Scott Kelly, DNR Capital’s Portfolio Manager for the Australian Equities Income Strategy and Fund, sat down recently to explain what franking credits are, and the important role they play in a balanced income portfolio.
One of the distinguishing features of the Australian equities market is the franking credits regime. A franking credit is generated when Australian resident companies pay income tax and distribute after-tax profits through dividends. And depending on their tax situation, shareholders might get a reduction in their income taxes or a tax refund as a result of receiving the franking credit. So as such, Australia’s been a market long characterized by high dividend payout ratios, which has largely been driven by franking policy. Which is why in Australia, we have an acute focus on franking and it’s therefore a source of enhanced investor interest.
We’re commonly asked two questions, which are, which companies have the [00:01:00] most franking credits, and which companies are the most likely to use these credits to distribute cash to shareholders via increased dividends or special dividends or an off-market buyback? The largest ASX stocks in terms of both dollar franking balance and market cap are BHP, RIO and Woodside Petroleum. These stocks have generally benefited over the last decade or so from record commodity prices, strong free cash flows, and big profits. These companies have significant tax bills, which accumulate franking credits, if they’re not paid out to investors as dividends. There are many other stocks that have reasonable franking balances of more than 5% of market capitalization and good balance sheets as well. These companies include Woolworth’s, Cube Logistics and Super Retail, for example. And [00:02:00] whilst the opportunity may not be as immediate and on a lesser scale, we believe capital management will inevitably be on the agenda for these companies.
Well, there are factors that are working for and against the franking rich companies rewarding investors with cash over the next 12 to 18 months. The biggest of these likely to cause companies to hold on to credits is the economic uncertainty. [00:02:30] Obviously, the number of COVID cases and deaths in countries such as India and the new COVID variants emerging around the globe potentially diminish or delay the global recovery. The countervailing factors are of course, the successful vaccines and the accommodative monetary policy and fiscal stimulus from governments. These are softening the blow and propelling the global economy forward. So those companies that have strong balance sheets, better visibility on the earnings outlook will therefore be better placed to embark on capital management practices.
In terms of the likelihood of payments to shareholders in the short term, we think BHP and RIO are definitely the strongest candidates. Free cash flow generation for both companies is very strong and balance sheets are robust. Woolworths is expected to initiate capital management initiatives of up to 2 billion now that the Endeavor Drinks demerger is complete. And we think an off market buyback is the most likely structure in their case. And then there’s Cube Logistics, which is another company likely to distribute a fully frank special dividend to investors following completion of the sale of Moorebank in the fourth quarter of this year.
Well, BHP is currently the second largest listed company on the ASX 200 with a market cap of 145 billion. Over the last decade, it’s paid out about half of its free cash flow in the form of frank dividends. As such, the company has essentially been building franking balances estimated to be almost 20 billion or over 10% of its market value. Now, compare that to CBA, which is the largest listed [00:04:30] company on the ASX 200 and has a market cap of around 175 billion. It does have plenty of excess capital, however it’s average payout ratio over the last decade has been closer to 80%, which means CBA has been paying out most of its franking credits to investors. As such, it has a franking credit balance of around 2 billion, which is only 1% of its listed market value.
Well investor awareness of excess franking account balances held by Australian companies is certainly a theme that’s been considered and pursued by informed and diligent investors. And here at DNR Capital, our investment strategy considers this as part of our quality framework in stock selection and portfolio construction. Currently, the Australian equities income strategy is positioned to benefit from increasing payout ratios as boards regain confidence and utilize franking credits through higher dividends and capital management, which of course is rewarding shareholders in this low yield environment.
This article has been prepared and issued by DNR Capital Pty Ltd, AFS Representative – 294844 of DNR AFSL Pty Ltd ABN 39 118 946 400, AFSL 301658. Whilst DNR Capital has used its best endeavours to ensure the information within this document is accurate it cannot be relied upon in any way and you must make your own enquiries concerning the accuracy of the information within. The information in this document has been prepared for general purposes and does not take into account the investment objectives, financial situation or needs of any particular person nor does the information constitute investment advice. Before making any financial investment decisions you should obtain legal and taxation advice appropriate to your particular needs. Investment in DNR Capital Funds can only be made on completion of all the required documentation. The Trust Company (RE Services) Limited ABN 45 003 278 831 AFSL No 235150 (as part of the Perpetual Limited group of companies) is the issuer of the PDS for the Funds. An investor should obtain and read the PDS and target market determination and consider their circumstances before making any investment decision. The PDS and target market determination are available at the Fund website at www.dnrcapital.com.au/invest, or a paper copy can be obtained, free of charge, upon request by calling DNR Capital Pty Ltd (‘Manager’), the investment manager of the Fund on 07 3229 5531. Total returns shown for the Fund have been calculated using exit prices after taking into account all of Perpetual’s ongoing fees and assuming reinvestment of distributions. No allowance has been made for taxation. Past performance is not indicative of future performance. The Manager or The Trust Company (RE Services) Limited does not guarantee the repayment of capital from the Fund or the investment performance of the Fund. An investment in this Fund is subject to investment risk including loss of some or all of an investor’s principal investment and lower than expected returns.