Given Its Financial Strength, BP Should Pay Its Dividend in Stock Rather Than Cut It

The main reason value investors may be willing to take a stab at BP plc (BP) stock after a nearly 40% drop since the rig explosion is their financial strength. BP earns about $20 billion per year and has a net debt to capital ratio of less than 20%. Combine very profitable operations and a strong balance sheet with plenty of borrowing capacity and you can see why even an ultimate liability of $15-$25 billion over the next several years could be absorbed by the company.

Given that these situations usually turn out to be buying opportunities, I have begun to accumulate small positions in the stock for some of my clients, even though I admit the ultimate financial impact is unknowable at this point. The company’s financial strength coupled with the $70 billion market value loss so far give me enough of a cushion to take a position so long as it is part of an otherwise diversified portfolio.

With the failure of the “top kill” procedure and news that relief wells likely will not be completed until August, there are renewed worries about the sustainability of BP’s dividend, which at $3.38 per share ($10.6 billion) annually stands at about 9.25% right now. Given that BP’s operations are still throwing off tons of cash and the company has only spent about $1 billion in the first five weeks of this disaster, cutting the dividend does not seem like a necessary step to take from the cash preservation perspective. Still ,with political pressures mounting, BP may not want to pay out billions of cash to shareholders until this spill is under control.

I think that makes sense from a PR perspective,  but BP should really consider paying out their dividend in stock rather than choosing to cut it for PR purposes. Such a move would succeed in padding the company’s cash hoard (which stood at $8 billion as of March 31st) and silence any critics who would be angered if the company paid out cash to shareholders before fixing the hole and paying for the cleanup. After this spill is contained, BP’s underlying profitability will be unchanged and any dividend cut would be reversed anyway. Some banks shifted to stock dividends in late 2008 and early 2009 and it worked very well. Such a move would both silence the critics and preserve precious cash, but the shareholders would not be completely left out in the cold. It simply makes more sense to do that rather than take on more debt and pay interest on the additional borrowings or sell certain assets that are the key to BP’s future success.

Full Disclosure: Peridot Capital was long BP at the time of writing, but positions may change at any time.