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Morningstar | Macquarie Is an Attractive Alternative to Consider if Labor’s Franking Credits Policy is Implemented

A change of government in May 2019 could see the Australian Labor Party running the country. The implementation of Labor’s proposal to ban the refund of surplus franking credits could reduce the income of hundreds of thousands of individual self-funded retirees and self-managed super funds, or SMSFs, in pension phase, if current investment asset allocations are not altered.

What could low tax paying individuals and/or the trustees of pension phase SMSFs do, to reduce the impact of the potential franking credit changes? Reallocating substantial parts of one’s investment portfolio from high yielding, moaty stocks trading within comfortable margins of safety to our valuations to high yielding less moaty stocks is risky, expensive and could potentially trigger capital gains tax liabilities while simultaneously putting capital at risk.

With the election now only weeks away, we suggest investors wait for the election result and the possibility the surplus franking credit proposal will be watered down in the Senate. It is unlikely the Labor Party will have enough support to pass the proposal in its current form as conservative-leaning independents are likely to hold the balance of power.

Individual investors and SMSFs are typically overweight the S&P/ASX 20 Index, including fully franked dividend stocks such as the major banks, the big miners, the large consumer stocks, the general insurers, and leading health care stocks. The alternative we like most is investing in quality ASX-listed stocks with strong earnings growth prospects paying low or zero franked dividends. We see some possible investment alternatives to popular high yielding, fully franked, blue chip stocks should the proposal be implemented. Attractive stocks within our financial services coverage include Macquarie Group, QBE Insurance, CYBG Plc, and Pendal Group. These stocks could be considered as part of a diversified investment portfolio to reduce the impact of Labor’s surplus franking credit policy.

It is difficult to identify enough good quality stocks with sustainable dividend yields high enough to offset the grossed-up dividend yields offered by many of the top 20 stocks by market capitalisation. Based on Morningstar forecasts, the average grossed-up fiscal 2020 dividend yield of the four major banks (ANZ Bank, Commonwealth Bank, National Australia Bank, and Westpac Bank) is currently 9.8%; the two big miners (BHP and Rio Tinto) average about 8.8%; the two big domestic insurers (IAG and Suncorp) average about 7.6%; and Telstra 7.0%. The average fiscal 2020 distribution yield for A-REITS under our coverage is currently about 5.2%, mostly unfranked, with the average distribution yield for Australian utilities and infrastructure stocks under our coverage currently about 5.7%, mostly unfranked or with low franking.

A greater exposure to offshore stocks, either directly or indirectly via managed funds neatly steps around the franking issue, but investment risk and transaction costs increase, and currency risk is introduced. Investing in small cap Australian managed funds focused more on growth than income stocks is a potential alternative. Small cap funds are more targeted toward capital gains than traditional large cap high yielding fully franked dividend stocks.

Narrow-moat-rated, medium uncertainty Macquarie is trading 3% below our valuation, no-moat-rated, high uncertainty QBE Insurance is trading in line with our valuation. No-moat-rated, high uncertainty CYBG is trading 24% below our valuation, and narrow-moat-rated, medium uncertainty Pendal is trading 7% below our valuation. Our fiscal 2020 dividend yield forecasts are relatively attractive with Macquarie at 5.1%, QBE Insurance at 4.7%, CYBG at 5.7%, and Pendal at 5.4%.

The key appeal of the four stocks listed above is attractive forecast earnings and dividend growth, irrespective of franking rates. We expect Macquarie’s dividend to be 45% franked for the next few years at least, QBE Insurance’s dividend is expected to be 10% franked from 2020, Pendal’s dividend is 15% franked, and CYBG’s dividend is not franked. All four stocks have a substantial proportion of offshore earnings with Macquarie approximately 66%, QBE Insurance 70%, U.K.-based CYBG 100%, and Pendal 87%.

We like the long-term earnings outlook for narrow-moat-rated Macquarie Group, particularly the global focus on infrastructure assets, renewable energy, corporate lending, investment banking and domestic investment, commercial and consumer banking. Our medium uncertainty rating is anchored on the group’s large exposure to non-capital market-facing businesses, with the so called “annuity” businesses accounting for 60-70% of group business unit profit contribution. Our Exemplary stewardship rating is confirmed with the recent seamless transition of CEOs another clear example of the Board and senior management focus on long-term shareholder value creation. Based on Morningstar analysis, Macquarie’s 10-year total shareholder return is an impressive average rate of 18% per year. Macquarie is geographically diversified, with two thirds of group operating income generated outside of Australia.

The group reports fiscal 2019 results on May 3, 2019 and we forecast net profit of AUD 3.0 billion and a 45% franked total dividend of AUD 6.20 per share. Recently confirmed earnings guidance is for fiscal 2019 net profit to be up to 15% higher than the AUD 2.56 billion in fiscal 2018. Our NPAT forecast is 17% higher. Consensus profit estimates are AUD 2.98 billion and dividend of AUD 5.94 per share.

Based on our earnings forecasts, we expect dividend CAGR of 8% for the next five years to end fiscal 2023. The five-year historical EPS CAGR to end fiscal 2018 is 25% and the five-year historical dividend CAGR to end fiscal 2018 is 21%. Macquarie is in a strong financial position with AUD 4.0 billion in surplus capital at Dec. 31, 2018.

Diversification and interlinking are key to generating long-term revenue growth for Macquarie. The extent of interconnectivity between Macquarie’s five business groups and operating leverage provides attractive earnings upside that we think the market underappreciates. We like the firm’s earnings growth outlook, long-standing senior management, long-term investment approach, and upside from exposure to infrastructure, energy, and technology sectors. We see the interconnectedness of Macquarie's adjacent businesses as a real competitive advantage and key to continued strong growth in shareholder returns. Macquarie is a world-leading infrastructure fund manager and has increasing exposure to renewable energy, putting it in a good position to benefit from huge growth in global infrastructure and energy investment in the next decade.

We updated Macquarie's moat rating to narrow in 2018, based on the competitive advantages of its underlying businesses. The asset management and corporate finance businesses benefit from customer switching costs and brand strength, while the investment banking businesses benefit from network effects and brand strength. The banking business is the only business we don't consider moat-worthy. We forecast attractive annual average EPS growth of 8% in the fiscal 2019-23 period, based on growing global need for investment in infrastructure and energy markets, robust global capital markets and ongoing institutional demand for Macquarie's mainly unlisted alternative infrastructure funds.

The stock currently trading 3% below our AUD 135 fair value estimate. Macquarie provides a reasonable exposure point to the long-term growth opportunities in global infrastructure and energy sectors. Macquarie currently trades on a P/E around 14 times and offers an approximate 5% dividend yield. Macquarie is relatively more expensive than Australia’s growth constrained four major banks but based on Macquarie’s more attractive earnings and dividend growth outlook and its 45% franking rate, we think Macquarie is an attractive alternative to higher yielding, fully franked dividend-paying stocks.