Tabcorp plays its cards right with shareholders

Given that there is a faint shadow over the future of the dividend imputation system in the form of this year's white paper on tax reform, it will be interesting to see whether there is a sudden burst of similar activity to the capital management activities unveiled by Tabcorp today.

Alongside its announcement of a very strong lift in first-half profitability today (a 64 per cent increase to $122.4 million) and a 25 per cent increase in its interim dividend, Tabcorp also announced both a $230m special dividend and a $236m capital raising.

The measures aren't so much about capital management as they are about capitalising on Tabcorp's franking credit reserves of about $400m and rewarding shareholders without diluting its balance sheet strength.

The special dividend, which will reduce Tabcorp's store of franking credits by about $100m, is a response to demands for yield and cash-hungry investors in an increasing low-yield environment as central banks around the world, including our own, continue to force interest rates down and devalue savings.

Franking credits, while an asset of the company, are of no value to it, whereas their ability to shelter dividends makes them highly attractive and tax-efficient in the hands of shareholders.

Their appeal to top marginal taxpayers and self-managed super funds in particular will make them a target of the 'tax the one percenters' movement that will inevitably provide a stream of discussion and debate in and outside the white paper on tax that the Abbott Government plans to complete this year.

There's long been resentment towards the imputation system that Paul Keating introduced in 1987 to end the double taxation of company profits and to address the bias towards debt over equity. While the risk of change might be small, there are billions of dollars of franking credits within company balance sheets that could be rendered valueless if the system were changed.

There may not, however, be that many companies as well-positioned as Tabcorp to emulate a strategy that Gerry Harvey deployed at Harvey Norman late last year.

While at face value it might appear odd that Tabcorp is both disbursing $230m and raising an equivalent amount at the same time, the related transactions do make sense from both its shareholders' perspectives and its own.

Apart from offsetting the impact of the $230m disbursement of cash from its balance sheet with the capital raising, Tabcorp would be well aware that by increasing its capital base, the raising will also increase the amount of cash required to ensure it at least maintains its dividend.

It's perfectly placed to execute the strategy. It is strong profitable, generates big cash flows (the big charges it incurs for the amortisation of its various licences disguises how much cash it does generate) and has a share price that is at record levels.

The consistency of the earnings and cash flows that it generates from its various gambling-related businesses provides confidence that it can service an expanded capital base while its share price means that the equity it is raising isn't overly expensive.

For the shareholders, the solid majority of whom are Australian and therefore can use the franking credits, they get the increased interim dividend, the 30c a share special dividend and an opportunity to either subscribe for more Tabcorp shares at a theoretical 13 per cent discount to the ex-rights price once it is adjusted for the two dividends or to sell their entitlement to the issue. The issue is a one-for-12 renounceable entitlements offer devised and underwritten by UBS.

If there are other companies that (a) have a meaningful store of credits; (b) have a very strong share price; and (c) have sufficiently strong and cash flows to be confident they can service an expanded capital base, the template Tabcorp is providing would be compelling, given the appeal of the outcomes for their shareholders.

The shareholders can effectively turn a tax-sheltered distribution of income into a concessionally taxed investment by re-investing the special dividend via the entitlement offer.

In a market where returns are getting squeezed and the risk-reward equations are being stretched the proposition -- at least when applied to Tabcorp's circumstances -- is likely to be greeted with enthusiasm.