Mining stocks do not seem to be suitable investments for defensive dividend investors, because their earnings vary with the volatility of commodity prices. However, with mining companies paying some of the highest dividend yields in the market, dividend investors have been paying more attention to the sector. Many mining companies seem to have sufficient earnings to cover their dividends, but keeping costs and capital expenditures under control is key to preserving free cash flows.
BHP Billiton (LSE: BLT) and Rio Tinto (LSE: RIO)have invested in increasing iron ore production, even as prices fall and demand from steel-making falls. This is because both companies enjoy very low operating costs compared to the rest ofthe industry, allowing them to capture more market share and remain profitable. Although this strategy may force higher-cost producers to withdraw from the market, competitors have yet to reduce production significantly, leading to significantly weaker prices.
Having spun out its non-core assets through the separate listing of South32, BHP Billiton does not intend to rebase its dividend, which effectively raises its dividend yield to 5.8%. The company is able to do this by lowering its capital expenditures for 2015 to $12.6 billion, from $15.2 billion last year. With the continued deterioration in commodity prices, its dividend cover is expected to fall from more than 2.0x to 1.15x.
Morgan Stanley expects that BHP wont have sufficient free cash flow to cover its dividends at todayscommodity prices, as the loss of South32 would cause a cash flow shortfall of about $400 million, which would need to be funded by raising debt. Net debt to EBITDA, a commonly used measure of indebtedness, was 1.5x in 2014.
Iron ore represents 79% of Rios underlying earnings, significantly more than BHP. But Rio is looking to increase diversification, through its investment in the Oyu Tolgoi copper mine in Mongolia. Similar to Rios Australian iron ore assets, the Oyu Tolgoi mine is large scale, which means projected cash operating cost are expected to be highly competitive.
Although metal prices have fallen significantly in recent years, Rios low operating cost base has allowed it to maintain a relatively high level of profitability. But that wont stop its dividend cover falling from 2.34x to 1.15x. Rio Tinto expects to spend $7 billion in capital expenditures this year, down from $8.2 billion in 2014. This should mean that Rio wouldbe able to fund its dividend without increasing net debt, so long as the price of iron ore doesnt fall much further. The company is also the least indebtedof the three, with a net debt to EBITDA ratio of 0.64x. Rios forward dividend yield is 5.3%
Vedanta Resources (LSE: VED) is muchmore reliant on zinc than the other two mining giants, with the metal accounting for 37% of its EBITDA. The market outlook for base metals is more attractive than for iron ore. Copper, zinc and nickel markets seem to be entering a medium term supply deficit, as new mines are not producing quickly enough to meet growing demand. So, although the prices of these base metals have recently fallen significantly,we could expect to see a recovery in medium term.
But, Vedanta has net debt of $8.5 billion, which is 2.3xits EBITDA. Its rapidly deteriorating oil and gas business and iron ore production setbacks are also concerning. The company made an underlying loss of 14.2 US cents per share for the year ending 31 March 2015. Although its shares have a tempting forward yield of 7.1%, this dividend is by far the most risky of the three.
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Jack Tang has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.