With the Australian economy partially ramping down to reduce the spread of the virus, the working capital squeeze begins for companies and households. Here, we explore what that could mean for dividends.
It’s too early to say with precision, but dividends could be cut by at least a third in the next 12 months, which would lead to a larger cut to aggregate dividends than we saw in the GFC.
This is because most companies are starting to move to survival mode in the shutdown, so they can thrive in the recovery.
Remember this crisis will pass. A prudent measure is to value companies on a mid-cycle three-year basis, so you can calmly look through the short-term pause to find companies that can grow their dividends in normal times. We believe this favours long-term investors. Further, there are pockets of real value on offer in the market now. Investors that can may consider adding selectively.
At the moment, revenues in Australia’s locked down economy are temporarily drying up and working capital is becoming an issue, even for the companies with low levels of debt – capital raisings are evidence of this. Keeping precious working capital is key, as companies move to preserve cash by temporarily standing down workers, negotiating rental abatements with landlords and reducing outgoings.
It is only reasonable that dividends are crimped to preserve cash too, particularly as debt costs for non-investment grade companies spike. Buybacks also haven’t been spared, with some big companies announcing buybacks, only to later cancel them. Again this is prudent and reasonable, as the precious franking credits can be used later, and of course the capital can be used to help those companies bridge the gap to the recovery.
Stimulus is being injected here and abroad, as governments focus one prong of stimulus for this liquidity to bridge this working capital gap and another on supporting displaced workers. While the lockdowns are in place, the government is the iron lung of our economy. But remember they won’t be able to replace all lost revenue and it’s not reasonable to expect meaningful dividends from a company receiving government stimulus.
What could change?
The majority of the dividends announced in February have been paid and there have been high levels of franking. Up to now, it had been a good financial year for dividends.
However, the virus outbreak and lockdown response has dramatically slowed economic activity particularly in sectors like travel and aviation initially. We can see that the consumer impact then has spread to retail, media and gaming.
We believe the rent and mortgage collectors will also likely face a short-term hit during the lockdown. Banks and REITs are the main sectors left to pay large dividends before the end of the financial year. In our view, both sectors will likely cut dividends sharply due to the knock-on effect of rent and mortgage abatements and the need to keep capital to service their own debts as these sectors carry high debt loads. Miners have been paying large dividends, which is welcome, but it is important to remember that many companies in this sector have dividend policies where they pay a percentage of profits out as dividends. This means that if commodity prices were to fall due to say reduced global demand this year, then dividends would naturally adjust lower with profits.
As we work through the next 12 months, in our minds, it is not beyond the bounds of possibility that dividends may be cut as much as a third in the market, which would make the impact worse than the GFC.
Companies with strong balance sheets still have the luxury to pay dividends, but management would have to make prudent decisions on the allocation of that cash so that it is best aligned to the long term success of their company. We are favouring investing in essential services; supermarkets, infrastructure, packaging and hospitals and aged care.
Our take on the big picture and where to from here
We expect telecommunications and service providers to that sector to do well as households have started to increase their mobile and broadband packages and carriers start their 5G capex spending.
With the Australian dollar at a multi-year low and uncertainty globally, we think Australians will take more domestic holidays once things settle down.
In our view, exporters like our energy, mining and even wine industries will benefit from this new currency tailwind. We think it’s prudent to diversify the sources of dividends and have a keen focus on balance sheets and cashflows, to position investor portfolios robustly ahead of any dividend cuts. This is a target-rich environment for long term investors.
It’s best to think of these dividend cuts like a landlord might, where you perhaps take a temporary drop in rent to keep a good tenant. When activity bounces back so too will dividends. In the meantime, capital raisings are going to be a happy hunting ground for new equity investment, in companies with fixed balance sheets.
There is also an opportunity to high grade an investor’s portfolio before the recovery as wishlist companies trade on sale. It’s important to make rational decisions now as there may be rewards when this period is over.
Source: Dermot Ryan, AMP Capital