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. 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.
As such, Australia has long been a market characterised by high dividend payout ratios, largely driven by franking policy. This is why, in Australia, we have an acute focus on franking and it’s a source of enhanced investor interest.
At DNR Capital, two common questions we get asked are: ‘which companies have the most franking credits up their sleeve’ and ‘which are most likely to use these credits to distribute cash to shareholders via increased dividends, special payments or an off-market buyback?’
The largest ASX stocks in terms of both dollar franking balance and market capitalisation are BHP, RIO and Woodside Petroleum. These stocks have generally benefited from record commodity prices, strong free cash flows and big profits. These companies have significant tax bills which accumulate franking credits if not paid out to investors as dividends.
There are many other stocks that have reasonable franking balances of greater than 5% of market capitalisation and good balance sheets. These include Woolworths, Super Retail and TPG Telecom. 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.
In terms of likelihood of payments to shareholders in the short term, BHP and RIO are definitely the strongest candidates in our view. Free cash flow generation for both companies is significant and balance sheets are strong. Woolworths is also expected to initiate capital management initiatives of up to $2bn to investors, following the completion of the Endeavour Drinks Group demerger in June. We think an off-market buyback is the most likely structure in this case.
However, there are currently 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 onto the credits is economic uncertainty.
Escalating COVID-19 cases and deaths in countries such as India and the new COVID-19 variants emerging across the globe, potentially diminishes or delays the global recovery.
The countervailing factors are successful vaccines and governments’ accommodative monetary policy and fiscal stimulus. Both have softened the blow and are propelling the global economy forward. Those companies that have strong balance sheets and better visibility on the earnings outlook, will be better placed to embark on capital management practices. And we place BHP at the top of this list.
With a market cap of ~$140bn, BHP is currently the second largest listed company on the ASX200. Over the last 10 years, it has paid out about half of its free cash flow in the form of franked dividends. As such, the company has essentially been building franking balances, estimated to be ~$17bn (or ~12% of its market value).
Compare that to CBA, which is the largest listed company on the ASX200 and has a market cap of ~$160bn. Its 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 ~$2bn of franking credit balance available or ~1% of its listed market value.
Investor awareness of the excess franking account balances held by Australian companies is certainly a theme that is being considered and pursued by informed and diligent investors. At DNR Capital, our investment strategy considers this as part of our quality web. Currently the DNR Capital Australian Equities Income Fund and strategy is positioned to benefit from increasing payout ratios as boards regain confidence and utilise franking credits, rewarding shareholders in a low yield environment.
The ASX DNR Capital Australian Equities Income Portfolio invests in listed securities with a style-neutral focus on companies included in the S&P/ASX 200 offering sustained income growth. The Portfolio aims to outperform the S&P/ASX 200 Industrials Accumulation Index and deliver higher levels of income (before fees) over a rolling three-year period.