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Morningstar | QBE Is an Attractive Alternative to Consider if Labor’s Policy on Franking Credits 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 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 earnings growth outlook for no moat rated QBE Insurance and the potential for strong dividend growth. The global insurer’s balance sheet is strong and based on improved earnings resilience we forecast a dividend CAGR of 8% for the next five years to end 2023. Based on Morningstar analysis, QBE Insurance delivered a very disappointing 10-year total shareholder return close to zero, but we think shareholders will benefit from attractive future returns as new CEO Pat Regan delivers sustained improvement across the group.

Regan was promoted to CEO effective Jan. 1, 2018 and has impressed with decisive action to fundamentally improve the productivity, profitability and accountability of core global insurance operations. Underperforming businesses have been jettisoned and importantly senior management are focused on long term shareholder value creation. However, despite the recent decline in global interest rates potentially slowing the earnings recovery for QBE Insurance, the strengthening in the global pricing cycle for commercial insurance is positive. QBE Insurance benefited from group-wide average premium rate increases of 5.0% in 2018 compared with 1.8% in 2017. We expect improved pricing conditions in all divisions in 2019.

Total dividends for 2018 were franked at a weighted average 46.8% with the interim franked at 30% and the final franked at 60%. But from the start of calendar 2020, management is guiding for franking of only 10% as the proportion of international income increases. The 2018 dividend payout of 70% of cash profit was modestly higher than the firm’s target of up to 65%, but reflects the positive outlook, stronger balance sheet, and modest business growth. Our longer-term payout forecast averages 60%.

The immediate past 12 months has seen an impressive recovery in total shareholder return with a positive 33% uplift. Our cash earnings forecasts for 2019 of USD 952 million will be 33% higher than 2018 if achieved. The stock is currently trading close to our AUD 12.50 fair value estimate. Since end-December 2018 the stock price has increased 24% on the back of increasing confidence management can deliver a sustainable improvement in future earnings. Turning the business around required changes in insurance portfolios, cost-cutting, tighter underwriting standards and greater accountability across the group.

We continue to believe the firm is capable of reporting midcycle cash profits of approximately USD 1.1 billion to 1.2 billion per year based on an insurance margin around 11%. The insurance margin has averaged 9% for the past nine years, excluding the loss-making year of 2017. We expect QBE Insurance to deliver midcycle returns on equity around low-double-digit levels, modestly above our 9% cost of capital estimate. If achieved, this will be a strong recovery from the disappointments of the past. Longer term, we expect more sustained and consistent earnings based on improving macro momentum with an eventual upturn in global insurance rates, stronger economic conditions in the U.S. and Europe, operational cost savings, and increasing global interest rates. QBE Insurance is geographically diverse, with approximately 70% of net earned premium sourced outside of Australia.

QBE Insurance’s 2018 cash profit was modestly below our forecast due to softer investment returns, but the strong underlying performance impressed. Earnings quality sets the foundation for good growth expected in 2019 and 2020. Management is applying the basics of running an insurance company – consistently good decision-making on underwriting, pricing and claims. Our stewardship rating is Standard and we are confident the long awaited turnaround is gaining traction.

The 2018 insurance result was an impressive improvement on 2017, with the combined operating ratio, or COR, of 95.7% within the firm’s 95-97% target. Investment returns were soft, but not surprising considering increased uncertainty in global equity markets in late 2018. Importantly, management delivered on its operational goals in 2018 including a significant improvement in COR, remediation of the underperforming Asian operations, cost reductions, asset sales, and portfolio exits.

The 2018 cash profit of USD 715 million was a substantial recovery from the USD 262 million cash loss in 2017. Underwriting losses in 2017 were the worst year on record for the global insurance industry. The net cost of catastrophe claims reduced significantly to USD 523 million in 2018 compared with USD 1.2 billion in 2017. Our cash profit forecast for 2019 is USD 952 million or AUD 1.19 billion with dividend of AUD 57 cents per share with a weighted average franking rate of 32%. Consensus estimates for 2019 are AUD 1.2 billion cash profit and total dividends of AUD 58 cents per share.

The balance sheet has recovered strongly after the extreme catastrophe experience of 2017. Regulatory capital comfortably exceeds regulatory minimums, with the firm’s Australian Prudential Regulation Authority, prescribed capital amount, or PCA, multiple 1.78 at Dec. 31, 2018, up from 1.64 at Dec. 31, 2017 and towards the upper end of the insurer’s internal 1.6-1.8 target PCA range. The group’s debt/equity ratio improved to 38% at Dec. 31. 2018 from 41% a year earlier and slightly above the insurer’s internal benchmark of 25%-35%.