SINGAPORE (Dec 31): On Dec 13, activist investor Quarz Capital issued an open letter to the directors of Sunningdale Tech to address the company’s stock price. Arguing that it was severely undervalued, the investor suggested that the company implement a dividend policy. “As Sunningdale’s free cash flow and balance sheet strengthen in 2019, we recommend the firm increase its dividend distribution to 60% of core net profit. This can potentially provide an attractive dividend yield of 7.1% to all shareholders. Sunningdale can continue to invest $25 million in capital expenditure and retain $17 million of cash flow per year,” Quarz Capital says.
Sunningdale is a precision engineering company that produces plastic parts for electronics such as mobile phones, routers, point-of-sale machines and printers. It also makes components for a number of mass market and luxury automotive brands.
Quarz Capital also says Sunningdale’s retained cash flow is more than enough to ramp up organic and inorganic growth strategies to undertake larger volume, more complex and higher-margin projects. Taking on the production of new consumer products as well as cutting input costs are likely to support earnings growth, it adds.
A more generous dividend policy and stronger earnings would boost investor interest in Sunningdale and its valuation, Quarz Capital suggests. After all, investors pick stocks for capital appreciation and income. And, often, they have to contend with a trade-off between capital appreciation and yield. This is evident in Chart 1, which plots the Straits Times Index against its 12-month average gross historical dividend yield. Price performance and yields are inversely proportional.
The STI’s average gross historical dividend yield during the five-year period was 3.59%, marginally lower than the Hang Seng Index’s average gross historical dividend yield of 3.63%. Both markets recorded higher dividend yields than the Standard & Poor’s 500 index, which averaged just 2%. The US market in general has been on a strong bull phase, and investors were rewarded with capital gains. For every $100 invested in the STI, the investor would be up just $1 as at Dec 7 this year; whereas an investor who invested $100 in the S&P 500 would have gained $48 (see Chart 2). Investors in the S&P 500 may have had lower dividends, but they would have made more money.
Dividends are all about earnings growth
Dividends are a function of a company’s earnings. If a company can grow its earnings, dividends will rise even if the payout ratio stays constant.
Unfortunately for dividend yield players, the outlook is murky for US equities. Market watchers are expecting the US earnings cycle to moderate. Romain Boscher, global chief investment officer of equities at Fidelity International, says US earnings growth for the year to Sept 30, 2018 averaged 24%. “The cocktail of lower corporate taxes, a reduced regulatory burden, and a growing economy helped the US market outperform other countries,” he says.
For FY2019, GDP growth (and hence earnings growth) is likely to moderate. Even if GDP growth stays at 3%, with inflation now at 2% and a share buyback level of 3%, Boscher is expecting earnings growth of roughly 8%. This is a third of FY2018’s earnings growth.
“Companies may well start to see headwinds such as rising cost inflation intensifying in 2019. Labour-intensive sectors are the ones most exposed, and we will be closely watching the extent to which freight cost inflation and increasing wage costs are borne by consumers. We see a risk that companies will have to absorb some of this, pressuring margins,” Boscher says. Still, he expects some companies to do well. Companies in a capital expenditure cycle (including capex on software and some hardware) will benefit technology and business service stocks in 2019.
In Singapore, too, the outlook is uncertain. In the December Survey of Professional Forecasters issued by the Monetary Authority of Singapore, forecasters expect GDP growth at 3.3% this year. The respondents in the survey expect GDP growth to ease to 2.6% in 2019, with core inflation expected at 1.8%.
In a nutshell, forecasters are expecting lower economic growth and marginally higher inflation. Unless monetary policy eases (and interest rates fall), these factors are likely to affect earnings growth for Singapore companies next year. According to estimates recorded by Bloomberg, earnings per share for the STI are likely to grow 2.26% in 2019, and another 7.68% in 2020. Dividends per share are likely to grow 4% in 2019, and a further 4.4% in 2020.
In a recent 2019 strategy report, UOB Kay Hian expects overall earnings growth of 4.9%. Healthcare is likely to grow 23.4% because earnings growth fell 21.3% in 2018. Earnings for shipyards are likely to grow 34.9%, after double-digit declines in 2016, 2017 and 2018. Elsewhere, land transport is forecast to grow 10.9%, after recording just 3.4% this year. Following an earnings surge of 19.8% in 2018, financial services, which are mainly the banks, are expected to grow a tepid 3.7% in 2019.
The three local banks have clearly calibrated dividends, which depend on earnings, retained earnings, common equity tier 1 capital adequacy ratios, and their own liquidity needs. Among them, DBS Group Holdings has the highest payout ratio. UOB Kay Hian prefers Oversea-Chinese Banking Corp for its potential to catch up in net interest margin expansion and dividend payout. OCBC’s dividends have been rising even though its payout ratio has stayed flat (see Chart 4). This is a bullish sign. In addition, OCBC is likely to benefit from a rising CET1 ratio. “Valuation-wise, OCBC is also attractive, trading at more than one standard deviation below its long-term mean price-to-book ratio,” UOB Kay Hian adds.
Companies that can raise dividends
In a recent report, KGI Securities pointed out the China Aviation Oil has steady dividend and growth prospects. CAO’s dividend policy, based on a growth-based dividend payout formula, comprises 30% of annual net profits. For FY2017, the company announced a dividend per share (DPS) of 4.5 cents, or a payout ratio of 32%, based on dividends paid of US$27.68 million ($38.1 million) and net profit of US$85.3 million (see Chart 5). The payout ratio was lower than that of FY2016, although DPS remained the same.
For this year, earnings have been somewhat volatile. While net profit for 9MFY2018 is up 7.62% y-o-y to US$75.13 million, 3QFY2018 net profit is down 7.99% to US$18.93 million. If CAO adheres to its payout ratio strictly and it has a good fourth quarter, DPS could be higher. In this event, DPS could rise to 5.18 cents, translating into a dividend yield of 4.2%. CAO is a key supplier of imported jet fuel to China’s civil aviation industry, which is seen as a growth industry as China moves towards a services-oriented economy.
Another local company with the potential to pay higher dividends is developer Stamford Land. For 1HFY2019 ended Sept 30, 2018, it reported a 36% y-o-y gain in net profit to $28.6 million and free cash flow of $76 million. The company is also in a net cash position of $16 million. Its payout ratio for FY2018 was 15% (see Chart 6), or $8.64 million, which translates into a DPS of one cent. With a higher net profit for FY2019, the company could easily afford to raise its DPS. A dividend of two cents would cost the company just an additional $8.5 million, as the number of shares in issue has fallen. Stamford Land has an aggressive share buyback programme; on Dec 13, its shares outstanding stood at 842.94 million, down from 855.96 million as at Sept 30. The share buyback programme has kept the company’s share price very stable amid market volatility.
Bond boost from Temasek
Bonds pay a regular fixed coupon and the Singapore Exchange is attempting to attract the issuing of bonds. To liven up the retail bond market and boost interest in it, Temasek Holdings issued the T2023-S$ Temasek Bond in October, comprising $500 million 2.7% a year guaranteed notes due in 2023. The placement — to institutional investors and high-net-worth individuals — was $200 million, and the public offer was $300 million. The placement tranche was seven times subscribed and the public issue was eight times subscribed, an indication of the demand for highly rated bonds. The public tranche, listed on the SGX, is trading above face value.
When compared with Singapore Savings Bonds, T2023-S$ offers a higher upfront coupon and is more liquid in that the bonds are traded on the SGX. Investors have to hold the SSBs to maturity. The coupon on SSBs start at 1.8% for the November 2018 tranche, with step-ups every year.
In June this year, Azalea Asset Management — which is a unit of Temasek Holdings — issued $242 million of Astrea IV PE Bonds, half of which were sold to retail investors. The Astrea IV PE Bonds are backed by cash flows from a diversified portfolio of private-equity funds managed by the likes of KKR, Carlyle Group and Blackstone. The coupon is 4.35% a year.
There are different classes of the Azalea IV PE Bonds: Class A-1, Class A-2 and Class B. Retail investors subscribed to Class A-1, the safest class. These are traded on the SGX and, at $1.059, are well above their face value. A bonus redemption premium of up to 0.5% in interest will be paid to the Class A-1 bondholders at redemption if its performance threshold is met.
While Astrea IV PE Bonds have a higher coupon, they are not guaranteed. T2023-S$ bonds are guaranteed, an indication that they are safer than the Astrea bonds.
The problem with perpetuals
On Sept 21, Soilbuild Business Space REIT — which owns business parks and industrial property — issued $65 million of perpetual securities with a coupon of 6%. The first call date is Sept 21, 2021. The “reset” will be the sum of the then prevailing three-year Singapore dollar swap offer rate (plus an initial spread of 3.79%). Lim Chap Huat, a major shareholder of the sponsor, who also owns 25.2% of the REIT, subscribed to $30 million of the perpetual securities. Ho Toon Bah, a director of SB REIT REIT’s manager, subscribed to $2 million. It is not known whether Tong Jinquan, who owns 6.39% of the REIT, subscribed to the perpetual securities.
These perpetual securities were used as part-payment for two Australian properties — an office building in Canberra and a poultry processing plant in South Australia, acquired in September for a total of A$116.3 million ($114.6 million). The acquisitions are expected to generate a net property income (NPI) yield of 6.17% for the REIT. The blended cost of funds would be below 6%, making the acquisition mildly accretive based on distributions per unit. Although the cost of the perpetual securities appears high, and only marginally above the NPI yield of the Australian properties, it is cheaper than SB REIT’s equity, which were trading at a forward DPU yield of 8.7% as at Dec 13.
Perpetual securities are useful tools for REITs, which are curtailed by a debt-to-asset ratio ceiling of 45%. When gearing is very close to this ratio, the only way to continue to grow by acquisitions without equity fundraising is to issue perpetual securities. They are considered equity by regulators and do not dilute unitholders’ share.
REITs that have issued perpetual securities include Ascott Residence Trust, Keppel REIT, Mapletree Logistics Trust, Lippo Malls Indonesia Retail Trust, First REIT and Frasers Hospitality Trust.
Perpetual securities are hybrids. They act like debt in that they tend to have low or no volatility. And, to incentivise the issuer to redeem the securities, there is a step-up in the coupon. Local perpetual securities act like five-year bonds because their first call date is usually at the five-year mark. However, their coupons are usually higher than similar tenor bonds. They are subordinated to debt instruments but rank above ordinary shares.
While perpetual securities are considered to be equity for accounting purposes, they are similar to debt in that they can contribute to the issuer’s becoming overlevered. Ratings agencies such as Moody’s Investors Service do not consider perpetual securities as 100% equity because there comes a point when issuers have to either pay it off or refinance it. Different rating agencies have different maximum levels that they recognise as equity.
For REITs, Moody’s applies a 50% equity treatment for perpetual securities, that is, only half of the issuance is viewed as equity. Moody’s also sets a limit on the amount of equity credit from the issuance of perpetual securities or other hybrid securities within an issuer’s capital structure. A rough rule of thumb is that the ratio of hybrid equity credit to equity should not exceed 30%. Any additional hybrid equity credit above that will be treated as debt by Moody’s. The rationale is that common equity is a more predictable source of funding, and should be the dominant component of an issuer’s capital structure.
UBS issued $700 million in Singapore dollar perpetual securities on Nov 28, with a coupon of 5.875%, but the securities were trading below face value as at Dec 13. UBS’s perpetuals are loss-absorbing — if there is a trigger event for a write-down or a viability event, the perpetuals will act like equity.
Both the SB REIT and UBS perpetual securities are for institutional and accredited investors only. The only perpetual securities for retail investors were the $500 million issued by Hyflux in 2016, which are now suspended.
All in, the perpetual securities market was challenging this year because of lower liquidity as a result of a stronger US dollar. If the US Federal Reserve turns more dovish in 2019 and the US dollar eases, issuers, including REITs, are likely to resume issuing perpetual securities.
