By Paul Rickard

Either BHP CEO Andrew Mackenzie is going to eat humble pie and say he was wrong, or BHP really is a stock for yield hungry investors as it is pretty hard to beat a dividend yield of 6.5%, fully franked!

When BHP announces its second half results on 25 August, one thing he can’t do is to say nothing. Hundreds, possibly thousands of investors have bought or will buy BHP shares on the promise.

The promise

It is not overstating it to call it a “promise”, because BHP has been so unequivocal about it. During its first half results presentation to the market on February 24, BHP said in its opening summary that “we remain committed to our progressive base dividend”, and later said that “we are confident that we can maintain our progressive dividend policy” and finally, as the slide below shows, “our progressive base dividend is fundamental”.  “We aim to maintain or grow the base dividend every period.” No ifs and buts, no get outs, no caveats, no rebasing following the S32 demerger. 

BHP paid a dividend of US62c per share in the first half. A progressive base dividend policy implies a dividend of at least US62c for the second half, and a dividend of at least US62c for the first half of FY16. Using an exchange rate of 0.7330 and last night’s closing price of $25.89, this implies that BHP is trading on a yield of at least 6.53%, fully franked!

Can BHP honour its promise?

Last week’s quarterly operational review showed just how tough things are in the resources game. On the production front, while BHP was able to trumpet that group production in FY15 had increased by 9% over the previous year, they guided for lower production in four of the key categories in FY16 – petroleum, copper, metallurgical coal and energy coal.

Deferral of drilling and development in the US gas fields largely drives the forecast decline in petroleum, while a decline in the grade of the ore from Escondida is responsible for the fall in copper production. Iron ore is the standout – up 14% on FY 14, and forecast to reach 247m tonnes (BHP share) in FY16 as it continues to improve processing efficiency in the Pilbara.

With flat production volumes forecast, prices become even more material to the revenue picture. And unfortunately, the outlook is still pretty grim.
The following table shows BHP’s average realised price (in US dollars) for fiscal year 14, first half 15, and the half year just completed (H2 FY15). Compared to 2014, the average prices received in H2 FY15 were 49% lower for oil products, 19% lower for copper, 48% lower for iron ore, 24% lower for hard coking coal and 10% lower for nickel.

Although not directly comparable due to differences in ore/output grades, the latest spot prices don’t make for pretty reading either. While iron ore appears to have found a base around US$ 50 per tonne, spot copper, nickel, and coal prices are still well below the average prices BHP achieved in the last half.

Flat production, lower prices means lower US$ revenue. The second half of FY15 will be considerably down on the first half, and 1H FY16 is likely to be down on 2H FY15.

On the upside, the Australian dollar has weakened from an average of around 0.7700 in the 2H, to 0.7300 as we head into H1 FY16. And they certainly appear to be aggressive on the cost front – Tuesday’s announcement of 100 jobs to go from their Melbourne office over the next few years was yet another in a long line of cost initiatives.

Can BHP meet its promise? We can all see the headwinds on commodity prices (offset to some extent by a weaker Aussie dollar), while production forecasts and capital expenditure estimates are well telegraphed. What we can’t see is the cost side – and this is why it is so important that the BHP CEO tells the market whether he thinks he can deliver sufficient production efficiencies to offset the revenue fall, thereby allowing BHP to meet its promise to pay its base dividend.

What do the brokers think?

I am almost hesitant to mention this, because the brokers (as a group) have largely been bullish (and wrong) on BHP for such a long time. According to FN Arena, sentiment is positive at +0.5 (on a scale of -1.0 most negative to +1.0 most positive), with four buys and four neutrals (0 sells). The consensus target price is $30.86.
Interestingly, the brokers’ expect this year’s earnings of 124.5 US cents per share to be less than half of that achieved in FY14, and are projecting FY16 full year earnings of only 95.6 US cents per share. On that basis, BHP is reaching into reserves to pay its FY16 dividend, with a forecast payout ratio of 131.5%. Clearly, the analysts have concerns about the sustainability of the “progressive base dividend”.

How to play it

There are several wise-heads in the market who say that you never buy a mining company for a dividend, let alone one that may be dipping into reserves to pay it. However, I have never seen a company so unequivocal about its resolve to pay (and potentially increase) its dividend.

Mr Mackenzie might be a canny Scott – however I do get a sense that he is also trying to upend the old maxim that it is very hard to “shrink to greatness”.

Bottom line – it really comes down to what BHP says on August 25. If they maintain their commitment to the progressive base dividend, back them and get out the cheque book. If the promise is subsequently broken, join me and the thousands of others who will be queueing up to see the class action lawyers.

In the meantime, there are no signs yet to suggest that the commodity bear cycle is over – so maybe you have a nibble in market weakness. Target under $25.00.

Disclosure: The author and his SMSF own BHP shares.