The TAMIM Australian Equity All Cap Value IMA is focused on finding investments in quality companies at a suitable margin of safety. Occasionally we are surprised to find that these investments will also offer a strong dividend yield.
Searching for Yield in Unlikely Places - 9 March 2017 -
In recent years investors have faced a difficult proposition when it comes to finding yield. Globally interest rates have fallen towards zero meaning government bonds and term deposits have lost significant appeal to the average investor. As a consequence people have been forced into riskier assets, whether it is property or shares, in order to gain income from their investments.
Thankfully on a global basis, Australian investors have had it better than most. Compared to other markets, the ASX features many companies with a yield substantially above peers. So for investors seeking yield, it has been a relatively happy hunting ground in recent years. The big four banks offer significant yields if credit conditions remain benign (something we challenged in our 2017 outlook) and Telstra has provided a gross yield of 9.5% over the last 12 months, although the 10% fall in the share price over the last 12 months offsets this (again we have questioned the sustainability of Telstra’s dividend).
The problem with investing purely for dividends is that sometimes those dividends can fall or disappear. In this regard hasn’t all been plain sailing for Australian investors with dividend cuts from the likes of IAG, QBE, Woolworths and Origin Energy in recent years. To that extent, we question whether investing purely for dividends it is a prudent strategy. Whilst dividends are an important source of returns for equity investors, unsustainable dividends are a good way of destroying capital.
So how do you take comfort that the dividends of a company are sustainable? There are a number of metrics that make sense to look at:
The payout ratio. If the company is paying out more in dividends than it is earning, that is unsustainable. If the payout ratio is high, the company is also less likely to withstand a shock.
The cash conversion of their earnings. It’s one thing to have accounting earnings but these earnings need to be backed by cash otherwise an increase in dividends with lead to an increase in debt.
The balance sheet. More highly geared companies will struggle to maintain payout ratios if earnings do not continue to grow.
Earnings growth. Those companies that can grow their earnings are more likely to be able to maintain and grow their dividends.
So all you need is a company with strong earnings growth backed by cash, a solid balance sheet and a maintainable payout ratio. It’s not much to ask really. However, when we look across the universe of Australian companies we find a number of candidates which tick a number of these boxes but fall outside of where investors might traditionally look for yield. All of these companies have a gross yield of over 4% (either on a projected forward yield or a historic 12 month basis in the case of IMF and UOS).
These companies aren’t exactly household names, so it’s worth looking briefly at the operations of each business:
Dicker Data: An IT distribution business specialising in hardware. It’s a simple business and whilst it is low margin, the company has grown significantly in recent years by winning more and more distribution agreements. The company was founded in 1978 and listed on the ASX in 2011. Since then the share price has risen from 20 cents to $2.46 with the founders David Dicker and Fiona Brown owning over 70% of the shares on issue.
Data #3: Another IT distribution business, this time in software. The company was founded in 1977 and first listed on the ASX in 1997. In recent times the company has sought to diversify their revenue base and has expanded into Services. Their service offering has become focused on assisting Small and Medium sized enterprises with their Cloud network needs.
Asia Pacific Data Centres: A REIT that was spun out of Data Centre operator NextDC in 2013. Whilst Data Centres have been a hot sector in the investing world, the property component has been largely ignored. This is the first such play in Australia and as a result has an opportunity to lead the consolidation of the sector. With a lowly geared balance sheet, we could see acquisitions of further data centres over the coming periods
Melbourne IT: An internet registry company that has expanded into IT services. Similar to Data #3, the company looks to assist companies with their cloud network solutions. By leveraging the customers of it's registry business, it now provides service across companies of all sizes, including 8 out of the largest 20 ASX companies.
IMF Bentham: Founded in 2001, IMF Bentham is the leading litigation funder in Australia. They have in recent years expanded successfully into both the US and Canada. The company has grown a significant case book and maintains plenty of financial flexibility.
United Overseas Australia: United Overseas was a company founded by two Australian educated, Malaysian born engineers. They raised $2.62m of equity on the Perth exchange and have over the years grown that into a $348m company. The company is a property developer in Malaysia, which does sound risky but when the balance sheet has significant cash and the shares trade at a 25% discount to Net Tangible Assets, there is a fair Margin of Safety in the share price. In addition, the founders of the company own the majority of the business.
Gentrack: A software company specialising in billing for Utilities and Airport management software. The company was founded in 1989 and listed on the ASX in 2014. Management have retained around 30% of the register with the remainder tightly held by institutions.
So how do these companies stack up relative to the criteria we have identified above?
The Payout Ratio
In the table below we have taken the most recent annual result - we compared the earnings per share (EPS) of each company against the dividend per share (DPS).
When we look down this table the first thing we notice is that all the dividends are covered by cashflow. For those close to 100% we need to delve a little deeper. Asia Pacific Data Centres is a REIT and as such needs to pay out distributable earnings. Their earnings are backed by long term leases and CPI increases so there is no concern around the 99% payout ratio.
Dicker Data has a payout ratio near 100% as well. This is purely at discretion of the management and it does mean that if earnings fall so will dividends. However, when we look at the listed history of the company, we are yet to see that. Both earnings per share and dividends have increased steadily each and every year.
Dicker Data Payout Ratio Analysis
Source: Dicker Data company filings
In addition the company has guided for revenue growth of 10% and dividend growth of 5.5%. This growth is backed by a number of new distribution agreements signed over the last year. Operationally the business is performing very strongly in the current environment.
In the table below we have taken the most recent full year Net Profit after Tax (NPAT) and Free Cash Flow (FCF). We then divide the FCF number by the NPAT to see what proportion of the accounting earnings has been converted into cash (FCF conversion).
Ideally you want the FCF conversion at or around 100%. In the instance above a majority of the companies are at strong levels. Dicker Data may have been a concern with their payout ratio but their cash conversion is remarkably strong. Two standout as lower than the others, Data #3 and IMF Bentham.
When we look at the history of Data #3 the last year appears to be an anomaly, typically the company’s Free Cash Flow exceeds its earnings.
Source: Data #3 company filings
So we take can some comfort that 2016 will likely be a one-off for Data #3. Particularly as the company grew earnings by 34% in the first half of 2017.
IMF Bentham is a different story, the nature of their business means that cashflows and profits will be lumpy. The company’s profit is dependent on the completion of cases and as such is difficult to predict. They do maintain a significant amount of cash on the balance sheet in order to manage the unpredictable nature of their earnings; however at times the company has cut the dividend in order to preserve capital. Investors need to be aware of this risk.
The Balance Sheet
In the table below we have gone to the most recent report from each of the companies and looked at their level of gearing. Gearing here is defined as Net Debt divided by Net Debt plus Equity.
Whilst there is a multitude of metrics we look at when analysing a company’s balance sheet the above table does a good job across this set of companies. Four out of the seven have net cash balance sheets whilst another two have gearing of less than 15%. The only concern comes from Dicker Data at 57%. However when offset by the strong cashflow seen above and the expected earnings growth, it’s not overly concerning.
In the table below we have simply taken the earnings per share growth (EPS growth) for each of the companies from their most recent report whether it was a half year or full year.
Pleasingly all these companies have reported earnings growth in recent times. The IMF Bentham number gives some idea again how lumpy their earnings can be. Elsewhere, Melbourne IT, Data #3 and Dicker Data have all benefitted from increased demand for IT services and products. In addition all three gave positive forward guidance.
Whilst the headline EPS Growth number for Gentrack is not overly impressive at 3%, we do note that revenue grew at 25%. The company has invested in a new office in the UK after winning a substantial amount of contracts in the region and has increased its research and development budget (fully expensed unlike some other software companies). These investments have driven down margins in the short term but should benefit shareholders over the long term. The company has recently provided guidance of 20% revenue growth for the six months to March 31 and has a long term target of revenue and EBITDA growth above 10%.
There is never a sure thing within investments, be it dividends or total return. However, by analysing the sustainability of a company’s dividend and assessing its future prospects we can increase our chances of both protecting capital and gaining an income stream. The companies listed above are by no means perfect but all have the combination of earnings growth as well as a strong dividend return to shareholders. As a result, we believe they are worthy of consideration within an investor’s portfolio.
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