Why Dividend Cuts Are Likely At Rolls-Royce Holding PLC, Rio Tinto plc And BHP Billiton plc

The FTSE 100 currently offers an attractive 4.2% dividend yield, but how safe is this payout?

I suspect that the FTSE’s chunky yield could fall over the coming weeks as a number of heavyweight income stocks announce dividend cuts.

Rolls-Royce to chop dividend?

According to newspaper reports, struggling Rolls-Royce Holding (LSE: RR) is expected to announce its first dividend cut for almost 25 years later this week.

The problem is that last year’s 23.1p per share dividend cost Rolls-Royce about £425m. With post-tax profits expected to fall to just £527m in 2016, this payout is starting to look unaffordable. Although the firm is thought to be keen to avoid raising fresh cash from shareholders, cutbacks are needed.

Rolls-Royce shares are down 4% today following these reports, but analysts have been forecasting a cut for some time. At the end of last week, forecasts were for a cut of about 23%, taking the payout down to 18p.

However, a number of City analysts appear to have trimmed their forecasts this morning. According to the FT, the consensus view now suggests a 30% cut to 17p for 2015, falling to 16p in 2016.

At the last-seen share price of 510p, this gives Rolls-Royce shares a prospective yield of 3.3%. This seems reasonable to me, but I don’t think there’s any rush to buy shares in Rolls. I certainly won’t be buying before this week’s results.

Mining payouts cut?

Some of the biggest contributors to the FTSE 100’s dividend yield are the big mining firms.

Rio Tinto (LSE: RIO) and BHP Billiton (LSE: BLT) have trailing dividend yields of 8.5% and 12%, respectively. But this itself is a warning that these yields are unlikely to be maintained.

The dividends paid by Rio and BHP in 2014/15 wouldn’t be covered by forecast earnings for 2015/16. Although both firms do have the financial strength to be able to support their payouts with debt, this is risky and makes little sense in my view.

Indeed, BHP chairman Jac Nasser recently hinted at a dividend cut when he told investors at the firm’s AGM that maintaining BHP’s A-grade credit rating was a top priority. Credit analysts have said recently that BHP’s progressive dividend policy could threaten its credit rating.

A dividend cut would be a big break from the past: BHP has grown its dividend continuously for nearly 30 years. Despite this, I suspect a cut between 30% and 50% is likely this year.

What about Rio?

Rio’s greater focus on iron ore has left the group in a stronger position to maintain its dividend payout than BHP. Forecast earnings for 2015 are $2.46 per share. This is just enough to cover the forecast dividend of $2.24 per share.

However, Rio’s earnings are expected to fall to $1.50 per share in 2016. As a shareholder, I would rather see Rio cut the payout now and move to a more affordable dividend policy. A sensible solution would be to switch to a policy of paying out a fixed proportion of earnings as dividends, regardless of last year’s payout.

This isn’t yet reflected in City forecasts, which currently show a dividend cut of just 5% for 2016.

Personally, I rate Rio as a buy, but I do expect the dividend yield to fall.

If you're hunting for above-average dividend yields with growth potential, then to be honest, I'd look elsewhere.

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Roland Head owns shares of Rio Tinto and BHP Billiton. The Motley Fool UK has recommended Rio Tinto. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.