2 Important Risks Investors Have to Note Regarding a Stock’s Dividend

Take a look at Australian mining giant BHP Billiton Limited’s interesting dividend policy below, as stated on its webpage:

“BHP Billiton has a progressive dividend policy. The aim of the policy is to steadily increase or at least maintain the dividend per share in US dollar terms at each financial half year.”

Said another way, the mining giant has the aim of growing, or at least maintaining, its dividends over the years. I would guess that this would sound like music to the ears of most income investors.

But, a crash in the prices of oil and iron ore over the past year – the two are BHP Billiton’s main commodities – have likely led to a change of heart for the mining giant. My Australian colleague Tom Richardson wrote earlier today:

“The group’s chairman, Jac Nasser, has already given a huge hint to investors at the company’s AGM last week that the balance sheet will take priority over hare-brained aspirations to increase dividends.

The company would likely have to borrow more to sustain its dividend policy, which would mean more debt on the balance sheet and longer-term problems created just to support a mindless promise over a dividend policy made in an entirely different operating environment.

Given the disaster at the Samarco mine in Brazil and fact management has already stated the balance sheet will take priority over borrowing to pay dividends, I would not be surprised to see the dividend slashed nearly in half this year.”

Partly as a result of BHP Billiton’s seeming change in its dividend policy, the mining giant’s shares had also crashed to a seven-year low today. BHP Billiton’s plight contains important lessons for us investors here in Singapore when it comes to our hunt for dividend stocks.

Lesson 1: Beware price takers

As a company mining for commodities, BHP Billiton essentially has no control whatsoever over the prices of its products. And so, when its key commodities crashed in price, BHP Billiton’s business had suffered, mightily – in fact, in its latest financial year ended 30 June 2015 (FY2015), the company’s profit had declined by a shocking 86.2% to US$1.91 billion on the back of billions’ worth of asset impairments.

When looking for dividend stocks, keep a close eye on the type of business the company is in. If it’s in the business of producing commodities, or is tightly linked to commodities, then the risk of falling commodity prices – which I’d state again is out of any company’s control – is something to bear in mind.

Lesson 2: Focus on the balance sheet

BHP Billiton’s latest financials, as of 30 June 2015, show that it has US$32.4 billion in total borrowings versus just US$6.75 billion in cash. When times are good, that huge debt load may not be noticeable. But when the going gets rough, the weak balance sheet can, potentially, be an albatross around the neck of the company.

BHP Billiton had likely focused on strengthening its balance sheet at the expense of its dividends in order to prevent itself from running into even deeper problems in the event that it had to borrow more to fund its payouts.

This highlights the important role that a strong balance sheet can play in protecting a company’s dividends in the event that it runs into a difficult business environment.

Bringing it all together

On the local front, there are a number of high-yielding shares that are arguably in similar circumstances to BHP Billiton. Two prominent ones, by virtue of their multi-billion-dollar market capitalisations, are Keppel Corporation Limited (SGX: BN4) and SembCorp Marine Ltd (SGX: S51).

Keppel Corp and SembCorp Marine market cap and dividend yield table
Source: S&P Capital IQ (click table for larger image)

Both companies’ businesses rely heavily on the construction of oil rigs and the repair/modification of vessels for the oil & gas industry. Keppel Corp and SembCorp Marine’s business fortunes are thus tightly tethered to the price of oil, since their customers – the producers of oil – are highly dependent on the price level of the commodity for their own livelihoods.

You can see in the chart below how Keppel Corp and SembCorp Marine’s net-debt (total debt minus cash & equivalents) to equity ratios have climbed over the past five years from negligible amounts to something worth paying attention to (more than 50%).

Keppel Corp and SembCorp Marine's net-debt to equity ratios since third-quarter of 2010
Source: S&P Capital IQ; author’s calculations (click chart for larger image)

While Keppel Corp and SembCorp Marine do have very tasty yields now, those numbers are backward looking. BHP Billiton’s experience has shown us what can possibly happen to the dividends – and share price – of a company that depends on commodity prices (which have crashed!) and that have a heavy debt load. When looking at Keppel Corp and SembCorp Marine (as well as other similar companies), those are important risks to note.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any companies mentioned.