There's no such thing as a free lunch, and that certainly applies to dividend investors who chase high yield stocks. More often than not, you get what you pay for.
BHP Billiton (NYSE:BHP) is the latest high yield stock to cut its dividend. This was BHP's first dividend cut in 15 years and reduces the company's dividend yield from 9.8% to an estimated 1.3%.
Prior to the announced dividend cut, BHP's Dividend Safety Score was 5, indicating that the company's dividend payment was riskier than 95% of all other stocks in the market and very likely to be cut - even despite BHP's 15-year dividend growth streak and management's commentary over the past year about prioritizing the dividend.
Our Dividend Safety Score analyzes a company's payout ratios, debt level, recession performance, free cash flow generation, recent financial performance, and more to rate how safe its current dividend payment is. In BHP's case, we were concerned by the company's payout ratio (over 100%), high debt load, and plunging profits. Very little cushion was left to protect the dividend.
The company's most recent earnings report showed that sales and earnings before interest and taxes (EBIT) fell by 37% and 84%, respectively, during the first half of fiscal year 2016 compared to the prior year's comparable period. While BHP did generate $1.2 billion in free cash flow during this period, it didn't come close to covering the company's dividend payments of $3.3 billion. With net debt of $25.9 billion, there were few levers left for the company to pull to continue paying its dividend without significantly endangering its long-term financial health.
BHP's low-cost assets, highest credit rating in the sector, and continued free cash flow generation are strengths, but they simply weren't enough to combat the severe crash in commodity prices over the last year.
Commodity stocks are often some of the riskiest investments that money can buy. Commodity businesses generally have little control over the selling price of their products, must invest heavily in capital to keep operations running, and depend more on capital markets to fund their operations compared to other businesses. Many of their characteristics are the exact opposite of what we look for when trying to uncover safe dividend stocks.
Going forward, BHP targets a minimum dividend of 50% of underlying attributable profit, which means that the dividend amount will now move around depending on BHP's profits, although the Board can return additional cash beyond the 50% payout mark if it desires to. The company notes this 50% payout policy is aligned with BHP's historical cash returns:
Source: BHP Investor Presentation
BHP's new flexible dividend policy seems like it will ultimately make management's job of managing the company's cyclical cash flows easier (a good thing), but dividend investors are likely to be disappointed by the greater amount of uncertainty over how much BHP will pay them any given year given the unpredictable nature of commodity markets.
BHP's new dividend policy will result in a minimum payout of $0.04 per share (paid twice per year), and the company's Board of Directors is also providing an additional $0.12 per share during the current semi-annual period (the Board can continue providing extra dividend payments at its discretion).
Assuming BHP pays another extra dividend of $0.12 per share in the second half of 2016, its total dividend payments for 2016 would amount to $0.32 per share for a new dividend yield of 1.3% - a far cry from its 9.8% dividend yield prior to the dividend cut announcement.
Investors who chased after BHP's high yield earlier this year probably thought they would be receiving $2.48 per share in dividends each year, which was the company's indicated annual dividend. If an investor purchased 1,000 shares of BHP, this would equate to annual income expectations of $2,480.
Instead, they appear likely to end up with a paltry $320 in dividend income this year. To make an uncomfortable situation worse, these yield chasers could also be sitting on substantial capital losses - BHP's stock has fallen by 50% over the past year. Focusing on total return rather than potential income return is critical.
Before reaching for high yield dividend stocks, it only takes a second to review the company's Dividend Safety Score using our Stock Analyzer tool to avoid the riskiest sources of income. If a company's Dividend Safety Score is significantly below 50 (average), it's probably best to move on. After all, there are thousands of dividend stocks in the market.
The dividend portfolios we manage have not incurred a single dividend cut to date. Our Conservative Retirees portfolio generates a healthy dividend yield near 4% and also operates with an objective of capital preservation. Our Top 20 Dividend Stocks portfolio also consists of high quality businesses that should deliver better total returns than what investors will likely end up with by chasing high yield stocks.
Conservative dividend investors can also review the list of dividend aristocrats, which contains companies that typically score above average for Dividend Safety and Dividend Growth ratings. While BHP's dividend cut was likely painful for many, the important thing is to learn from the situation and make better decisions going forward.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.