Where will companies spend their cash?
By and large, the balance sheets of corporate Australia are in great shape, and for shareholders this means a bonanza with either higher dividends, buybacks, or mergers and acquisitions (M&A) in the second half of 2021.
At WaveStone, we rate companies on their Sustainable Competitive Advantage (SCA) score, and we also expect our companies to allocate capital to maximise returns over the long term.
In order to provide some insight into what companies are doing with our capital, we’ve broken the Top 100 companies up into four sections – resources, financials, domestic industrials and international industrials.
RESOURCES
With double-digit yields, the iron ore miners BHP, Rio and Fortescue look very enticing!
However, the share prices will move in line with the near-record iron ore prices. Unlike in the last iron ore boom, mining companies are far more disciplined with their capital which should see the iron price stay elevated above US$100 ($136 million) until further supply comes in a few years.
The miners have strong balance sheets and fixed capex plans so will pay special dividends and consider buybacks on-top of what’s delivered via their payout ratio-based guidance. In simplistic terms, we expect 90% of net profit to be distributed. For Fortescue and Rio, these returns are likely to be via fully franked dividends, whilst for BHP we expect a combination of a special dividend and off-market Australian buyback and on-market English buyback with the final form determined by the prevailing PLC/LTD discount and size of the program.
Outside of this, we do not expect significant capital returns for the energy sector and metals stocks given their growth aspirations.
Table 1 looks at the potential dividends the miners could pay over the next two halves to utilise some of their substantial franking credits.
FINANCIALS
In FY20, the major banks increased provisions, expecting the $240 billion of deferred loans (as at June 2020) across the sector to result in a bad debt cycle, as the economy went into a COVID- induced recession.
At the height of the crisis Westpac and NAB issued equity, however due to the easing of interest rates and the large Government stimulus programmes, bad debts have been substantially lower than expected.
Banks have also been selling non-core assets like wealth management and insurance which we liken to ‘shrinking to the core’ as they become more focused on Australian banking. Hence all four major banks are sitting on surplus capital above the regulatory minimum plus a buffer.
Therefore, we expect the banks will start to increase dividends and launch ongoing buybacks. Of course, banks will continue to support the economy during lockdowns and the size of the capital returns will depend on the rate of loan growth, but this is the potential.
As bank share prices have bounced, we think they will opt for off-market buybacks at a discount to the prevailing share price, to utilise surplus franking credits. A potential scenario for each bank could look like this, but we do note that ANZ is more likely to pursue an on-market buyback (due to its low franking credit balance) whilst the Commonwealth Bank and NAB should do both.
On the M&A front, Citibank Australia’s retail assets are for sale and we expect one of the major banks to buy. This follows Bank of Queensland purchase of ME Bank and NAB’s of neobank 86400. The insurers are still recovering from elevated claims in 2020 and low interest rates which are affecting investment returns. The fund managers are in growth mode preferring to expand offshore with Macquarie, Perpetual and Pendal buying US-based asset managers in the last 12 months. Yields remain healthy for the financial sector and we would expect growth in dividends for FY22.
DOMESTIC INDUSTRIALS
Purely domestic-focused companies (excluding the financials) include infrastructure, telecommunications, utilities, property and supermarkets. The infrastructure sector has been hit harder than most by COVID-19. We would normally consider this sector as a defensive asset class, however it looked anything but as the pandemic unfolded, as movement restrictions reduced the utilisation of toll roads and airports, significantly impacting their cashflows.
As vaccines roll out, movement restrictions are reduced and borders gradually reopen, 2022 should see the beginning of a cashflow recovery for these assets.
Transurban (TCL) distributions reflect changes in traffic flow but are amplified by operational and financial leverage. The market is expecting a proportionate increase in traffic of a little over 10% across their portfolio in FY22, bringing traffic back to 5% below where it was in FY19. This should result in a 57¢ distribution or 4.2% yield at current prices. TCL has a surplus capital position having recently sold 50% of its US roads for $2.8 billion and regeared some of its Australian assets. However, the upcoming sale of the remaining 49% of WestConnex by the NSW Government, means this capital is likely earmarked for this $5 billion transaction, as opposed to being returned to investors.
Woolworths has recently demerged its liquor and gaming operations, Endeavour, and has been a beneficiary of COVID-related online and at home food consumption which sees its balance sheet able to entertain a $2 billion buyback. Telstra is cashed up after selling a 49% interest in its towers business and is also promising buyback of $1.3 billion on top of its 4% yield.
INTERNATIONAL INDUSTRIALS
At WaveStone, we prefer to see Australian companies that have substantial operations offshore predominantly utilising capital to grow their business organically or via bolt-on acquisitions. In the last six months, there has been a number of these.
Healthcare companies focused on a strategy of organic growth including spending on research and development as well as expanding capacity include CSL, on flu vaccines and plasma processing. Resmed, Cochlear, Fisher and Paykel, and CSL spend between 7% to 11% of sales each year on research and development (R&D). CSL also invests heavily with $1 billion per annum on manufacturing capacity, to allow capacity growth to drive sales higher in future years.
Interestingly we are seeing ‘shrinking to the core’ from Boral as it has sold its share of the USG Boral JV to Knauf for $1.3 billion. They have bought back 7% of a total 10% of its equity whilst Seven Group grows on its register to >30%. Boral has also sold its US Building products for $2.9 billion, which will be largely returned to shareholders via a buyback or capital return. With a current market capitalisation of $8.5 billion – that will be 30% of its equity back via buyback or some form of capital returns.
Another company that has continued to invest in R&D and bolt-ons is Aristocrat. Despite operating in an industry hit by hard by the pandemic, they are now in a stronger market position than pre-COVID, given management continued to invest heavily in design and development (11% to 12% of sales). This is well ahead of their competitors, and we believe this sets up Aristocrat for long term sustainable organic growth. M&A remains a real option for the company. With low gearing, Aristocrat can leverage its expertise as a content and distribution company into iGaming which is now legal in several US states.
WaveStone continues to focus on companies that allocate capital appropriately to generate long-term returns for shareholders. We regularly meet with board and management teams to ensure that they are focused on growth and if not, are returning capital to shareholders. We believe Australian companies, with a few exceptions, are allocating capital wisely.
Catherine Allfrey is principal and portfolio manager at WaveStone Capital.
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