Income investors love big dividends, but an unusually high yield could be a sign that the current dividend is unsustainable. Investors who buy solely on the basis of the yield may face huge losses as their payouts abruptly get cut and the share price falls as other investors sell out of their positions.
Like most energy shares, BP has had a positive year so far in 2016. The value of the oil giant's shares have climbed 28.6% year-to-date, thanks in large part to the modest recovery in oil prices and falling value of sterling. Nevertheless, BP underperformed many of its peers, including its larger rival, Shell, whose shares have gained 36.0% year-to-date.
Much of this underperformance has been attributed to its weaker than expected earnings this year. Its third quarter results were particularly disappointing, as BP reported a 50% fall in underlying replacement cost profits to just 4.96 US cents a share. That's despite the recovery in crude oil prices, as shrinking refining margins caused the fall in downstream earnings to more than offset the gain from the recovery in profits from its upstream operations.
As such, City analysts now expect BP to deliver adjusted earnings of just 14.6p a share this year, which gives its shares a dividend cover of less than 0.5x. With earnings not even able to cover half of its dividend, I reckon BP's 7.3% dividend yield is at risk.
However, BP's management has repeatedly said that its dividend was a priority and that there is enough financial flexibility to cope. But, then again, it wouldn't be the first time a company went back on its word and subsequently cut dividends.
Unless oil prices recover significantly above $50 a barrel, a dividend cut in the longer term may be unavoidable. While BP can cut capital investments and sell assets right now, it cannot do so indefinitely. These measures can only to taken in the short term to preserve cash, as cutting back on investments would only reduce the company's long term earnings potential and reduce its dividend cover in the future.
easyJet's (LSE: EZJ) dividend may be in better shape, though. The budget airline advised that pre-tax profits dropped 27.9% during the 2016 financial year, as revenue fell 0.4% from £4.69bn last year to £4.67bn. As a result of the fall in earnings, its dividend was cut by 2.5%, from 55.2p a share to 53.8p.
The airline blamed its weak earnings on softening demand because of "unprecedented external events", which undoubtedly included June's Brexit referendum result and a recent terror attacks in Europe. And as a budget carrier, easyJet is more heavily exposed to the fall in the number of Brits taking foreign holidays, which explains why it is doing worse than some of its rivals.
City analysts expect more bad news to come - their forecasts point towards a further fall in earnings of 20% for the year to September 2017, with a further reduction of 4% in the following year. But, given that dividend cover is more than 2.0x this year and expected to remain above 1.5x over the next two years, a further dividend cut may not be inevitable.
But it's clear that airlines are highly cyclical businesses, so I wouldn't look to invest in its shares while the cycle seems to start heading down.
A better pick for growth?
If you're looking instead for a good growth pick, then don't miss out on this free special report: A Top Growth Share From The Motley Fool.
Mark Rogers, a top investor from the Motley Fool, believes he may have just discovered a true growth gem.This stock has already delivered triple-digit returns in recent years and he thinks more growth is to come.
Click here to find out which stock we're referring to. It's completely free and there's no further obligation.
Jack Tang has no position in any shares mentioned. The Motley Fool UK has recommended BP and Royal Dutch Shell B. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.