Show me the money

During the commodity price boom from 2004-2011 BHP Billiton's board raised the firm's dividends to unsustainable levels and now in the commodity bust it has been forced to cut dividends by 75%.  Well, so what?  A firm that experienced an unanticipated surge in cash flows paid out a large part of that cash to shareholders as dividends - terrific.  That is a lot better than wasting the cash on bad projects or value destroying acquisitions.  Strident critics of BHP's dividend management need to explain exactly what the BHP board should have done with its surplus cash instead of raising dividends.

BHP announced its half yearly results on 23 February.  They painted a grim picture.  Operating profits fell by 92% to $US412 million and assets (US energy assets) were written down by $US7.2 billion.

As expected BHP's board ended its 'progressive' dividend policy which had been 'to steadily increase or at least maintain the dividend per share in US dollar terms at each financial half year.'

BHP's board has been heavily criticised for its conduct of dividend policy.  Critics have focused mainly on the type of dividend policy and timing of dividend changes.  But that misses the big picture in a cycle of boom and bust.

The performance of BHP's board and its management should be measured by the amount of shareholder value created, after controlling for factors beyond their control.  Was the windfall of cash generated in the mining boom either invested wisely, used to pay down debt or paid out to shareholders?  Or, alternatively, was it wasted on bad investments and value destroying acquisitions?  The latter has been the historical norm for global resource companies through resource boom and bust cycles.

 Figure 1: BHP uses of cash in the mining boom (Source: BHP)

Figure 1: BHP uses of cash in the mining boom (Source: BHP)

BHP's operating cash flows grew from $5 billion in 2004 to $30 billion in $2011 (all the figures here are in US dollars).  BHP responded by increasing dividends nearly sixfold, from 9.5 to 55 US cents per share in just the seven years from 2004 to 2011 (29% annual growth).  In the following four years dividends grew only another 7 cents per share (3% annual growth).

After 2011 the price of all of BHP's commodities fell; first slowly and then quickly.  Cash flow shrank to point that BHP's board was ultimately forced to choose between its 'progressive' dividend policy and its 'A' credit rating.  The credit rating prevailed.

 Table 1: Uses of cash, BHP 2004 0 2011

Table 1: Uses of cash, BHP 2004 0 2011

Debt reduction, share buy-backs, dividends:  $25 billionof the windfall of cash was used for debt reduction and $44 billion was returned to shareholders in the form of share buy-backs ($22 bn) and dividends ($22 bn)  --  a total of $69 billion.  Thank goodness for that.

Acquisitions:   BHP spent 'only' $11 billion of its cash flows on acquisitions in this period.  $6 billion on Western Mining in 2005 and $5 billion on the Fayetteville gas assets.   Another $15 billion was spent on the Petrohawk gas assets only days after the end of this period.  Unfortunately, the first half earnings announcement included a write down of the US gas assets by $7.2 billion.  But criticism of the purchase of those assets relies mainly on the advantage of hindsight.

Nonetheless, it is by good luck rather than good management that more was not wasted on expensive acquisitions - especially in BHP's failed bid for Rio Tinto in which the then CEO Marius Kloppers offered to pay at least $20 billion over the odds for Rio.  This assessment does not rely on hindsight.  It is based on the increase in the BHP share price and decline in the Rio Tinto's share price at time that the BHP bid was withdrawn.

Capital expenditure:   BHP spent the largest part of its extra cash flow on expanding production.  There is always a danger that firms that receive cash windfalls will waste the cash on low return investment projects.  For the most part BHP has not done that in this cycle.  Although, the plans for the $20 billion expansion of the harbour in Port Hedland were a very worrying sign.

After considering how BHP's windfall of cash flow was used in the boom period of 2004-2011, is it right to criticise the BHP board for paying out a large amount of cash as dividends, even if that made dividends unsustainable?

The board might have made greater use of buy-backs, especially to buy back more shares on the London Stock Exchange where BHP shares traded at a large discount to the same shares on the ASX.  It might also have declared 'special dividends', but that would have signalled that they did not believe the cash flows were permanent.

But those considerations about how cash should be paid out of the firm are not the first order issue when an unanticipated surge of cash flows occurs.  The total volume of cash paid out is what shareholders should focus on.  BHP's board should be applauded for raising dividends during the boom.  That proved unsustainable, but so what?