|Summary: Australian shareholders are missing out on billions of dollars in dividends as a consequence of many companies choosing to store up their franking credits, most typically for internal spending purposes. In essence, these companies are not acting in the best interests of their investors.|
|Key take-out: Retailer Harvey Norman is retaining the highest proportion of franking credits as a proportion of its market capitalisation – it has almost $660 million in stored credits, representing a ratio of around 19%.|
|Key beneficiaries: General investors. Category: Shares.|
Many of Australia’s major companies are hoarding record amounts of franking credits, even as corporate earnings prospects continue to improve.
Collectively, there is at least $100 billion of franking credits being hoarded across the market, and the top 15 account for almost $30 billion.
Research conducted by Eureka Report has discovered the worst offenders out of the larger blue-chip stocks on the ASX. Shown in the table below, they are ranked in descending order by the ratio of franking credits to their market capitalisation. Standouts include Harvey Norman (HVN), Tabcorp (TAH), Reece Australia (REH), Woodside Petroleum (WPL) and Santos (STO).
Franking credits amass as a by-product of lower payout ratios and by cash not being released back to shareholders, such as through special dividends or share buy-backs.
Franking credits are valuable to shareholders because they raise the value of dividends. While a $1 dividend is only worth 76 cents to an investor at the highest marginal tax rate, it’s worth $1.21 to a super fund paying 15% tax and $1.43 to a retiree with a pension as they can claim a refund from the Australian Taxation Office for the franking credits they can’t use.
“For companies not to manage their franking credit pool sensibly and intelligently is not ultimately being responsible, and not ultimately acting in the best interests of their shareholder base,” says Frank Villante, Chief Investment Officer at Celeste Funds Management.
While a large proportion of these franking credits had built up in the drive to conserve earnings during the global financial crisis, the economy has since stabilised and sentiment has been improving for some time. Further, earnings upswings are likely over the coming months (see Adam Carr’s Four reasons for an earnings upswing).
Companies with large franking credit balances should consider releasing them to shareholders, but it depends on their outlook and whether they have a strong enough cash flow, says Michael Heffernan, Senior Client Advisor at Lonsec. Further, companies with high capital expenditure, like in the resources sector, might have cause to reinvest their earnings in growth.
Villante disagrees. He believes companies can pursue growth and deliver franking credits to shareholders at the same time.
“There’s nothing wrong in a company paying out a special dividend with franking credits attached and then having a rights issue to take in an equivalent amount of cash,” he says. “The costs in that whole process are pretty minimal relative to value that you can impart to the shareholder base.”
Regardless, when it comes to the offenders whose franking credits make up a substantial portion of their market caps, some have more acceptable explanations than others for not releasing value that rightfully belongs to their shareholders.
Retail giant Harvey Norman has infamously withheld franking credits from its shareholders for years.
The company’s franking credit balance has climbed from $466 million in 2007 (the year Harvey Norman’s share price soared to a record high of $7.15) to $660 million in 2012-13, reaching levels of around 20% of its market cap.
The credits have built up due to a dividend policy that typically pays out the lower end of between 50-70% of the company’s net earnings. Instead, capital has been devoted to buying properties and expanding operations overseas.
In comparison, the franking credits of rival retailer JB Hi-Fi (JBH), which runs almost as many stores, makes up just over 4% of its market cap. It has a higher payout ratio than Harvey Norman as it has chosen to rent its properties rather than buy them, and its operations are confined to Australia and New Zealand.
Co-founder and chairman Gerry Harvey, who owns 30% of Harvey Norman, wants to see a more robust return to profit before he begins releasing franking credits to shareholders. The retail sector has endured sluggish growth over the past few years due to low consumer sentiment and the assault of online retail, which Harvey Norman was late to join in on.
However, consumer sentiment has improved since the federal election and Harvey Norman enjoys high exposure to the revitalised property market through its household goods.
“Maybe over the last couple of years with Harvey Norman it was precautionary, but now they should be giving more consideration to reducing the balance,” Heffernan says.
This may be unlikely. Where a dominant shareholder controls a company the interests of smaller shareholders are often not fairly represented, unlike in companies where institutional shareholders hold large stakes and can influence management decisions more.
Tabcorp’s franking credits have lifted to $349 million – to 13.3% of its market cap – over the past few years as the company battles with a series of structural challenges.
Net profits fell 13% this year following the loss of Tabcorp’s duopoly with Tatts Group over poker machines in Victoria. Tabcorp is in the process of suing the Victorian Government for $686.83 million on the basis it was guaranteed a payment from the government when its 18-year licence expired.
Dividends were cut to 19 cents a share this year from 24 cents, even as the payout ratio jumped to 81% (excluding the write-off of Victorian Tabaret goodwill) from 50.9%.
In the previous two years Tabcorp has also had to find its footing after demerging with Echo Entertainment (EGP), which was a strong source of operating cash flows for the business.
Another challenge has been online gambling’s astonishing growth. Like Harvey Norman, Tabcorp was late to adapt and has lately poured capital into transitioning the business into the space.
Management says it will consider distributing franking credits once it can generate enough surplus cash. Though Tabcorp is highly geared at around 80%, the business is steadying.
“Our 2012-13 initiatives have substantially de-risked Tabcorp and have created a clearer agenda for 2013-14 and beyond,” said chief executive David Attenborough at the end of last financial year.
Ian Curry, chairman of the Australian Shareholders Association, says Tabcorp has a fairly predictable business now and thinks franking credits aren’t being released due to excessive caution more than anything else.
“They’ve got to find ways to release franking credits, like through a special dividend,” Curry says.
Franking credits take up almost 12% of Reece’s market cap, even after the plumbing and bathroom supplies business added more than $600 million to its value in recent weeks.
The market darling has surged 15% to $31.05 since announcing late last month that pre-tax profit is expected to be 5-7% above the previous period for the six months to December despite expecting tough economic conditions to persist. Its share price had already been running hot, with investors drawn to the company’s solid return on equity performance over the past few years.
But the stock now appears expensive, with a price-earnings ratio at around 25 times, and may be due for a correction, as John Abernethy points out in Is Reece’s hot share price overheated? Abernethy has an “underperform” recommendation on the stock.
One way Reece could sustain investor interest is by releasing some of its $363 million of franking credits to the market through a higher payout ratio coupled with a share buy-back or special dividend – as Woodside did earlier this year.
At the moment Reece’s strong cash flows have been used to invest heavily in new retail sites and business acquisitions rather than being released as dividends; usually around 50% of retained earnings are paid out to shareholders.
Interestingly, like Harvey Norman, Reece’s major shareholder owns a large stake in the company and runs the business. Alan Wilson, whose family owns 70%, is the chairman, and his son Peter is chief executive.
Woodside accumulated over 11% of its market cap, or around $3.6 billion, in franking credits by the end of 2012.
The oil and gas producer had been paying its shareholders roughly half of its retained earnings while shoring up the other half to develop large-scale projects.
But with its decision to shelve the $40 billion Browse LNG project in Western Australia in April, Woodside cut capital expenditure and freed up its cash flows. Shortly afterwards the company announced a special dividend of US63c a share and targeted a payout ratio of 80%, which it expects to remain in place for several years.
“These initiatives reflect the board’s commitment to disciplined capital management and desire to distribute additional franking credits to our shareholders,” said chairman Michael Chaney.
Investors welcomed the changes. On the day of the announcement the stock surged 9.7% – its biggest increase in four and a half years – to $37.96. It broke through $39 on November 14, and is still trading above $38.
The interim dividend paid out in late September was up 28% on the previous year’s to 83 cents a share, and analysts expect the final dividend to increase by the same amount.
Santos’s franking credits climbed to $931 million as at the end of 2012, just over 6% of its market cap, which is reasonable given the company has been investing heavily into its part-owned PNG and Gladstone LNG projects.
However, with development in Gladstone over 65% complete and PNG over 90% done, cash flows are set to surge as capital expenditure winds down and revenue ramps up.
“Going out to 12-18-24 months, the case could be made cash flows could increase substantially, where credits might be released to the market,” says Shih Thing Wong, portfolio manager at Prime Value Asset Management. “But it’s all predicated on how LNG negotiations and LNG projects progress.”
In fact, in the company’s half-year report this year, chief executive David Knox said that management intends to review capital management options as the company closes in on PNG LNG production.