Fellow Contributor Fun Trading recently provided what I found to be a solid overview of Helmerich & Payne's (NYSE:HP) 1Q 2016 results, and the piece is largely an excellent article that recaps the results quite well for investors. However, I do believe his dividend cut projection in 2016 is too aggressive, and I'll address that concern in this research piece. The driving point of this piece is going to be that dividend payments are a cash activity, and Helmerich & Payne's statement of cash flows, and not the income statement, is what should be used to analyze whether or not a dividend is sustainable. This concept is largely familiar to investors in MLPs and REITs, who are familiar with the "funds from operations" measurement, but may be new to investors who traditionally do not invest in those corporate structures.
Income Statement versus Statement of Cash Flows
Most retail investors look to the payout ratio as a means of tracking whether a dividend can or cannot be paid. I'm guilty of knee-jerk reactions like this as well when I notice outsized payout ratios, which is a ratio that compares earnings per share to dividends per share. Most investors believe that if earnings per share is higher than dividends per share, the company is paying out more money than it is making; a red flag.
If you have to remember one thing about earnings per share, remember that earnings per share includes non-cash charges, like impairment losses or depreciation and amortization expenses.
In Helmerich and Payne's case, we are primarily concerned with the company's outsized depreciation and amortization expenses. As said, depreciation and amortization expense is a non-cash charge on the income statement in GAAP accounting, and is used to expense the cost of a long-lived asset over time. As a result, the income statement and the statement of cash flows are out-of-sync.
Why does this discrepancy exist? Accountants the world over decided this was for investors' benefit. Illustrating this is best served by an example. When Helmerich & Payne completes a new rig, the cash is obviously spent immediately before the rig can go into service and start earning income. If costs were expensed immediately, earnings per share would fall dramatically during years where the company invested in itself via capital expenditures, and would be artificially inflated during years that the company made no investments, but profited from capital expenditures completed in prior years.
In GAAP accounting, depreciating the asset over its useful life smooths out the income statement, giving investors a better picture of the long-term trend in company's earnings. For Helmerich & Payne, drilling equipment has an estimated useful life of 4-15 years, depending on management's expectation on how long the equipment will be technologically viable. As an example, a drilling rig that cost $10M would hit the statement of cash flows with a $10M capital expenditure charge in the year it was built. On the income statement, assuming a useful life of five years, the asset would instead be depreciated and expensed at $2M per year until it is no longer viable in year 5.
During the boom in oil prices, Helmerich & Payne built out a substantial number of rigs, all the way through most of 2015. As a result, the company guides for still high depreciation expenses in 2016:
"As mentioned in the past, we expect our total annual depreciation expense for fiscal 2016 to be approximately $580 million"
- Helmerich and Payne, 1Q 2016 Earnings Call Transcript
Keep this $580M figure in mind for later.
Historical Cash Flow Statement
*Sourced from company 10-Q and 10-K filings
As we can see from above, the back out of depreciation expense from net income has historically become a significant part of operational cash flow in recent years. Helmerich & Payne generated more than $1.4B in operational cash flow in 2015, with $1.1B being plowed back into capital expenditures and the $300M being used to pay the dividend. What this tells us is that the company was basically cash flow neutral, despite a weakening oil environment.
Now, in this weaker oil environment where most of the fleet sits idle, it doesn't make sense to be building new rigs. As a result, in 2016 capital expenditures are going to be drastically cut, to $300-400M:
"Capital expenditures for fiscal 2016 are still expected to be in the range of $300 million to $400 million."
- Helmerich and Payne, 1Q 2016 Earnings Call Transcript
As a result, we will see capital expenditure spending fall $700-800M year/year. This is a large change, and it is being done directly to control for the drop in net income.
Tying It All Together
We know two key cash expenses at this point according to management guidance, that being the current $300M in dividend obligations (assuming no increase) and $350M in capital expenditures (assuming mid-point of guidance). As such, the company needs to generate $650M in operating cash flow to be cash flow neutral for the full year.
Thus far, through one quarter of fiscal 2016, the company has generated $300M in operating cash flow already:
- Helmerich & Payne, 1Q 2016 Press Release
Backing out depreciation, the company would have made $158M in net income in the first quarter. In fact, the $580M in depreciation expense, by itself, almost covers all of the company's guided obligations of $650M for capital expenditure spending and the dividend. And even if results turned drastically worse for the rest of 2016, the company will likely easily remain cash flow neutral for the year.
Additionally, even if there is some material weakness to where the company cannot generate $350M in operating cash flow for the rest of the year, the company still has its fortress balance sheet, which now totals nearly $850M in cash and cash equivalents.
In short, there is little to no risk of a dividend cut in 2016, even if the company begins generating earnings per share losses. Investors need to focus on the company's cash flow, not its earnings per share, to fully evaluate whether dividends will or will not be cut. MLP and REIT investors are ahead of the investing game, in my opinion, by shifting their focus to what I find to be the more important financial accounting statement: the cash flow statement, not the income statement.
Disclosure: I am/we are long HP.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.