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BHP's Results Helped by Rising Iron Ore Price But Variable Dividend Policy Muddies Income Outlook

BHP is the largest mining company in the world. The firm extracts and processes iron ore (63% of EBITDA), copper (20%), petroleum (10%), and coal (9%).

Commodity businesses generally have little control over the selling price of their products and must invest heavily to secure and extract new resources.

Coupled with their high fixed costs and operating leverage, firms such as BHP can experience major swings in earnings from one year to the next, making it harder for them to pay predictable dividends.

In 2016, BHP acknowledged these challenges by implementing a flexible dividend policy tied to the performance of its business.

Specifically, BHP targets a minimum dividend of 50% of underlying profits. The board can also return additional cash beyond the 50% payout mark if it desires to.

This policy is why we have assigned BHP a Borderline Safe Dividend Safety Score. Investors should expect BHP's dividend to fluctuate over a full economic cycle as its earnings ebb and flow.

Iron ore is BHP's most profitable business, so iron ore prices play a key role in the dividend's short-term direction.

Iron ore prices have surged roughly 50% since late April, driven by disruptions to global supply and China's economic recovery (a major consumer of steel, which uses iron ore).

This development has buoyed BHP's overall business despite the pandemic. The company's latest earnings report on August 18 showed underlying profit dipped only 4% in the year ended June 30, 2020.

BHP's balance sheet also remains in good shape with net debt at the low end of the firm's target range and an investment grade credit rating.

However, the firm's payout ratio was already well above its 50% minimum target level. 
Source: Simply Safe Dividends
As a result, management on Tuesday declared a semi-annual dividend payable in September 2020 that's about 15% lower than the last payment made in March 2020.

Even still, this will keep BHP's trailing payout ratio near 70%, recognizing the company's overall financial strength which made management comfortable parting with cash above the 50% minimum payout ratio level.

Barring an unexpected improvement in BHP's earnings (analysts expect EPS to fall 13% in the year ahead), investors shouldn't be surprised if the firm's semi-annual dividend drifts lower over the next year.

BHP's resources remain critical to the global economy, even as it evolves its portfolio, but shareholders should understand that its dividend will fluctuate any given year due to the unpredictable nature of commodity markets.

That's not necessarily reason to sell, but now could be a good time for income investors who prefer more stable payouts to revisit their investment in BHP since shares have rallied strongly alongside rising iron ore prices, which may prove unsustainable as supply returns.

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