Income Report / Income Report; Spotting dividend traps (AHY, NAB, AMP)

By Market Matters 18 July 18

Income Report; Spotting dividend traps (AHY, NAB, AMP)

Market Matters Income Report 18th July 2018

 

In the last 24 hours we’ve seen commentary from our own RBA along with testimony from the US Federal Reserve. Interest rates in Australia look likely to be on hold for an extended period while in the US, the gradual rise from emergency settings will continue. Listening to the Federal Reserve Chair Jerome Powell overnight, he did seem very cognisant of the current trade discussions  concluding that if they escalate it will provide a drag on growth and the Fed would be forced to stay on the sidelines for longer, however the bond and currency markets shrugged it off with both US bond yields and the US Dollar tracking higher overnight.

In terms of the MM Income Portfolio, it was down -0.23% over the past week . Since inception (5/7/17), the portfolio is up 6.36% versus its benchmark (RBA + 4%)  which equates to 5.68%. Yesterday we reduced the weighting towards Perpetual (PPT) by 3% to make room for the Axesstoday listed bond (AXSHA) due for list next week. The bond will have an initial weighting of 5%.

Perpetual was bought in two tranches, the second of which was 3% at $40.92. To view all past activity on the Income Portfolio – click here

Spotting dividend traps

Yesterday we saw Asaleo Care (AHY) downgrade guidance by ~30% (click here) which caused a pretty savage 34% decline in the share price – the 7.6% yield is of little comfort when the shares drop by such a considerable amount, however there were signs that AHY was a dividend trap.

Asaleo Care (AHY) Chart

Dividend Trap; A dividend trap is a high yielding stock whose dividend is unsustainable. It might be high for a short term reason, or it simply might be high because the share price is low. As an investor ask the question, does this dividend yield make sense within a certain industry?

There are three simple rules we can use as a starting point to determine whether or not a stock may be a dividend trap;

Rule 1 – A high dividend yield

While not a red flag in its own right, a high dividend yield in some stocks / sectors is a sign that the sustainability of the dividend may be low. The list below outlines stocks within the ASX 200 that have current dividend yields greater than 6%. Interestingly, the average return over the past 12 months from this list below is a decline of 7% - hardy spectacular in a reasonable market implying that buying for yield in isolation doesn’t work.  

Digging a little deeper into the list below, we know SIG is in trouble given they lost the Chemist Warehouse contract, CWN paid a special dividend last year so they will be closer to 4.5% this year, GMA have capital releases available which will support their dividend, Fortescue will be dependent on where the Iron Ore price goes, TLS will be maintained in the short term however they probably will cut from FY20 onwards while AMP’s woes have been well documented.

ASX 200 stocks with current dividends greater than 6% (excludes franking)

Source Bloomberg

Using AHY as an example, the dividend yield was running above 7% for the last 12 months which would be our first red flag.

Rule 2  - A high payout ratio

Stocks that pay a high proportion of free cash flow back to shareholders as dividends have a lower buffer for any variance in earnings. Free cash flow is essentially the earnings of the company minus the costs of running and maintaining the operation. In the case of AHY, for the 12months to December 17, free cash flow was 10cps while they paid 10cps out in dividends. Clearly, the dividend is at risk if earnings decline.  AHY were originally expecting earnings to be in the range of $113m to $119m before guiding yesterday to $80-$85m at the EBITDA line.

The table below highlights stocks within the ASX 200 with payout ratios greater than 95%.

You’ll notice some anomalies here with a few of the stocks printing exceptionally high payouts in the short term. This is most likely because of a one off anomaly in reported earnings –which was the case with Wesfarmers (WES). Elsewhere, companies like Genworth (GMA)  have capital they can release supporting the payout (due to lower demand for their products), while Alumina (AWC) simply passes through receipts earnt from Alcoa in the US.  

ASX 200 stocks with high payout ratios

Source; Bloomberg

Rule 3 – High debt

Stocks that carry high levels of debt are more prone to cut their dividends if conditions deteriorate. Think about your own personal balance sheet for a moment. Mortgage repayments don’t disappear if your earnings decline, they simply become a bigger burden to bare and you have less capital available to buy ‘stuff’ or invest for the future.

Below is the top 10% of the ASX 200 in terms of debt to equity levels, i.e. the companies carrying the most debt. A general rule of thumb is debt to equity lower than 100% (a ratio of 1 or less) although this is dependent upon what industry we’re considering. For instance, a regulated utility that has stable, consistent earnings can sustain a higher debt burden than say a commodity company, whose earnings are at the whim of global commodity prices.

Again, using AHY as an example, total debt sits at $307m as at December 2017 which is okay, however less comfortable post the 30% rout in expected earnings. That debt costs them about $11m a year in interest, or about 13% of their new earnings guidance.  

ASX 200 stocks with high debt to equity ratios

Source Bloomberg

The other component to high debt is around rising interest costs. Companies carrying high debt will incur higher borrowing costs as global interest rates rise.                                             

Conclusion (s)

Putting these factors together spits out two potential dividend traps; AMP and NAB. While we think NAB is unlikely to increase its dividend for many years and clearly they have less buffer or more chance of cutting it if economic conditions deteriorate, we don’t think NAB is a dividend trap for now.

AMP on the other hand is, and we covered our bearish views on this stocks a few weeks ago (click here)

Have a great day!

James & the Market Matters Team

Disclosure

Market Matters may hold stocks mentioned in this report. Subscribers can view a full list of holdings on the website by clicking here. Positions are updated each Friday, or after the session when positions are traded.

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