Shareholders Best Interests Part 2

Before I start, I want to add a caveat on comments I make when describing/valuing companies.  About 3 months ago, in my post here, I described the big 4 banks as having 2 classes, with WBC & CBA representing better value than ANZ & NAB.  Since then, the share prices of CBA & WBC (including dividend to WBC) have appreciated by 14.04% and ANZ & NAB have appreciated (including dividends to both) by 4.97%.  Under these circumstances, you must be sure to note the time when comments were made allow for any share price movements in the intervening period.  To clarify my position here, I would say that despite their combined $275b girth, you could now throw a blanket over them in valuation terms.  I would say it is improbable that the 4 will outperform the indices over the longer term (5 or more years).  I would be disinclined to single one out, but with a gun to my head, I would probably nominate WBC as most likely to lead the pack over the medium to long term.

Back to best interests… For Australian listed companies (who earn a substantial proportion of their profits at home), another routinely mishandled (by management) area is franking credits.  Franking credits are worthless to the companies that own them, but enormously valuable to the majority of shareholders, in particular retail holders with a marginal tax rate of less than 30% and super funds.  The most commonly cited franking credit hoarder is HVN (Harvey Norman), whose franking credit account held about $620m, or about 58.5 cents per share.  In order to pay out this full balance in the form of a fully franked dividend, they would need to pay about a $1.36 dividend.  This seems hardly practical based on a share price of $2.97 at time of writing, so obviously another tack needs to be found.  I suspect that Gerry Harvey had expected that his forays into foreign markets would solve this problem.  That is to say with a substantial proportion of profits earned overseas, the balance would be eroded by continuing to pay fully franked dividends.  These ‘International Profits’ have evidently been harder to come by than expected, though in time this choice may work out.

One outstanding recent example of a clever application of capital management, which successfully found a way of returning substantial franking credits to shareholders, whilst still enhancing shareholder value was this recent initiative by WOW (Woolworths) here. Now granted, Woolworths are facing some headwinds in the way of a rejuvenated Coles and weaker retail conditions, but you would be hard pressed to find an ASX50 company that has used capital management to better effect for its shareholders over the last 10 or so years.  To contrast, about 3.4% of WOW share price sits in the franking account, whereas about 19.7% of HVN share price is in the franking account. I stress, these credits are worthless to the companies, but invaluable to many shareholders.  I have no financial interest in WOW (or HVN) by the way.

To explain the benefits of the WOW plan, I will lay it out in brief. At the time the share-price was trading at about $29.80, the buyback was conducted at a 14% discount ($25.62), so shareholders who elected not to participate were immediately benefited by having a portion of the shares eliminated at below market cost to the company.  Those who elected to participate received $3.08 in capital component (so if you’d bought your shares at $15.08, you had a $12 per share capital loss to use against future gains).  They then received the remainder as a $22.54 per share fully franked dividend, which of course, carried a $9.66 franking credit.  This means holders who took this option received $35.28 (18.4% above market prices) in total value.  This was obviously chiefly beneficial to shareholders in lower income tax brackets and superannuation funds, but as I pointed out, longer-term shareholders also benefited by eliminating shares at a discount to prevailing market prices, thereby strengthening, or concentrating their shareholding.

Another recent example of cleverly returning capital to shareholders was in the recent special dividend by FFI Fresh Food Industries (disclosure – my wife has a small holding of FFI).  They announced a fully franked 50 cps special dividend, with a new DRP at a large 10% discount, virtually forcing all shareholders to participate, but when a management can average an 18.1% return on equity through the GFC, you have reason to believe they will be able to put the additional equity to work at reasonable returns.  They put about 1/3 of their franking balance where it belonged (in shareholders hands) and substantially improved liquidity on a small and fairly illiquid stock.  This type of owner oriented action is what I scour the bourse for, and it usually comes in situations like FFI, where the board and senior executives are substantial owners, take salaries that are eminently reasonable and consistently act with the best interests of shareholders at front of mind.  If you enjoy reading annual reports (there are only a few of us), I can commend you to this one (FFI’s) as it displays, in my opinion a clarity and directness in communication that you see too infrequently with leading Australian corporations - Tony Hansen 14/02/11