Wednesday, December 19th, 2012
The following article by Paul Zwi featured in the December 2012 ASX Investor Update email newsletter and asx.com.au.
Over the course of 2012 we have seen an increase in the share prices of many Australian companies traditionally known for their dividend yield. The big banks and Telstra are good examples.
As the official cash rate is down to 3 per cent and the yield on 10-year Australian Government bonds is above that (in early December) it is hardly surprising that investors are searching for income-producing alternatives.
Australian companies have 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 (the true value of the company): National Australia Bank, Westpac Banking Corporation, Telstra, Treasury Group and Growthpoint Properties Australia.
1. National Australia Bank (ASX:NAB)
Despite being our least favoured bank among the Big Four, NAB does have two factors in its favour: it offers a high dividend yield of 7.5 per cent (grossed-up for franking credits 10.7 per cent) and a valuation 24 per cent above the current share price ($23.50 compared to Clime’s valuation of $29.19).
Over the past year we have preferred to avoid NAB because of its poor relative profitability, return on assets and costs-to-income ratios compared to the other big banks. NAB’s provisioning for bad debts is the lowest among the major banks, and although this may be appropriate at this point in the business cycle, it does reduce NAB’s relative flexibility should asset quality come under pressure.
NAB’s businesses in the US and UK are constraining its overall profitability and this puts NAB at a structural disadvantage to the other major banks. Nevertheless, the point has arrived where we consider these factors 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 $23.6 billion in 2012. Expectations are for sector profits to increase by around 10 per cent in 2013.
Importantly, dividends across the sector continued to increase (+4.6 per cent) to $18.7 billion in 2012, indicating that Australian bank boards are confident with their current capital positions, albeit supported by underwritten Dividend Reinvestment Plans.
Capital generation in the sector is strong and capital ratios are broadly in line with Basel III requirements. Current expectations are for sector dividends to increase around 4 per cent in 2013, and pre-tax yields continue to be attractive relative to bonds or term deposits.
Our assessed valuation for NAB of $29.19 is based on an expected normalised return on equity of 19 per cent (incorporating the benefit of franking credits) and a required return of 12.5 per cent. At the current share price of $23.50, and considering the attractive dividend yield, we calculate there is a sufficient margin of safety between the share price and the valuation to merit investment.
2. Westpac Banking Corporation (ASX:WBC)
With its origins dating back to 1817, Westpac is Australia’s oldest bank and at current prices it is the second largest 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 per cent over the year on the back of increasing housing loans. This growth in loans was outpaced by deposit growth of 9 per cent, 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 fourth year running WBC has achieved the lowest costs-to-income ratio of the Big Four. This ratio has a big impact on profits, return on equity (ROE) and Clime’s valuation.
Westpac continues to be well capitalised, with a tier-one capital ratio of 10.3 per cent. Although statutory ROE was softer for the year at 14.12 per cent, it is encouraging that CEO Gail Kelly is targeting ROE of 15 per cent 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 84 cents, a 5 per cent increase on the previous final dividend. At current prices, WBC is offering a dividend yield of 6.5 per cent (grossed-up forecast yield of 9.3 per cent). Based on our current valuation of $26.77, WBC is trading slightly below fair value levels.
3. Telstra Corporation (ASX:TLS)
A year ago Telstra was the company everyone loved to hate because of its poor share price performance over the previous decade. This year, Telstra is one of the most popular shares on the market, having delivered a very attractive dividend yield coupled with substantial capital growth as the market re-evaluated its prospects.
With its consistently high return on equity, 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 cents 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, Telstra announced revenue increased 0.8 per cent to $25.5 billion and net profit after tax (NPAT) increased 5.4 per cent to $3.4 billion for the year. Mobiles were the bright spot, with 4.6 per cent revenue growth; estimates suggest Telstra increased market share in mobiles by around 2 per cent at the expense of Vodafone. Operating cash flow (including interest expense) was strong at $8.1 billion for the year.
A number of key market events affected Telstra in the past 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 have been added over the past two years. It achieved mobile revenue growth of 8.5 per cent and margins increased by 3 per cent to 36 per cent.
- The agreement with, and shareholder ratification of, the National Broadband Network compensation arrangements was a major positive. The 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 utilising more coherently to grow its market share.
Based on its 28 cents dividend, Telstra is trading on a yield of 6.7 per cent (grossed up for franking credits 9.6 per cent). We view the business as being strong and the profitability levels attractive. Our forecast normalised return on equity is high at 40 per cent. 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 on to the shares.
4. Treasury Group (ASX:TRG)
Treasury Group Limited invests in and supports the management of small to medium-size asset management companies. TRG began its involvement in funds management in 2000 and now 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 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 on to a sizeable portfolio. Funds under management at June 2012 totalled $16.4 billion (2.3 per cent down on the previous year) and has since grown to $17.6 billion during the September quarter. Importantly, TRG is starting to enjoy positive inflows, particularly from boutiques Investors Mutual Limited, small-cap manager Celeste and global infrastructure specialist RARE Infrastructure.
Although 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 cent per annum over the next three years.
TRG is in a sound financial position with a strong and liquid balance sheet. It has a solid level of profitability and is forecast to achieve a normalised return on equity of 25 per cent. 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 per cent (grossed-up yield of 10.9 per cent).
Based on our forecast normalised return on equity of 25 per cent and a required return of 14.5 per cent, 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.
5. Growthpoint Properties Australia (ASX:GOZ)
Growthpoint Properties is an Australian-based property investment company with investments in industrial (51 per cent) and office (49 per cent) property. At June 30, 2012, it had a portfolio of 41 properties valued at $1.6 billion spread across all states, with the geographical focus on Queensland (40 per cent) and Victoria (29 per cent). GOZ enjoys high occupancy rates (99 per cent), long weighted average lease expiry (7.2 years) and no significant rental arrears.
Growthpoint’s philosophy is to be a “pure” landlord; it has 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 per cent, with intentions to reduce this to below 45 per cent in the medium term. It has no debt maturing until December 2014, with 94 per cent of interest rates on drawn-down debt hedged for an average duration of 3.9 years.
In the year to the end of June 2012, GOZ recorded a 14.1 per cent increase in statutory after-tax profit and a 58.5 per cent 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 per cent increase. The distribution was 84 per cent tax deferred with the remaining 16 per cent 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 security holders (up 4 per cent on last year).
Based on the forecast distribution, GOZ’s payout ratio will reduce to 92-94 per cent from 99 per cent for FY 2012. Directors have reduced the payout ratio because of 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 compared to industrial properties. GOZ’s policy remains to distribute as much distributable income to security holders “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 per cent.
About the author
Paul Zwi is a Director, Private Clients, at Clime Investment Management. Clime’s online valuation and research service, MyClime, assists investors in identifying companies with attractive dividends and yields. Register for a free 14-day trial.
Yields in this story are based on closing share prices on November 22, 2012.