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Morningstar | Pendal 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 8% 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 attraction 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, CYBG’s dividend is not franked, and Pendal’s dividend is 15% franked. All four stocks have a substantial proportion of offshore earnings with Macquarie 66%, QBE Insurance 70%, U.K.-based CYBG 100%, and Pendal 87%.

We believe Pendal’s breadth of product offerings across asset classes, geography, and lower-cost investment options places the group to take advantage of industry dynamics while still able to manage headwinds. Our Standard stewardship rating is underpinned by CEO Emilio Gonzalez’s long and successful record in the wealth management industry, an experienced and well-rounded investment team which lessens key person risk, and a successful acquisition of the highly profitable JO Hambro Capital Management business in the United Kingdom. Thanks to management’s capable hands, long-term shareholders of Pendal Group were well-rewarded by returns averaging 22.8% per year over the past 10 years. The primary risk facing Pendal is the uncertainty surrounding Brexit and in particular, how will JO Hambro operate under a range of Brexit scenarios while experiencing recent periods of underperformance. Nevertheless, we are confident management can turn its fortunes around.

Pendal reports its half-year interim results on May 2, 2019. We forecast a full-year fiscal 2019 revenue of AUD 516.7 million and cash profit of AUD 171.1 million. We expect a challenging fiscal 2019 due to adverse markets (especially over the recent December quarter which saw a drop in FUM by close to 9%), but expect improvement from fiscal 2020 onwards as the group proactively increases its range of strategies and further enhances its global distribution channels. We expect EPS to decline to around AUD 0.60 per share in fiscal 2019 before growing at 4.4% per year through to AUD 0.72 per share by fiscal 2023.

Our dividend forecasts are based on an 82% payout ratio in line with the company’s payout ratio target. In line with our earnings forecasts, we expect a marginal drop in fiscal 2019 DPS of AUD 0.50 per share, before growing at 4.2% per year through to AUD 0.59 per share by fiscal 2023. While the forecast growth in both EPS and DPS are lower than historical standards, it is important to note our base-case scenario assumes very marginal net inflows (after distributions) of around 1% per year for open funds, and zero inflows for closed funds. Our earnings and dividend forecasts may therefore turn out to be conservative if the group’s new offerings succeed in stimulating better-than expected streams of FUM inflow.

We expect consistent, sustainable and long-term revenue growth from the group. Underlying our thesis is the group’s prudent and adaptive strategies to navigate the structurally challenged asset management landscape. These include expanding its geographical reach into new and existing markets, diversifying its product and asset class offerings, and expanding and building its distribution channel strength While Pendal’s cost structure will be challenged in the future in the face of managing Brexit risks and their pursuit of growth, the group has significant scope to improve its cost efficiency given its strong FUM pool and significant variable cost base.

Our fair value estimate for the stock is AUD 10.30 per share, implying a P/E multiple of 17.5 times our 2019 earnings estimate, 17.7 times our 2020 earnings estimate, and 17.6 times our 2021 earnings estimate. At current prices, the stock offers investors an 8% margin of safety.