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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%.
No-moat-rated, U.K. regional bank, CYBG, continues to impress and we like the bank’s attractive long-term earnings outlook despite ongoing Brexit uncertainty. CYBG’s primary listing is the London Stock Exchange with CHESS Depository Interests, or CDIs, listed on the Australian Securities Exchange. Good volume growth, better-than-expected net interest margins, in line loan losses, and an uplift in expected cost savings underpin our earnings forecast. Being a U.K. company, CYBG does not generate Australian franking credits and dividends are unfranked.
CYBG paid its maiden dividend in fiscal 2017 of just GBX 1 per share followed by GBX 3.0 per share in fiscal 2018. We forecast a steady increase in dividend to GBX 20 per share in fiscal 2023 based on a 48% payout. Our fair value estimate is GBX 280/AUD 4.90, and at current prices, the AUD securities are attractively priced trading 24% below our valuation.
CYBG reports first-half fiscal 2019 results on May 15, and full-year fiscal 2019 results on Nov. 27. We forecast a full-year fiscal 2019 cash profit of GBP 358 million and a GBX 7 per share dividend based on a 26% payout. Our equivalent forecasts are AUD 635 million for cash profit and zero franked dividends of AUD 12 cents per share. At current prices and currency conversion rates, our fiscal 2019 dividend yield forecast is 3.3% and 5.7% for fiscal 2020. The payout is steadily increasing to the bank’s long-term target of less than 50%.
We forecast a challenging fiscal 2019 performance for CYBG, but from fiscal 2020 and beyond, we expect better times with EPS forecast to grow an average of 14% per year from fiscal 2020-2023. Our forecasts are based on significant cost savings, in part from merger synergies, targeted volume growth in consumer and SME lending, good margin management, and further strong outcome with loan quality.
CYBG merged with Virgin Money in October 2018 and management confirm good progress with merger integration and in late January upscaled estimated annual run rate costs synergies to GBP 150 million from the previous forecast of GBP 120 million per year. The pro forma merged lending mix is 83% mortgages, 11% SME and corporate, 5% credit cards and 1% other unsecured. We like the way the combined entity is positioned to benefit from good growth in targeted segments, but we are concerned by risks around merger integration, potentially overpaying and rebranding of the iconic establishment Clydesdale and Yorkshire brands to the more edgy Virgin Money brand.
Despite the Brexit debacle, the regional bank is doing well with modestly improved margin guidance for fiscal 2019 of 165-170 basis points from previous guidance of 160-170 basis points. First-quarter fiscal 2019 annualised margin of 1.72% declined on prior periods, Virgin Money adjusted, due to intense pricing competition for U.K. mortgages. Our fiscal 2019 forecast margin of 1.70% is unchanged. Based on CYBG management projections, the combined entity is well positioned to benefit from good earnings growth, but we are concerned by risks around merger integration, potentially overpaying and rebranding of the iconic establishment Clydesdale and Yorkshire brands to the more edgy Virgin Money brand. First-quarter fiscal 2019 asset quality was good with annualised loan impairments of 22 basis points in line with management expectations.
The political and economic outlook in the U.K. is uncertain, but the group is heavily focused on the Virgin Money integration. Strong levels of capital and balance sheet strength provide comfort if the U.K. economy suffers as a result of Brexit negotiations. Despite easing somewhat, the 14.5% common equity Tier 1 capital ratio is well above regulatory minimums. Combined group assets remain materially below systemic bank thresholds resulting in no required domestic systemic risk buffer.
Morningstar | CYBG 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 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%.
No-moat-rated, U.K. regional bank, CYBG, continues to impress and we like the bank’s attractive long-term earnings outlook despite ongoing Brexit uncertainty. CYBG’s primary listing is the London Stock Exchange with CHESS Depository Interests, or CDIs, listed on the Australian Securities Exchange. Good volume growth, better-than-expected net interest margins, in line loan losses, and an uplift in expected cost savings underpin our earnings forecast. Being a U.K. company, CYBG does not generate Australian franking credits and dividends are unfranked.
CYBG paid its maiden dividend in fiscal 2017 of just GBX 1 per share followed by GBX 3.0 per share in fiscal 2018. We forecast a steady increase in dividend to GBX 20 per share in fiscal 2023 based on a 48% payout. Our fair value estimate is GBX 280/AUD 4.90, and at current prices, the AUD securities are attractively priced trading 24% below our valuation.
CYBG reports first-half fiscal 2019 results on May 15, and full-year fiscal 2019 results on Nov. 27. We forecast a full-year fiscal 2019 cash profit of GBP 358 million and a GBX 7 per share dividend based on a 26% payout. Our equivalent forecasts are AUD 635 million for cash profit and zero franked dividends of AUD 12 cents per share. At current prices and currency conversion rates, our fiscal 2019 dividend yield forecast is 3.3% and 5.7% for fiscal 2020. The payout is steadily increasing to the bank’s long-term target of less than 50%.
We forecast a challenging fiscal 2019 performance for CYBG, but from fiscal 2020 and beyond, we expect better times with EPS forecast to grow an average of 14% per year from fiscal 2020-2023. Our forecasts are based on significant cost savings, in part from merger synergies, targeted volume growth in consumer and SME lending, good margin management, and further strong outcome with loan quality.
CYBG merged with Virgin Money in October 2018 and management confirm good progress with merger integration and in late January upscaled estimated annual run rate costs synergies to GBP 150 million from the previous forecast of GBP 120 million per year. The pro forma merged lending mix is 83% mortgages, 11% SME and corporate, 5% credit cards and 1% other unsecured. We like the way the combined entity is positioned to benefit from good growth in targeted segments, but we are concerned by risks around merger integration, potentially overpaying and rebranding of the iconic establishment Clydesdale and Yorkshire brands to the more edgy Virgin Money brand.
Despite the Brexit debacle, the regional bank is doing well with modestly improved margin guidance for fiscal 2019 of 165-170 basis points from previous guidance of 160-170 basis points. First-quarter fiscal 2019 annualised margin of 1.72% declined on prior periods, Virgin Money adjusted, due to intense pricing competition for U.K. mortgages. Our fiscal 2019 forecast margin of 1.70% is unchanged. Based on CYBG management projections, the combined entity is well positioned to benefit from good earnings growth, but we are concerned by risks around merger integration, potentially overpaying and rebranding of the iconic establishment Clydesdale and Yorkshire brands to the more edgy Virgin Money brand. First-quarter fiscal 2019 asset quality was good with annualised loan impairments of 22 basis points in line with management expectations.
The political and economic outlook in the U.K. is uncertain, but the group is heavily focused on the Virgin Money integration. Strong levels of capital and balance sheet strength provide comfort if the U.K. economy suffers as a result of Brexit negotiations. Despite easing somewhat, the 14.5% common equity Tier 1 capital ratio is well above regulatory minimums. Combined group assets remain materially below systemic bank thresholds resulting in no required domestic systemic risk buffer.
Underlying
Virgin Money UK
Provider
Morningstar
Morningstar, Inc. is a leading provider of independent investment research in North America, Europe, Australia, and Asia. The company offer an extensive line of products and services for individual investors, financial advisors, asset managers, and retirement plan providers and sponsors.
Morningstar provides data on approximately 530,000 investment offerings, including stocks, mutual funds, and similar vehicles, along with real-time global market data on more than 18 million equities, indexes, futures, options, commodities, and precious metals, in addition to foreign exchange and Treasury markets. Morningstar also offers investment management services through its investment advisory subsidiaries and had approximately $185 billion in assets under advisement and management as of June 30, 2016.
We have operations in 27 countries.
David Ellis
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