings.
Anglo American’s 10.3% dividend yield already implies a very high likelihood that its dividend could be cut in the very near future. Its share price has fallen 45% over the past six months, and this should mean that any announcement to cut its dividend or raise equity in the near term should not come as too much of a surprise.
The future’s uncertain
All three companies already suffer from a shortfall in free cash flow to fund dividend payments, but all three have, so far, prioritised the dividend. Only BP and BHP should have sufficient financial flexibility to sustain current dividend levels for another few years with commodity prices at today’s levels. In the longer term, the outlook that their dividends could be sustained is far more uncertain.