ConocoPhillips (COP) is one of the biggest oil producers in the world and the newest case study regarding the dangers of chasing yield (the stock had a dividend yield of 7.7% as of yesterday evening).
Despite its $45 billion market cap, $2.4 billion in cash on hand, and single-A credit rating, COP slashed its quarterly dividend from $0.74 per share to $0.25 per share, representing a 66% reduction. The stock’s yield just fell from 7.7% to 2.6% (using yesterday’s closing stock price of $38.63 per share), and a theoretical $10,000 investment in COP will see its annual income generation drop from about $770 to $260.
Even worse, income investors that chased COP are sitting on another 2% capital loss this morning as the stock has traded off on the news (COP is down 18% YTD). Chasing yield is a dangerous game, and dividend investors need to remember that we are still playing a total return game where income and price matter. To avoid riskier dividend stocks, income investors might be interested in reviewing our earlier article reviewing how to find safer dividend stocks.
Fortunately, we did not own COP in any of our dividend portfolios because it had one of the lowest Dividend Safety Scores in our database with a score of 17 (scores of 50 are average, 75 0r higher is excellent, and 25 or lower is risky). To better understand the safety of a dividend payment, we believe prudent investors must look at a handful of key metrics, including a company’s payout ratios, free cash flow generation, cyclicality, and balance sheet.
As a commodity company, COP required extra scrutiny. Commodity companies are notoriously capital-intensive, often carry high debt loads to fund their operations, generate less predictable free cash flow, and have little to no control over the selling price of their products.
If these businesses overextend themselves during peak operating conditions (e.g. taking on debt to fund major growth projects, acquire a competitor, or repurchase), they can be in for a world of pain when their markets inevitably but unexpectedly cycle down. The timing is almost never good.
With the oil market, this is exactly what happened. OPEC (Organization of the Petroleum Exporting Countries), the largest and lowest-cost group of oil producers, decided to flood the market with supply to take market share back from higher-cost North American shale oil producers. Tepid demand and a flood of incremental supply is a recipe for disaster in any commodity market and oil has been no exception, falling over 70% from its 2014 peak.
No one knows when oil prices will recover or the price they will recover to. However, higher cost producers with extended balance sheets and less diversified businesses are feeling the noose tighten around their necks.
Why did COP have to cut its dividend? Let’s take a closer look at the company’s financials.
Through the first nine months of 2015, COP generated approximately $6 billion in operating cash flow. The company’s capital expenditures totaled $7.9 billion over this period, resulting in a free cash flow drain of about $1.9 billion. COP also paid out about $2.7 billion in dividends during this period. Once dividends are added in, COP’s cash flow drain reaches $4.6 billion through the first nine months of 2015.
When a company is burning through cash, it will not be able to survive longer term unless it either (1) has a boatload of cash reserves on the balance sheet; (2) improves its profitability or capital efficiency; (3) issues equity; (4) issues debt; and/or (5) sells off assets, which only goes so far.
In the case of COP, its cash on hand ($2.4 billion) isn’t enough to even cover the amount of dividends it paid out and is hardly above the $1.9 billion free cash flow loss the company reported.
Profitability improvements also appear unlikely because COP’s margin is mostly impacted by the price of oil. The company is slashing its spending and working hard to reduce its production costs, but the 70% drop in oil prices is hard to offset, especially depending on the quality of a company’s oil reserves and the regulatory environment it operates in. Furthermore, COP is more impacted by lower oil prices because it has no downstream operations after it separated from Phillips 66 (PSX). Downstream businesses are performing very well in this environment and providing a bit of a cash flow hedge for integrated producers such as ExxonMobil (XOM).
With little cash on hand and operating cash flow unable to even cover capital expenditures, much less the dividend, COP needed to sell off non-core assets and tap debt markets to keep the game going.
COP did issue $2.5 billion in debt through the first nine months of 2015, but its balance sheet was reaching increasingly dangerous levels. As seen below, COP had nearly $25 billion in debt compared to $2.4 billion in cash. In 2014, the company only managed to generate $1.25 billion in free cash flow, or about $1 for every $3 in dividends it paid out that year.
Source: Simply Safe Dividends
At some point, banks become less willing to lend to distressed businesses, especially on favorable terms. However, companies will always make interest expense and debt principal payments before paying a dividend.
In COP’s case, we can see that reducing the dividend would free up several billion dollars in cash flow each year, which the company could desperately use during this period of distressed oil prices. Poor cash management, weak cash flow generation, excessive leverage, and dependence on unpredictable commodity prices ultimately drove COP’s dividend cut.
Despite the turmoil impacting energy markets, we actually own two oil companies in our Conservative Retirees dividend portfolio. Unlike COP, however, each of these businesses generated positive free cash flow in 2015 (even excluding asset sales) and have much better production cost profiles and diversification.
While practically no oil company’s dividend will be safe if $30 oil prices persist for the next five years, we expect these two producers to be some of the last ones standing if it comes down to that (we don’t expect it will).
For investors seeking safe dividend stocks, reviewing some of our favorite blue chip dividend stocks and the lists of dividend aristocrats and dividend kings are good places to start. And remember – high yields are more often than not high for a reason, especially with cyclical, indebted commodity stocks.
Interesting analysis. I would be curious what your analysis would have been each year between 2010 – 2013.
Best Regards,
Dividend Growth Investor
Hi DGI,
Thanks for stopping by and commenting. Our scores started last year, but I imagine COP would have looked quite favorable during 2010-2013. At the end of 2010, COP had around $10 billion in cash on hand (vs $2.4 billion today) and about $23.5 billion in total debt (vs $25 billion today). It was also generating plenty of free cash flow to comfortably cover the dividend in 2010-11 (44% FCF payout in 2010; 57% in 2011 – both excluding proceeds from asset sales). During those years, the only major ding against the company would be its participation in a cyclical industry, which could cause its payout ratios to suddenly double during an unexpected time of distress (e.g. earnings get cut in half, and COP’s payout ratios would exceed 100%), and a minor flag for the high amount of debt. Even still, I imagine it would have scored at least average for dividend safety in light of stable sales and earnings trends.
Not surprisingly, what really set off the alarm bells was when COP’s sales and earnings started to drop by double-digits in late 2014. By the summer of 2015, COP was no longer generating free cash flow and had seen its cash balance drop to $3.8 billion compared to debt of about $25 billion and annual dividend payments of about $3.6 billion. As a commodity company, this raised additional concerns given the amount of macro luck that can impact near-term financial results – it could help COP or lead to even worse things, which is what played out. It also made the company increasingly dependent on asset sales and credit markets to keep the dividend (and itself) afloat.
Of course, it’s easy to explain these things looking back and focusing on just one stock / Dividend Safety Score – there’s a saying about hindsight vision being 20/20 for a reason!
I certainly didn’t intend for this piece to come off as a chest-thumping endorsement of Dividend Safety Scores, and I apologize if it did – there is certainly no such thing as a fool-proof quantitative scoring system, and each business has a unique set of operating qualities. However, I have enjoyed using the scores myself as a gut-check and for quickly cluing me in on issues that I might want to give greater consideration to when it comes to protecting my portfolio’s income.
Thanks again for your comment, and I enjoyed reading your analysis on COP as well. Keep up the great work.
Best Regards,
Brian
Thank you for your thoughtful reply. The place where things are a little murky is what happens to a stock that looks great, but then fundamentals decline. This is perhaps where I was going with my question, rather than trying to attack your work, which is very good.
I usually hold if fundamentals look soft – sometimes the fundamentals slow down temporarily and then bounce back and selling would have been a mistake.
Other times however, fundamentals keep deteriorating, culminating in a dividend cut. In those cases, selling early would have been smart. But then the risk would have been whipsawing yourself in and out of stocks.
Perhaps, this is why people say that investing is part art, part science.
You are absolutely right. Your article today was great on that very topic. Generally speaking, I prefer to hold if fundamentals soften as well. With 90-day reporting periods, anything can happen. While nothing should be completely ignored when the market is telling you that you might be wrong, it’s hard to argue that 90 days of business is representative of a business with 90 years of operating history in some cases.
It gets really murky with situations like an IBM – is its long-term earnings power permanently impaired? IBM is still generating plenty of free cash flow to use to reinvent itself, but is it likely be successful? The industry seems to be changing at a faster pace than ever before. These judgement calls are very hard to make, and I think you nailed it – part art, part science.
Thanks,
Brian
Commodities are a risky business… It’s all cycles and waves… The good times are always better than expected, and so are the tough times, like right now…
No one could have predicted sub $30 oil, but here it is today… I think the writing was on the wall with COP, which is why I took out a big short position prior to today’s cut.
The problem is too many retail investors chase yield and don’t even bother looking at the balance sheet… KMI, COP, etc…
Even with a stock like CVX, investors become so infatuated with the “safe yield” that they justify these type of companies taking on debt to keep funding their unsustainable dividends. At $30 oil, there’s no reason why CVX shares should be trading close to $90… In 2011, that was the stock price when oil was ~$100!
Don’t fall so in love with dividends that you neglect reality! At some point, the market will care about 30% to 50% decline in revenues, negative EPS, etc.
Further, a company will never give you ample warning until it’s too late.
If you’re going to play commodities, I would focus on the companies with the strongest balance sheets and the ones who can make the most of this difficult period by being nimble enough to snatch up assets for pennies on the dollar. That’s how you really build long-term value for shareholders, not by paying out dividends as you continue selling off your own assets! Companies like COP cannot even afford to buy right now b/c they have no cash to invest with! And no one wants to blow out their share structure at 52 week low share prices either…
It really sucks for income investors b/c the shares are gonna get further decimated and the income has already been slashed by over 60%!
You really have to pay attention to macro events when it comes to commodities. Further, more than any sector, you have to buy low and sell high… COP is a buy ~$25 post dividend cut, NOT when it was over $50 with a “8% dividend”.
Hi FI Fighter,
Thank you for your thoughtful comment. You are absolutely right about commodities – they cut both ways, and leverage only magnifies things. Chasing yield on these stocks is one of the riskiest moves an investor can make, however great the temptation might be.
One of my favorite George Soros quotes come to mind when dealing with the cycles commodity stocks go through:
“It does not follow that one should always go against the prevailing trend. On the contrary, most of the time the trend prevails; only occasionally are the errors corrected. Most of the time we are punished if we go against the trend. Only at an inflection point are we rewarded.”
Thanks,
Brian
This article shocked me. I had no idea COP cut their dividend. That’s huge news. It seems like we are really starting to see the impact of the long term depression of oil prices. COP may be the first of many large companies to cut their dividend if these low rates persist. A lot of dividend investors like myself and unlike you own a lot of oil companies and are probably sitting on the edge of their seat waiting for the per barrel price to rise. My focus is mostly on the larger oil companies vs. the spec/niche companies, so I feel a little better than others.
Bert
Hi Bert,
Thanks for stopping by. If oil remains below $45 a barrel for the next year, the worst is likely yet to come (from a dividend perspective). Will be interesting to see how much pain Saudi Arabia is willing to take and how quickly North American production / inventories begin to decline. I am especially weary of the equipment suppliers – seems like another major capex cut from the big oil companies happens every week.
Thanks,
Brian