Despite the almost 19% increase in its stock price since the beginning of the year, BP's (BP - Get Report) dividend yield of 5.4% is still attractive. But the giant integrated oil company will still face some headwinds.
After having paid $52.7 billion over the last several years for damages related to the Deepwater Horizon oil spill, BP will still have to pay about $2 billion in 2019 and $1 billion every year until 2032. Also, management preferred to finance the $10.5 billion acquisition of BHP's U.S. onshore assets with debt and asset divestiture instead of share issuance.
That signals management thinks the company isn't overvalued. But it also increases the leverage as gearing (defined as the ratio of net debt to the net debt plus shareholders' equity) increased to 30.3% compared to 27.4% in 2017. And even with the recent rise in oil prices, the pre-2015 prices above $100 per barrel are still a remote possibility.
With this context, let's estimate the sustainability and the growth potential of the dividend.
Reducing Debt FirstAfter the 2.5% increase in July 2018, BP's dividend represented a cash outflow of $8.1 billion last year. The company proposed a scrip dividend alternative but management indicated a share buyback program would offset the dilution it implies. Thus, to simplify, I assume the dividend is fully paid by cash and there's no dilution.
The $8.1 billion dividend was well covered as the 2018 underlying operating cash flow, BP's measure of profits, amounted to $12.7 billion. Even if we take into account the exceptional costs (reorganization, Deepwater Horizon payments, etc.), the $9.4 billion of profits covered the dividend as well.
Also, during the Q4 earnings call, management indicated the organic cash break-even was at around $50 per barrel on a full dividend basis. In simpler language, that means the profits cover the dividend at a Brent oil price of about $50 per barrel. And with the five-year plan announced in 2017, management expects the dividend to be covered by Brent oil prices in the range of $35 to $40 per barrel by 2021.
With a Brent price above $70 per barrel at the time of writing this article, then, there's room for the dividend to grow. But considering the level of debt and the gearing ratio target, I don't expect any meaningful dividend increase in 2019. Instead, management will focus on reducing net debt.
Due to the cash outflow from the Deepwater Horizon payments and the BHP acquisition, BP's net debt increased by $6.3 billion in 2018. With net debt of $44.1 billion, gearing exceeded 30% at the end of 2018 against a medium-term goal of 20% to 30%.
However, with a diminishing break-even oil price and lower gearing, the potential for a dividend increase in the next few years is important. Also, management expressed its confidence in growing the pretax free cash by 40% to 50% from 2021 to 2025.
Valuation Is Reasonable
Considering its growth potential and current oil prices, a PE ratio of about 16 is reasonable for BP. Also, the market values BP at a fair price compared to other major oil companies.
The chart above shows BP's higher leverage compared to its peers; it confirms BP needs to reduce its net debt. Also, the dividend yield is in the high range of the peer's dividend yields. Thus, the company doesn't need to increase its dividend in the short term to offer a competitive return to dividend-oriented shareholders.
"The cash flow dynamic gives us increased confidence in BP's ability to maintain its dividend payout, a key factor supporting shares against any downturns in commodity prices and a crucial consideration for our income-oriented members," said the team for Jim Cramer's Action Alerts Plus Portfolio, which owns BP.
If you are a dividend-oriented investor, investing in BP for its dividend yield is an interesting proposition. Because of the company's level of debt, I don't expect any meaningful dividend increase in 2019. But with the decreasing break-even oil price, the dividend is safe from reductions. And considering the expected growth in free cash flow over the next few years, there's potential for dividend increases in the medium term.