High dividend yields are tempting to income investors, but they could also be a sign of potential dividend cuts. To differentiate between the value plays from the dividend traps, investors need to look at the sustainability of dividend payments.
Common methods of assessing sustainability include using earnings and free cash flow coverage ratios. But it is also important to look at the strength of the companies’ balance sheets, their longer-term fundamentals and underlying sector trends.
Rio Tinto
Rio Tinto (LSE: RIO) currently pays a dividend yield of 5.8%. Of the large mining companies, Rio has the best earnings and free cash flow coverage ratios. Its 2015 dividend should be covered by 1.1x earnings, but its free cash flow shortfall is expected to be at least $2 billion this year.
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With a net debt to underlying EBITDA ratio of 0.64x, Rio also has one of the strongest balance sheets in the industry. The company’s low level of indebtedness means it can absorb the shortfall in free cash flow even if commodity prices fall further. But, with growing excess supply situation in the iron ore market, the outlook for iron ore prices is very unattractive. Even though Rio may cope with lower iron ore prices over the medium term, low iron ore prices could persist for even longer.
Glencore
Glencore (LSE: GLEN), the diversified miner and commodities trader, has attractive exposures to base metals. The outlooks for copper, nickel and zinc are better than those of other commodities, because demand growth is expected outstrip supply growth in the medium term.
Glencore currently has a dividend yield of 5.6%. Its 2015 dividend is just about covered by its projected earnings. With stable cash flow generation from its commodities trading business and cuts to its capex plans, Glencore should also have no shortfall in free cash flow in 2015. Nevertheless, we may not have seen the bottom for Glencore’s shares, as commodity prices could fall further with slowing growth in China.
Aberdeen Asset Management
Aberdeen Asset Management (LSE: ADN) has a current dividend yield of 5.1%. Analysts expects its dividend will grow by 9% this year to 19.6 pence, from 18.0 pence in 2014. This implies prospective dividend yield of 5.4%. For 2015, estimates suggest its dividend will be covered by 1.6x earnings, and free cash flow cover of the dividend is projected to be 1.7 times.
Despite recent net outflows from Aberdeen, the outlook for the asset management industry is very optimistic with the introduction of the government’s pension reforms. Asset managers stand to gain from higher retail cash inflows as pensioners are no longer required to purchase annuities.
Ashmore
Ashmore Group (LSE: ASHM) pays a higher dividend yield of 6.1%. Its earnings and free cash flow coverage ratios for 2015 are projected to be 1.2x and 1.3x, respectively.
Like Aberdeen Asset Management, Ashmore also has a heavy exposure to emerging market assets. Although emerging markets are likely to stay out of favour with investors in the near term, the worst of the net outflows seems to be over. In the longer term, Ashmore’s long-term track record with managing emerging market investments should reward the company when investments flow back into emerging markets.
Conclusion
Because of the better longer-term fundamentals for the asset management industry and stronger dividend coverage ratios, Aberdeen Asset Management and Ashmore Group seem to be resemble value plays. Although Rio Tinto and Glencore’s dividends seem secure in the medium term, the weak outlook on commodity prices could mean their shares have further to fall.
