Caution: This Yield Appears to Be Unsustainable

Piyush is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Editor's Note: The initial version misstated BP's dividend yield. This version has been corrected

It’s a good strategy to create an income-growth portfolio, to ride choppy market conditions. But not all companies have sound fundamentals to sustain their dividend payouts. Companies which outstretch the financials to lure investors with lucrative yields, often end up with spoiled balance sheets. Hence it’s always advisable to pick companies with sound fundamentals that can sustain their dividend payouts, rather than blindly going for the highest yielding stock. The companies under my radar are BP (NYSE: BP), Chevron (NYSE: CVX) and ExxonMobil (NYSE: XOM).

<table> <tbody> <tr> <td> <p>Company</p> </td> <td> <p>Yield</p> </td> <td> <p>Payout Ratio</p> </td> </tr> <tr> <td> <p>BP</p> </td> <td> <p>5.00%</p> </td> <td> <p>30.16%</p> </td> </tr> <tr> <td> <p>Chevron</p> </td> <td> <p>3.26%</p> </td> <td> <p>27.98%</p> </td> </tr> <tr> <td> <p>ExxonMobil</p> </td> <td> <p>2.56%</p> </td> <td> <p>21.99%</p> </td> </tr> </tbody> </table>

The above table lists the yields and payout ratios, and a new investor might pick Chevron for its highest yield. However, these numbers don’t guarantee their dividend payout sustainability, and new investors shouldn’t be fooled by the numbers.

Dividend Analysis of BP

Beginning with BP, the company has been selling off its non-core assets under a divestment program to raise around $38 billion. Its total asset sales now stand at around $35 billion, and the company expects to complete its divestments by the end of 2013. Its management announced that the company would now be focusing on high margin oil production, and the recent divestments would allow the company to reallocate resources, and focus on its core competencies to achieve its long term goals. Talking about its projects, management stated that it has 15 projects under development, out which 11 are high margin oil projects. The operations of these projects are expected to commence by 2014.

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BP Free Cash Flow data by YCharts

The company ended the third quarter with $10.9 billion in cash balances, and its long term debt/equity comes out to be a modest 35%. Over the last 5 years, oil prices have decline due to weaker global demand, which justifies the drop in cash flows and net income as shown in the above chart. The thing to note here is that its dividend payouts have declined more than its net income, and its cash balance has grown by 232.8% over the same period. This indicates that the company won’t be having any problems with its dividend payouts.

Dividend Analysis of Chevron

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CVX Dividend data by YCharts

However that’s not the case with Chevron. Its cash and cash equivalents have risen by nearly 160% and its dividends have been raised by 55.17% over the last 5 years. Though its payout ratio of 28% seems sustainable, one should note that its net income has remained flat. These metrics indicate that the board believes in returning value to its shareholders and its net income is flat due to higher payouts and lower oil prices. Moreover its debt/equity ratio equates to a meager 9% and in my opinion, Chevron also appears to be a good income investment.

Reasons to Avoid Exxon

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XOM Free Cash Flow data by YCharts

ExxonMobil seems to have a disappointing set of metrics altogether. Even though its debt/equity ratio stands at 7% and the company pays out a modest 22% of its earnings, its cash and cash equivalents have shrunk by a massive 68%. Moreover its net income and free cash flows have also declined, but the company managed to increase its dividends by 42.5%.

For an overall healthy growth, a company needs to report growth in its revenues, earnings and margins, but the absence of these growth figures should discourage income investors. I believe that we could be looking at dividend cuts in the near term future. Moreover, analysts at Goldman Sachs downgraded its shares, citing that its ROCE is deteriorating and the company lacks positive triggers to power up its stock.

​A Short Conclusion

In my opinion, BP and Chevron appear to be good income investments, and the rising crude prices would further bolster their EPS growth. However I also believe that ExxonMobil should be avoided, due to ordinary performance, with deteriorating fundamentals.

PiyushArora has no position in any stocks mentioned. The Motley Fool recommends Chevron Corp. The Motley Fool owns shares of ExxonMobil Corp. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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