If you were to list your top 10 dividend-paying stocks, I can probably guarantee that oil and gas producer Santos Ltd (ASX: STO) would not make the cut.
But what about top 20? No? Top 50??
It's understandable. If volatile oil prices weren't enough to put you off, then the billions of dollars of capital expenditure probably would be. Additionally; Santos lacks the extra allure of a dividend set in U.S. dollars which Woodside Petroleum Limited (ASX: WPL) offers.
However consider this: Santos is about to commence the strongest period of production in the company's entire history, while the share price is at decade lows. Paying a current (trailing) dividend yield of 4.4%, let's take a closer look and see how Santos' dividend really stacks up.
Dividend Policy and Performance
Santos has in place a 'progressive' dividend policy which aims to increase distributions to shareholders as cash flows grow from its new projects. These are the 13.5% stake in the Papa New Guinea (PNG) LNG project, which started production in 2014, and the 33% stake in the huge GLNG joint venture in Queensland which is expected to start production later this year.
The dividend policy still allows for debt repayments and for ongoing investment to grow the company which makes sense.
Santos has a strong history of dividend payments and despite spending billions on its key capital projects has paid steady dividends over the last five years.
| 2010 | 2011 | 2012 | 2013 | 2014 | |
| Total Revenue (billions) | $2.306 | $2.803 | $3.289 | $3.651 | $4.099 |
| Capital expenditure* (billions) | $1.791 | $2.918 | $3.191 | $3.978 | $3.508 |
| Annual dividend(cents per ordinary share) | 37 | 30 | 30 | 30 | 35 |
Source: Santos 2014 Annual Report. *Excludes exploration
In 2014 a strong first half result saw the dividend increase, but the impact of falling oil prices in the second half of the year resulted in the board maintaining the final dividend, bringing the total year's dividend to 35 cents per share (cps), fully franked.
Show us the cash flows!
Operating cash flows are crucial for the payment of dividends. Santos' exposure to lower oil prices will drive lower operating cash flows going forward, despite the strong growth over the last five years.
Above: Santos has achieved a positive stepping up of operating cash flows over the last five years. Source: Santos Shareholder Review, 2014.
The oil price fall will be partially offset by rising production and by a 10% reduction to production costs going forward. Santos forecasts production growth of up to 18% for the full year 2015 (FY15) to as much as 64 million barrels of oil equivalent (mmboe).
The most important aspect for dividends are free cash flows. Free cash flows are what is left over after capital expenditure and tax to potentially pay to investors.
After the completion of the GLNG project capital expenditure expected to drop 44% to $2bn in 2015 and Santos has noted that at US$60 per barrel the company will be free cash flow positive by the fourth quarter of 2015.
That's great news for investors, but here's the catch: Santos still holds a sizeable debt position. Santos has gearing (net debt divided by net debt plus equity) of around 44%, so although only small amounts of debt are set to come due before 2017 any free cash directed towards debt means less cash to pay out to investors.
Summary
I would rate Santos' dividend report card as a 'B-'. Beyond 2015, if the price of oil rises along with production and lower capital expenditure Santos could be producing high free cash flows for investors. A large chunk of this will likely be used to pay down debt, but with an expected shortfall in LNG from 2020, Santos could be a long-term winner for investors willing to take some risk.
