If you’re buying a dividend stock, you’ll often be forced to choose between quality and quantity.
This is very much the case in the commodity sector at the moment. At the quantity end of the scale are companies such as BP (LSE: BP), whose shares currently offer a forecast yield of 6.9%.
The problem with this payout is that it hasn’t been covered by earnings since 2014. And broker forecasts suggest it won’t be covered in 2017 either. Paying dividends without free cash flow or earnings cover means that a company must draw on its cash reserves or borrow more money.
In BP’s case, dividend payments are one of the reasons why the group’s net debt has risen from $22.8m in 2014, to $39.8m at the end of June. This represents a multiple of 6.9 times analysts’ forecast 2017 earnings of $5.8bn. That’s quite a lot of debt.
Although I don’t expect this borrowing binge to result in financial distress, there is a modest risk of a dividend cut. Even without this, I’m not convinced BP’s share price offers that much upside. The stock currently trades on a forecast P/E of 20, falling to a P/E of 15 in 2018. In my view, the price of oil will need to surge higher to generate further gains.
If I owned this stock for income, I’d continue to hold. But if I was looking for a high quality mix of growth and income, I’d consider my next stock.
Profits are rocketing
Shares of Chile-based copper miner Antofagasta (LSE: ANTO) rose by 5% to 1,000p this morning after reporting an 88% increase in profits for the first half of the year.
The FTSE 100 group said that earnings before interest, tax, depreciation and amortisation (EBITDA) rose by 87.8% to $1,079.8m during the six-month period as copper prices rose by 25% and sales volumes rose by 14%.
Antofagasta’s soaring profits highlight the firm’s key attractions — low costs and high profit margins. The group’s net cash costs for the period were $1.24/lb, compared with an average copper sale price of $2.72/lb. This resulted in the group reporting an impressive operating profit margin of 35%.
Free cash flow for the period was $432m, almost exactly matching the group’s half-year post-tax earnings of $455.6m. That’s a sign of high-quality profits, in my view. It enabled management to reduce net debt by 20% to $859m, while also increasing the interim dividend by 232%, to 10.3 cents per share.
Today’s upbeat figures were modestly ahead of expectations. The group’s H1 earnings of 29.5 cents per share suggest to me that full-year forecasts of 51 cents per share may be upgraded. Dividend guidance may also improve slightly.
However, Antofagasta’s rebound is basically what was expected from this company. It’s a high quality business. And that’s why it has always been an expensive stock, with a low dividend yield.
The copper miner’s shares currently trade on a 2017 forecast P/E of about 24, with a prospective yield of about 1.6%. The income investor within me would rather buy BP, but I think there’s a good chance that the total return from Antofagasta — share price gains plus dividends — could beat the returns from BP shares.
