Woodside Now A Yield Play; BHP And Rio Next?

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– Woodside hands out dividend presents
– Brokers question implications for growth
– Woodside will now out-yield the banks
– Fresh pressure on BHP and Rio?

By Greg Peel

There are two things we can claim to be certainties in the stock market of 2013. Firstly, Australian investors, and investors the world over, are chasing yield in a low global interest rate environment. Witness Australian banks which, by any metric, are overvalued in the eyes of analysts yet which continue to be price-supported due to attractive, fully franked yields. Secondly, investors in Woodside Petroleum ((WPL)) have had every cause to be frustrated by the company’s share price performance.

Earlier this week, Woodside announced a special dividend of 63cps on an ex-dividend date of April 30 and, more notably, a lift in intended dividend payout ratio to 80% of underlying profit for the next “several” years. The company previously attempted only to exceed a 50% payout.

Resource sector companies, at least in Australia, are not meant to be “yield stocks”. Utilities, telcos, property and infrastructure funds are all yield stocks. Mining and construction service companies with ongoing maintenance contracts are yield stocks. Banks, which simply use money to make money, are yield stocks. Supermarkets, with their staple cash flow businesses, are considered as yield stocks. In each case, earnings are relatively stable, relatively defensive, and do not normally offer runaway growth opportunities.

Resource sector companies, including oil & gas companies, are cyclicals. Their fortunes rise and fall with the global economy, and with the rise and fall of commodity prices. They offer risk, in the form of exploration gambles, enormous capex spend on major projects, and stiff global competition for their wares. While legacy operations such as iron ore in the Pilbara or LNG in the North West Shelf can offer reliable earnings streams, higher risk means higher volatility of earnings, and thus a reluctance to tempt the market with high capital returns. Resource sector investments are meant to be attractive for their growth potential, such as Queensland CSG LNG, not for their dividends. Resource sector companies need to hang on to their retained earnings to smooth out cycles and to invest for growth.

Arguably the most popular yield stock in Australia is Telstra ((TLS)), which offers around a 6% fully franked yield at present on a 90% payout ratio. Given a relatively wide range of forward earnings expectations for Woodside from different brokers, the 80% payout suggests forward yields over the next three years of 6-7%. Given Woodside’s vast pool of franking credits, these dividends are fully franked. Commonwealth Bank ((CBA)) is another yield darling of the market at present. It is currently offering a little over 5% in forward dividends, fully franked.

If you were holding Woodside shares ahead of Tuesday’s announcement you probably would have uttered one word when the news broke: Woohoo! A high yield stock with growth options? Utopia. Prima facie, Woodside shareholders suddenly look like big winners instead of sorry losers. But the story is not quite that simple.

Woodside has several growth options offering potential in the LNG space. The company would not be able to pursue all of them. Rising costs and the strong currency have also conspired to make growth options more tenuous in their economic viability, particularly given the extent of capex required to be deployed over a number of years of project ramp-up. Woodside’s Pluto LNG project is now delivering solid cash flows, providing funds which could now be deployed on one or more growth projects or on acquisitions of existing projects. But international competition is fierce. In a world of risk, delaying or deferring major projects has now become necessary. The same problem has beset the big miners BHP Billiton ((BHP)) and Rio Tinto ((RIO)), both of which have now shelved major tier one project developments in favour of steady-as-she-goes earnings generation from developed projects.

Earlier this month Woodside announced it was deferring the construction of a massive LNG processing and export facility at James Price Point for its Browse LNG development project in WA. Browse has thus been delayed. In February, on the release of the company’s 2012 earnings report, Woodside management told investors the company would endeavour to return capital to shareholders if projects were to be deferred or delayed. The announcement of the Browse delay thus sent stock analysts into a frenzy of speculation. Would Woodside, or would it not, now return capital? [See Will Woodside Return Capital?]

Consensus suggested the company would. However opinions were divided on whether it should, how much it might return, how long it would wait to return the capital, and whether the return would be meaningful or merely “token”, to appease long suffering investors. On a rough basis, half the brokers in the FNArena database suggested a decent return was likely, albeit maybe not until later in the year. The other half either saw a token return or simply questioned whether a return was in any way sensible. Virtually all brokers suggested a special dividend would be unlikely, and that a share buyback was clearly the most sensible option.

More than one broker pointed out an element of “be careful what you wish for”. Were Woodside to return retained earnings to shareholders, the implication would be that growth options would be off the table. Woodside management is faced with a dilemma. Either the company takes bigger risks on project sanction or expensive acquisitions, or the company forsakes such deals as imprudent and returns capital to shareholders instead. The second option may be prudent, but the trade-off is a lack of investment and therefore future growth.

Woodside has chosen option two. The up-front special dividend may be one thing, but the 80% payout ratio may imply diminishing actual dividends over time as earnings growth stagnates.

Deutsche Bank likes the deal. While management has suggested the 80% payout will be in place for “several” years, Deutsche is assuming three. Management has not set the payout in stone, rather it will remain unless growth options such as project sanctions or acquisitions are approved in the future. The analysts still see material future growth value for the company in Browse FLNG, Sunrise, Leviathan and offshore Myanmar.

BA-Merrill Lynch has interpreted the news more negatively, suggesting the new capital return policy implies Sunrise and Leviathan are unlikely to progress over the next two years and that the M&A market is too competitive in which to be contemplating acquisitions. Woodside’s net production will thus decline over two years and any earnings growth would be reliant on Pluto LNG price negotiations and oil price movements, the broker suggests. (LNG contract prices are indexed on a scale to the oil price.) Aside from delaying Browse, Woodside has also ceased any talk of a second train at Pluto, at least for now.

Credit Suisse would have preferred a buyback to a special dividend. Goldman Sachs suggests the dividend is “prudent”, but like Merrills is assuming the decision means there will be no sanction decisions on big LNG projects over the next two years and no acquisition attempts. Goldman also points out, nevertheless, that the policy is flexible and the payout could be reduced if the right project came along.

JP Morgan believes a special dividend is the “next best thing” to the buyback the analysts had expected. JP Morgan joins others in assuming the new policy implies the next wave of growth projects will not come within the next three years. Will three years of high yield be enough to sustain investor interest until growth options reemerge down the track? The analysts applaud the decision to be pragmatic with capital returns and not engage in a chase for high risk growth, or just sit on cash, but the decision does highlight the issue of a declining production profile, they note.

“We can provide little comfort to those who fear Woodside may be left behind in a growth-driven rally,” say the analysts, “other than to note the company's healthy oil price exposure and prospects for positive LNG contract repricing over the next few years”.

Macquarie does not beat around the bush. Woodside’s new dividend policy is “simply not sustainable”, the analysts warn, noting the company’s reserve life has already fallen from 25 years in 2007 to 17 years today, with the prospect of further declines ahead. For Macquarie, the fact Woodside’s share price jumped 10% on the day of the announcement suggests the market is only looking at the dividends themselves and not at the reasons behind the new policy. The analysts feel that while dividends over risky growth imply discipline, management is only pandering to a yield-hungry market mood.

CIMB is as blunt as Macquarie. “Woodside’s yield might be favourable,” the analysts suggest, “but in our view it isn’t sustainable. We rate the stock Underperform into the structural, decade-long de-rating we foresee”. If the company sticks to this capital return policy, production could fall some 25% over the next ten years, CIMB declares.

The dilemma, therefore, is not just for a company caught between not wishing to blow money on risky growth and needing to appease shareholders one way or the other, but for shareholders having to decide whether a very attractive yield from the outset will look nearly as attractive with no growth prospects ahead. An 80% payout of diminishing earnings means diminishing dividends.

Then there is the small matter of Shell’s 23% shareholding in Woodside, which has hung like a dark cloud over the stock for some time. Brokers agree that a yield-play Woodside is not as attractive to Shell as a growth Woodside, and what’s more the foreign company does not enjoy franking benefits. The risk may now be heightened, therefore, of Shell deciding to dump its stake.

Citi is another warning of the yield/growth dilemma, but the only broker in the FNArena database to have changed its rating since the Woodside announcement. Citi has downgraded to Neutral from Buy, to provide two Buy, five Hold and one Sell (or equivalent) ratings. Prior to the announcement, the consensus price target sat at $39.20 but has since fallen to $38.63, in contrast to the fact Woodside shares jumped 10% on the day of the announcement and are up another 4% since. The new target suggests only 0.3% upside.

It is interesting to note that over the past two days, both US oil & gas giants Exxon Mobil and Chevron have announced increases to their dividend payments. Exxon increased its dividend by 10.5% to provide a 2.8% yield, remembering that the US cash rate is as good as zero (and effectively negative given QE) while the Australian cash rate is 3%. Chevron then trumped Exxon with a dividend increase to take its yield to 3.4%. Clearly the yield story is a global one, not just an Australian one, although it must be noted that Chevron has increased its dividend every year for 26 years.

While a 6-7% yield for Woodside puts it ahead of the banks and Telstra, and despite resource sector companies not being traditional yield stocks, the average oil & gas stock yield in Europe is 5%, Merrills notes, with some companies exceeding Woodside in yield. Those dividends are not however necessarily covered by free cash flow, the analysts add.

It is also interesting to note that as soon as Woodside made its capital return announcement, speculation was triggered as to whether BHP and Rio would have to bow to the pressure and do the same. Like Woodside, BHP and Rio have deferred risky big-ticket project proposals and reined in their capex programs. When these announcements were made, analysts and shareholders similarly wondered whether a special dividend or some other form of capital management would be forthcoming as a result. But instead, both companies simply threw their shareholders a bone.

Both increased their dividend payout ratios, a la Woodside, but neither paid out a special. The payouts rose to 50% for BHP and 35% for Rio – well short of Woodside’s 80%. Given the world-wide trend of improving yield for shareholders, might BHP and Rio now feel the pressure to further up the ante?

UBS thinks not. While all three are resource sector companies, the two diversified miners are very different to the oil & gas major. BHP and Rio have reined in their wild ambitions, but they still have growth projects underway, such as iron ore expansions, which are sucking up capex and will do so for a while yet. BHP is carrying 31% gearing and Rio 25%. Between spending and interest payments neither company will generate much in the way of free cash flow over the next twelve months, which rather rules out further capital returns. Both BHP and RIO are nevertheless looking into non-core asset sales, the proceeds of which could well go toward one-off capital returns. The problem is that the assets both are looking to unload are those less valuable to either, but thus also to potential buyers.

Merrills agrees. Cash flow will be “skinny” in 2013-14, the analysts note, as both companies attempt to “live within their means”. Both must maintain strong balance sheets in order to prevent credit rating downgrades. Capex on existing projects will begin to run off eventually, but not really until 2015.

Furthermore, BHP and Rio both run “progressive” dividend policies rather than “loose” policies, Merrills points out. Rather than chopping and changing depending on immediate circumstances, both attempt to slowly grow dividends over time.

So investors shouldn’t be waiting with baited breath for any new announcements from the diversified miners. And they should evaluate the message being sent by Woodside beyond what might prove to be a brief visit from the Mr Whippy van.

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