Give credit to franking

Imagine if I said to you that most companies have hidden assets that aren't on their balance sheet, and some are massive in size. You'd say I'm crazy, right?

The catch is that the assets aren't worth the same to every investor and it takes proactive management for the value to be realised.

The hidden asset I'm referring to is a company's franking credits.

Ever since the imputation system was introduced in 1987, Australian companies have accumulated franking credits when they pay tax. They prevent double taxation for shareholders (for more on how they work try Franking credits made simple).

Most companies distribute them quickly; they have value to shareholders but none to the company after all. But a guilty few don't, and their shareholders are worse off for it.

Harvey Norman (ASX:HVN) is a repeat offender, having sat on over $500m of franking credits since 2008, letting inflation slowly eat away at their value. Holding franking credits worth 11% of its market capitalisation seems like a lot, and it is, but it's nothing compared to a few struggling retailers.

The share price falls of Oroton (ASX:ORL) and Specialty Fashion (ASX:SFH) has made their franking credit balances only slightly less than their market caps.

The most common reason companies hoard franking credits is because they are unable to distribute them. A lack of retained earnings needed to declare a dividend or a lack of cash needed to fund it are the main reasons. That's true for both Oroton and Specialty Fashion, but Gerry has no excuses.

Another reason is that investors overlook their value. You won't find them featuring prominently in company presentations – and they only appear in the footnotes to the annual report. It's rare to see broker reports mention franking too, even when they are as good as cash to Australian resident investors because they get deducted from their tax bill.

Because investors overlook them it means hoarders are not under pressure to pay them out, so a large slice of value goes unused.

When investors overlook a company's value, trade buyers normally swoop in. But the laws governing franking credit transfers in takeovers are complex so they're rarely a motivating factor. The only one I've seen was in April this year when WAM Capital (ASX:WAM) acquired a private investment company. Outside of tax benefits like franking credits, I can't see another reason why they would issue $32.1m of their own shares to buy a $25.5m investment portfolio. 

If you're looking for the gold standard of franking credit management then look no further than ARB Corporation (ASX:ARB).

They pay semi-annual dividends to distribute the majority of their franking like many companies do. But what makes them special is how they utilise the leftover franking credits.

Every five years ARB Corp pays a special dividend which cleans out the franking credit account. After doing so in 2005, 2010 and 2015, it will pay to mark 2020 in your calendar. Lacking cash to fund a special dividend isn't an obstacle either because they use a dividend reinvestment plan (DRP), so shareholders receive new shares instead of cash, as well as an underwriter to eliminate the risk of any shortfall. 

If you know of any other companies with good franking credit management please put them in the comments below (or other hoarders too).

The more investors focus on franking credits and push companies to distribute them the better off they'll be.