We face a period of uncertainty with slowing world growth, commodity markets off the boil, a stiflingly high Australian dollar, and low levels of business and consumer confidence. Nevertheless, share investors with a rational way of valuing businesses will have the opportunity to be rewarded over time. In this article, Clime Investment Management take a look at where to find quality companies that at current prices offer attractive yields in 2013.
Reliable yield is vital
Over the course of the last year, we saw an increase in the share prices of many Australian companies traditionally known for their yield, with the big banks and Telstra good examples. As the official cash rate is down to 3.25% (at time of writing in late November) and the yield on 10-year Australian Government bonds below that level, it is hardly surprising that investors are searching for income-producing alternatives. Australian companies have also recognised the increasingly conservative nature of investors and many have been quick to take advantage by raising capital through issuing interest-bearing securities, such as corporate bonds and hybrids.
Five companies offering attractive yield
In our view, the following companies are worthy of attention in 2013 if they can be bought below their intrinsic value: National Australia Bank, Westpac Banking Corporation, Telstra, Treasury Group and Growthpoint Properties Australia.
National Australia Bank (ASX:NAB)
Despite being our least favoured bank amongst the Big Four, NAB does have two factors in its favour: it offers a high dividend yield of 7.5% (grossed up for franking credits 10.7%) and a valuation 24% above the current share price ($23.50 versus valuation of $29.19).
Over the past year, we have preferred to avoid NAB due to its poor relative profitability, return on assets and cost to income ratios. NAB’s provisioning is the lowest among the major banks, and while this may be appropriate at this point in the cycle, it does reduce NAB’s relative flexibility should asset quality come under pressure. NAB’s businesses in the US and UK markets are constraining its overall profitability and this puts NAB at a structural disadvantage to the other major banks. Nevertheless, the point has arrived where these factors are considered to be “in the price”, and the high dividend yield and large discount to valuation create an opportunity for investors.
Generally speaking, the banking sector is doing well: it has a market capitalisation of $300 billion and reported profits of $23.6B in 2012. Expectations are for banking sector profits to increase by around 10% in 2013.
Importantly, dividends across the sector continued to increase ( 4.6%) to $18.7B in 2012 indicating that Australian bank boards are confident with their current capital positions (albeit supported by underwritten DRP plans). Capital generation in the sector is strong and capital ratios are broadly in line with Basel III requirements. Current expectations are for banking sector dividends to increase around 4% in 2013. Banking sector pre-tax yields continue to attract relative to bonds or term deposits.
Our assessed valuation for NAB is $29.19. This is based on an expected normalised return on equity of 19% (incorporates the benefit of franking credits), and a required return of 12.5%. At the current share price of $23.50, and considering the attractive dividend yield, we calculate that there is a sufficient margin of safety between the share price and the valuation to merit investment.
Westpac Banking Corporation (ASX:WBC)
With its origins dating back to 1817, Westpac is Australia's oldest bank and at current prices, Australia's second-largest bank ranked by market capitalisation.
WBC recently reported full-year results that we regard as reasonable in a tough environment. Loan growth, a key driver of revenue growth, increased 3.6% over the year on the back of increasing housing loans. This growth in loans was outpaced by deposit growth of 9%, which continues the welcome trend of retail deposits comprising a larger portion of the funding base.
While costs to income increased 19 basis points over the previous year, for the 4th year running WBC has displayed the lowest cost to income ratio of the Big Four. Obviously, the lower the costs the better this ratio has a big impact on profits, ROE and our valuation.
Westpac continues to be well capitalised with a tier-one capital ratio of 10.3%. While statutory return on equity (ROE) was softer for the year at 14.12%, it is encouraging that CEO Gail Kelly is targeting ROE of 15% as a minimum in future years. To achieve this, either profits will have to grow faster than the equity base or increased dividends paid to reduce the equity base. This supports our view that a special dividend from Westpac is a distinct possibility, as the group's franking balance builds and the capital ratio remains at sound levels.
Westpac declared a fully franked final dividend of 84c, a 5% increase on the previous final dividend. At current prices, WBC is offering a dividend yield of 6.5% (grossed-up forecast yield of 9.3%). Based on our current valuation of $26.77, WBC is trading slightly below fair value levels.
Telstra Corporation (ASX:TLS)
A year ago, Telstra was the stock everyone loved to hate because of its poor share price performance over the previous decade. This year, Telstra is one of the most popular stocks on the sharemarket, having delivered a very attractive dividend yield coupled with substantial capital growth as the market re-evaluated its prospects. With a consistently high return on equity (ROE), strong market position, historically consistent dividends, and backed by robust operating cash flows, we are content to maintain a holding in Telstra and enjoy its high yield. We are comforted that management has confirmed a 28 cent dividend, at least for the next year, and view any risk to the dividend in future years beyond 2014 as being to the upside.
In its most recent results, TLS announced revenue increased 0.8% to $25.5bn and NPAT increased 5.4% to $3.4bn for the year. Mobiles were the bright spot with 4.6% revenue growth estimates suggest TLS increased market share in mobiles by around 2% at the expense of Vodafone. Operating cashflow (including interest expense) was strong at $8.1bn for the year.
A number of key market events affected Telstra in the last 12 months:
- The business and service upheaval at Vodafone caused its customers to seek a better mobile offer. This clearly benefited Telstra and added to its market share. Three million new mobile customers were added over the past two years. TLS achieved mobile revenue growth of 8.5% while margins increased by 3% to 36%.
- The agreement with and shareholder ratification of the NBN compensation arrangements was a major positive. This arrangement improves Telstra’s free cash flow and creates options for the company in capital management. With core earnings likely to be relatively flat, NBN payments will be the key driver of expected earnings growth over the next couple of years.
- The rollout of the 4G mobile network involves significant capital investment but gives Telstra a short term competitive market edge. However, it does involve significant capital investment in its early years.
- The continued push forward with bundled retail product to households is an advantage that Telstra is now utilizing more coherently to grow its market share.
Based on its 28 cent dividend, TLS is trading on a yield of 6.7% (grossed up for franking credits 9.6%). We view the business as being strong, and the profitability levels as attractive: our forecast normalised return on equity for TLS is high at 40%. Although the company’s shares are trading at a premium to our current valuation, we view the sustainable dividend yield as justifying the decision to hold onto the shares.
Treasury Group (ASX:TRG)
Treasury Group Limited invests in and supports the management of small to medium sized asset management companies. TRG commenced its involvement in funds management in 2000 and today owns stakes in various fund managers including Investors Mutual Limited, Orion Asset Management and RARE Infrastructure.
The TRG model is somewhat unique in the Australian market place and comprises a suite of support services and infrastructure aimed at supporting talented funds management teams. TRG streamlines the operations of its boutiques, allowing the investment teams to focus on achieving sound investment performance for their respective clients.
TRG recently expanded its offering with new investments in boutique asset managers Evergreen Capital Partners and Octis Asset Management.
Despite tough equity market conditions, and some pressure on underlying earnings and funds under management, TRG has managed to hold onto a sizeable portfolio. FUM as at June 2012 was $16.4 billion (2.3% down on previous year), and has since grown to $17.6 billion during the September quarter. Importantly, it is now starting to enjoy positive inflows, particularly from boutiques Investors Mutual Limited, small cap manager Celeste and global infrastructure specialist, RARE Infrastructure.
While TRG is exposed to equity market risk, this is mitigated somewhat by the company’s multi boutique model, which better equips the company to deal with differing market cycles. TRG is well positioned to leverage off the expected growth in the Australian funds management industry, forecast to grow 9% per annum over the next three years.
The company is in a sound financial position with a strong and liquid balance sheet. TRG has a solid level of profitability and is forecast to achieve a normalised return on equity of 25%. TRG has maintained the payment of franked dividends over the past decade, and this year will pay a fully franked dividend of 34 cents per share, representing a dividend yield of 7.6% (grossed up yield of 10.9%).
Based on our forecast NROE of 25% and a Required Return of 14.5%, our valuation for TRG is $4.70. An investment at current market prices provides both a good yield and leveraged exposure to the long term growth of the Australian funds management industry.
Growthpoint Properties Australia (ASX:GOZ)
Growthpoint Properties is an Australian-based property investment company with investments in industrial (51%) and office (49%) property. At 30 June 2012, it had a portfolio of 41 properties valued at $1.6 billion spread across all states, with the geographical focus on Queensland (40%) and Victoria (29%). GOZ enjoys high occupancy rates (99%), long weighted average lease expiry (7.2 years) and no significant rental arrears.
Growthpoint’s philosophy is to be a “pure” landlord, (that is, no interest in being a developer or having a funds management arm). It has a stapled entity structure with internalised management. GOZ’s objective is to provide investors with a tradeable security producing consistently growing income returns and long-term capital appreciation derived from rental income. GOZ has a fairly high level of gearing at 50%, with intentions to reduce this to below 45% in the medium term. It has no debt maturing until December 2014 with 94% of interest rates on drawn down debt hedged for an average duration of 3.9 years.
In the year to end June 2012, GOZ recorded a 14.1% increase in statutory after tax profit and a 58.5% increase in distributable profit from the previous year. The full year distribution for GOZ securities was 17.6 cents per stapled security compared to 17.1 cents in financial year 2011, a 2.9% increase. The distribution was 84% tax deferred with the remaining 16% being a concessional capital gain (tax free).
Forecast distributable profit for the year ending 30 June 2013 is between 19.4 and 19.8 cents per stapled security, of which 18.3 cents per stapled security is expected to be distributed to securityholders (up 4% on last year).
Based on the forecast distribution, GOZ’s payout ratio will reduce to 92-94% from 99% for FY 2012. Directors have reduced the payout ratio due to the changed nature of the property portfolio, particularly the increased office weighting (office properties require more capital expenditure and have greater tenant turnover, leading to increased cash requirements to fund costs associated with lease renewals when compared to industrial properties). GOZ’s policy remains to distribute as much distributable income to securityholders “as is prudent each year”.
The large spread between property yields and bond rates should continue to support the appeal of real estate investment compared with other asset classes. Offshore property investors will probably continue to be attracted to investment in Australian commercial real estate, where yields are globally competitive and the security of earnings is reasonably high, barring further significant increases in the Australian dollar.
With the cash rate under increasing pressure and bond yields close to historical lows, GOZ represents a solid income-producing alternative. An investment at the current market price is forecast to provide investors with an attractive yield of 8.5%.
By Paul Zwi
Director, Private Clients at Clime Investment Management.
Clime's online valuation and research service, MyClime, assists investors in identifying companies with attractive dividends and yield. Register for a free 14-day trial at www.clime.com.au.
Yields in this story are based on closing share prices on November 22, 2012.