Should Royal Dutch Shell’s £47bn bid for BG Group go ahead, that figure is likely increase somewhat, assuming of course, that Shell continues to pay out a similar level of dividends as it has historically.
Shell of course is of the view that it will continue to pay a dividend, going as far as to announce its intended dividend for this year and next: $1.88 per share. However, it did say that gearing will increase to 20% on a 2014 pro-forma basis and it intends to prioritise debt repayment after completing the transaction.
Analysts and fund managers are divided as to the firm’s prospects post the transaction. As my colleague Alex Sebastian points out, Fidelity’s Michael Clark, manager of the Fidelity MoneyBuilder Dividend Fund sees no danger of Shell changing its dividend policy as a result of the deal.
Matthew Beesley, head of global equities at Henderson Global Investors, is less convinced, however, pointing out that as a result of the deal Shell will be taking on a portfolio of “potentially riskier assets” and making a “bold strategic bet that oil prices will recover towards the $70-90 level in the medium term”.
“In the interim, Shell is taking on more risk and in issuing more shares and also in paying out cash to BG shareholders. As a result their balance sheet will become more stretched. And this potentially puts some strain on this dividend as they redirect cashflows to paying down debt ahead of growing the dividend,” he said.
Cover concerns
While the sheer size of the BG deal pushes Shell almost into another league, the concerns raised about its dividend and particularly its dividend cover can just as easily be laid at the door of many other firms with high dividend yields.
Ian Kelly, co-manager of the Schroder Global Equity Income Fund points out that high dividend yields in the UK market are concentrated in a few large stocks with low dividend cover.
During a presentation in London on Wednesday morning, Kelly added that there are a very small number of mega stocks propping up the market dividend and, “high yield with low cover can be a dangerous combination”.
As can be seen from the graph below, not only is there a concentration at a stock level but there is also a steep drop off in dividend cover as yields increase.
While almost half of those companies paying a dividend between 3 and 4% have a more than two times dividend cover, that falls sharply to 16% for stocks yielding between 4 and 5% and to zero for stocks with a dividend yield above 5%.
As Nick Kirrage, co-manager of the Schroder Recovery Fund explained at the same presentation, while a low dividend cover is not necessarily cause for concern, “The old-fashioned, historical rule of thumb was that a firm should be able to pay out around half of earnings in dividends. By that measure, these companies are probably paying out more than they should.
Jeremy Hall, manager of the TM Cartesian Absolute Alpha Fund agrees that dividend cover is a concern.
“There are some in the market that are in effect baking in special dividends into their expectations of normal dividends. This is worrying because if there is a downturn, the first thing to go will be special dividends.”
Hall points too to the difference between growth in dividends and growth in earnings per share, as companies, in an effort to remain attractive to yield-hungry investors have pushed dividends ever higher.
Source: Cartesian Capital Partners LLP / Bloomberg
He says: “Mid and large-caps are expensive at present and more risky than the market believes.”
Silver lining
But, while concerns have been raised, particularly in those areas of the market that have been chased up by investors searching for yield, the prospect of dividend cuts could be a blessing in disguise say the members of the Shroders value team.
As Jamie Lowry, co-manager of the Schroder Global Equity Income Fund points out, one of the best sources of dividend growth is companies that have seen a dividend cut.
“Markets react negatively to a dividend cut, but what we have found is that those companies that make amends see their dividends grow faster than the market.”
That is not to say that all dividends are at risk, or, indeed, that there is not value on display in the market. But, it is likely that dispersions are going to increase from here, with some stocks continuning, while others disappoint
There is no way to know for certain exactly how Shell’s bid for BG will turn out; if it happens, the enlarged group will be the world’s biggest non-state owned oil producer and a significant player in the FTSE 100.
But, what it does do is highlight once again just how large these firms are and how big a part of the income world they are. And, given how intent markets are on their mad dash for yield at the moment, stopping and pausing for breath every now and then might just be a good thing.
