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Morningstar unearths the dividend plays for a covid-19 world

Emma Rapaport  |  29 May 2020Text size  Decrease  Increase  |  
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Just when you thought dividends from reliable sources were drying up, financial services company Link Administration Holdings and funeral home operator InvoCare Limited are poised to grow theirs by 2021.

Link (ASX: LNK) and InvoCare (ASX: IVC) are among a handful of stocks forecast to offer attractive yield even as companies slash dividends at a rate not seen since the global financial crisis, according to a special report by Morningstar analysts.

Link withdrew its guidance in late March, citing the unprecedented challenges COVID-19 and the ensuing market volatility. However, Morningstar analyst Gareth James notes that over 80 per cent of the group's revenues is recurring.

He also believes the federal government’s decision to allow people in financial distress to access their superannuation will benefit Link's retirement and superannuation solutions divisions, allowing the company to deliver increased payouts to shareholders.

"[This] is likely to mean significant additional work for Link on behalf of its clients," he says.

"At this stage, the extent of this revenue boost is too uncertain to incorporate into our forecasts, but it could potentially boost group revenue by around 2 per cent."

 Morningstar Premium members can download the full report (PDF), including dividend outlook for all companies under Morningstar coverage.

InvoCare, the giant behind nearly 40 brands including White Lady Funerals and Guardian, has had coronavirus-induced troubles of its own. It has deferred its dividend in April until it better understands the impact of COVID-19 and in the interim is asking investors to pitch in $200 million. 

While social distancing and smaller funerals weigh on pricing, Morningstar analyst Mark Taylor says there has been minimal impact to case volumes, as the number of deaths is broadly following long-term averages.

Analysts believe both companies will grow dividends in fiscal 2021 over fiscal 2019—with some franking and attractive dividend yields to boot.

Dividends disrupted

Morningstar’s new report comes as Australian investors face a dividend void, with blue chips ditching or deferring their dividends in an effort prioritise the survival of their businesses over distributing predictable cash payments to their shareholders.

As global GDP contracted and cities slowed to a standstill, companies with high levels of operational gearing feared a material impact on profitability, and in some cases, even solvency. The ability to cancel or delay dividends offered boards an important source of funding to preserve the balance sheets or avoid a dilutive equity raising.

Almost a quarter of the Australian companies under Morningstar coverage cut, cancelled, suspended or deferred their dividends since the coronavirus fallout hit markets in late-February. And it's not just within one industry. Dividend suspensions have been widespread.

Notable mentions include three of the big four banks as well as Westfield mall owner Scentre Group (SCG), which shelved its first-half dividend after a collapse in shopper numbers caused by lockdown measures, Ramsay Health Care (ASX: RHC), Qantas (ASX: QAN) and Harvey Horman (ASX: HVN).

Westpac (ASX: WBC) followed the lead of smaller rival ANZ (ASX: ANZ), which deferred paying shareholders an interim dividend after posting a 62 per cent slide in its first-half cash profit due to the COVID-19 hit. Meanwhile, Australia’s largest business bank, NAB (ASX: NAB), has also made a $807 million provision for coronavirus losses and slashed its dividend by 64 per cent to 30 cents per share.

Even recent asset sellers sitting on excess cash have decided to err on the side of caution. A case in point is building products supplier Fletcher Building (ASX: FBU), which has cancelled its interim dividend.

American business magnate John D. Rockefeller famously said the only things that gave him pleasure was to see his dividends coming in. Australian investors who subscribe to this philosophy have seen better days.

Board action on dividend payouts in 2020

 Click to see the full list of ASX200 cuts 

dividend changes

Source: Morningstar analysts, ASX Announcements. Data as at 21 May 2020.

Australian companies aren't alone in their decision to suspend or cut dividends. Oil industry giant Shell (AMS: RDSB), which paid out $15 billion to shareholders last year, has cut its payout for the first time since 1945. In the US, the roster of corporations cutting or suspending their dividends includes General Motors (NYS: GM) and rival Ford Motor Co (NYS: F), industrial bellwether Boeing and entertainment giant Walt Disney (NYS: DIS).

And the risk of further dividend cuts "isn’t off the table", says Morningstar director Johannes Faul. Despite the gradual easing of restrictions in Australia and overseas, uncertainty reigns as businesses continue the feel the economic impact of the COVID-19 restrictions on movement. Almost half of Australian businesses surveyed by the Australian Bureau of Statistics (ABS) in mid-March said they had experienced an adverse impact as a result of COVID-19.

A handful of businesses have withdrawn their dividend/distribution guidance – primarily in the real estate sector. This includes residential real estate investment trusts such as Mirvac Group (ASX: MGR) and Stockland Corporation (ASX: SGP). A-REITs saw a huge uptick in investor interest in 2019, likely resulting from the hunt for yield as the Reserve Bank of Australia cut the cash rate to record lows.

Blow to income investors

The Australian market has a reputation for high levels of dividends so the growing list of companies suspending dividends is a blow to income investors who rely on the payouts as a tax-effective cash flow source.

Since May 2000, the ASX 200 has returned an average of 7 per cent annually. The proportion of total return that comes from dividends is around 60 per cent.

Investment growth: S&P/ASX 200 Total Return v S&P/ASX 200 Price Return (XJO), 10 Yr

Total return indices include dividend reinvestment in addition to tracking price movements.

Time period: 01/05/2020 to 30/04/2020

xjoasx200

Source: Morningstar Direct

Among the hardest hit are self-funded retirees, many of whom rely heavily on dividends and franking credits from income-paying stocks to fund their retirement. Asset managers say this reliance has become acute in the past few years amid record low interest rates, with retirees loading up on financial sector stocks with the promise of high yields.

Retirement income investment specialist Plato Investment Management estimates the big four banks paid 30 per cent of gross dividends (cash dividends plus franking) of the entire S&P/ASX 200 index in 2019.

Anton Tagliaferro, founder of Investors Mutual and co-manager of the silver-rated Investors Mutual Australian Share Fund, is acutely aware of how difficult it’s been for retirees.

"Their cash earnings from many direct shares owned has gone virtually zero.” he says. “And, as we know, many retail investors in Australian are skewed to companies like the big four banks and the REITs many of which are going to deliver nothing in distributions in the next 6 months.

"In addition, returns on cash and term deposits are dismal, and if they own an investment property it's likely that there's some tenancy relief being granted.

"It's very tough for people who've spent many years building up a portfolio that was designed to provide them with a good, low risk income stream in their retirement."

Light at the end of the tunnel

Morningstar analysts believe the dividend tap will flow again as withheld earnings eventually find their way back into the pockets of shareholders. Analysts expect earnings visibility to gradually increase by the end of this year, while a potential effective treatment for COVID-19 by year-end could clear the way for a strong economic rebound. NASDAQ-listed Gilead Sciences’ remdesivir has been touted as a potential breakthrough drug.

"The emergence of vaccines should put any remaining global health concerns to rest," Faul says. "We expect a vaccine to be available by mid-2021."

MORE ON THIS TOPIC: Coronavirus vaccine progress accelerates

"Absolute dividend payments are a function of earnings and payout ratios, and we forecast the spurt in earnings growth and reduced uncertainty to foster a broad trend of reinstating and increasing dividends, but potentially a reset dividend payout ratios and yields."

Morningstar analysts forecast about half of the companies under coverage will grow dividends in fiscal 2021 from fiscal 2020 levels. However, they think median payout ratios will be relatively low at 60 per cent. This compares to ratios of 71 per cent in fiscal 2019.

By sector, they see the greatest opportunity for rising payout ratios and near-term dividend growth in the utilities, industrials (including defensive infrastructure names), and consumer defensive sectors.

Tagliaferro anticipates cautious Directors of many companies will opt to withhold dividends in the current uncertain environment. But he doesn't think the COVID-19 shock will force a long-term rethink on dividend policy. 

"Will companies reduce their dividends well into the future? No, I don't think so," he says.

"Companies like Coles or Amcor or Telstra understand the culture of earning money and paying out 50 per cent to 70 per cent of their earnings in dividends—that's very well entrenched.

"At the moment it's almost impossible to make forecasts for FY 2020 for many stocks—you don't really know what's going to happen next month let alone in three months or next year.

"But I think when there's a bit more clarity around earnings, companies will feel comfortable to resume dividends as per normal."

In the interim, however, Tagliaferro says some sectors will take longer to resume normal payouts. Banks, he says, are a special case, alongside many REITs.

"We'll have to see what the fallout of high unemployment means for things like property prices – obviously that could cause some major issues for the banks. Some of the shopping centre REITs may have problems too and we'll have to wait and see which tenants within those shopping centres are capable of reopening.”

Tagliaferro also believes companies that funded growth and higher payouts with cheap debt before the crisis will have to rethink their distribution/dividend policies once the dust has cleared. One such example he says is Sydney Airport (ASX: SYD).

Dividends, but at what price?

So, where are the dividend sanctuaries? In the face of a global crisis, which companies will wrangle a growing dividend this year or next?

Morningstar analysts say there are only a few places for investors to hide in the short term because in many cases these relatively sheltered businesses have been bid up.

"For instance, we don’t forecast the dividends of grocery retailers Woolworths and Coles to be materially impacted by trading restrictions, social distancing, or a weaker economy, but shares of the companies trade well north of our fair value estimates," Faul says.

Given the unpredictability of dividends, income shouldn’t be the only priority for investors. Long-term investors are instead urged to consider valuations and competitive advantages.

"We view companies with economic moats as more likely to succeed in growing earnings and dividends when the economy recovers," Faul says.

"In fact, companies which entered the crisis with a competitive advantage and the capacity to invest through the cycle are likely to come out of it in a stronger position."

Coming out of the crisis, Faul says the appeal of dividends, particularly from traditional income stocks, is likely to stay despite investors losing some trust in dividend sustainability. Income investors have long favoured bond proxy stocks such as utilities and REITs.

"The reason is record low interest rates, spurring on the hunt for yield. Some more traditional income stocks in sectors like utilities and real estate are undervalued and we expect them to grow dividends again from near-term troughs," he says.

"Examples are AGL Energy (ASX: AGL) and Charter Hall Social Infrastructure REIT (ASX: CQE)."

Revenues from these types of stocks are somewhat resistant to economic downturns compared to other sectors like consumer cyclicals because of the long duration contracts or their natural monopolies over essential services.

But while solid dividend growth opportunities in these sectors, Faul points out that many utilities and REITs trade above analyst's fair value estimates, suggesting risk of subpar capital gains.

Opportunities exist for investors willing to looking beyond traditional income stocks.

Port in a storm

Among the moat rated stocks that are both trading at a discount to fair value and carrying a relatively low uncertainty rating is the aforementioned Link Administration Holdings Ltd.

The company, which provides administration services to large industry superannuation funds, withdraw its earnings guidance in March. However, the Link board hasn't indicated it will need to raise capital.

Morningstar’s James says Link will likely feel a financial impact from the downturn, even though most of the group’s revenue is recurring.

"The fund solutions division, which comprises around 10 per cent of group revenue, to be impacted by lower assets under management, and the corporate markets division, which comprises around 25 per cent of group revenue, to be impacted by less corporate activity," he says.

However, James believes these impacts should reverse once the crisis resolves.

In fiscal 2020, James forecasts Link's dividend per share to drop from 20.5 cents to 17 cents. He attributes this largely to new laws which require inactive, low-balance superannuation fund members' balances to be transferred to the ATO, in turn impacting the number of accounts which require administration services. He forecasts dividends per share to grow to 29 cents in 2021.

Analysts also highlighted construction materials business Adelaide Brighton (ASX: ABC), InvoCare and beverage company Coca-Cola Amatil (ASX: CCL) as solid dividend payers trading at suitable margins of safety. CCL will only have franking (50 per cent) from fiscal 2021.

Morningstar Premium members can download the full report (PDF), including dividend outlook for all companies under Morningstar coverage:  Australia's dividend visibility is clouded, but the dust will settle

is an editor for Morningstar.com.au

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