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Long Way Down

(The following are extracts from an article that appeared in the Money supplement of the
Sydney Morning Herald and Melbourne Age on 12th April 2006

By Barbara Drury

Dividends cost you money. That's the inescapable conclusion of a study of 12-month total returns chalked up by high-dividend-paying companies. But it's a conclusion that's likely to fall on deaf ears.

Australian investors love their dividends, many preferring to sail in the calm waters provided by a steady income stream as a buffer against short-term share price turbulence.

Yet an unsustainably high dividend may sink the ship, taking the company's share price and investors' total returns down with it.

Just ask any long-suffering Telstra shareholder. The Australian sharemarket has surged by more than 85 per cent since it hit rock bottom in March 2003, but Telstra has fallen more than 7 per cent in that time. Not even an 8 per cent dividend yield can paper over a crack that wide. In the 12 months to March 31, its total one-year return - that is, share price plus dividends - fell 18.9 per cent.

Of course, an unsustainable dividend is not the only reason Telstra's share price has tumbled. Its outlook is under threat from competition, Government regulation and full privatisation. It also faces significant execution risk, that is, the ability of management to navigate the rough seas ahead.

These were the risks cited by Moody's when it downgraded Telstra's debt rating in December, making it more costly to borrow. At a time when the company needs to fund a large capital expenditure program to remain competitive and fulfil its charter, borrowings have become more expensive. This raises the question whether earnings would be better directed back into the business rather than into the pockets of shareholders.

Unfortunately, directors are caught between a rock and a hard place. High dividends keep shareholders happy and encourage them to sit tight during tough times. To reduce dividends now could spark a share-price free fall.

According to market wisdom, a booming market makes the most foolish investor look good because a rising tide lifts all boats, yet even a king tide won't lift a leaking ship. As the tables below show, Telstra is not the only shipwreck sunk by high debts and an overgenerous dividend policy.

Professor John Price, developer of the Conscious Investor share analysis software, says Australian companies do a disservice to investors when they insist on setting high levels of dividends then increasing them every six months in all circumstances, even if they have to increase their borrowings to do it.

"In the end it's going to cost shareholders a lot more money through a falling share price as well as lower dividends than if they received more realistic dividends in the first place. Eventually the chickens come home to roost," Price says.

In fact, a spot check of the sharemarket's top chooks reveals just that. Price looked at all listed companies with a market capitalisation of more than $500 million and a dividend yield above 5 per cent. He then singled out those companies with a debt-to-equity ratio of more than 80 per cent and those with a debt-to-equity below 40 per cent.

The 18 companies in the high-debt group had an average total one-year return of 6.88 per cent. By comparison, the 16 low-debt companies enjoyed an average total return of 15 per cent. "I think this makes it clear that, in general, investors should be suspicious of companies with both high debt and high dividend yield," Price warns.

Of course, some companies with high dividends and high debt have performed very well. Yet investors would do well to think beyond immediate reward of dividends in the hand to a company's overall health and long-term prospects. Some companies even borrow money to maintain their dividends, a practice that should sound alarm bells. One example is the cleaning group Tempo Services, which borrowed money to pay a special dividend despite falling earnings, rising debt and a rapidly collapsing share price. The company ended up in the hands of receivers and was delisted a year ago.

"If sales and earnings are flat, debt is increasing and dividends are growing then eventually the company will run into trouble," Price says.

Fat Prophets' senior analyst, Greg Canavan, says people forget that dividends drain companies of cash. If a company then needs cash to grow the business they have to borrow and more cash is needed to service the debt. "It becomes a vicious cycle," he says. Canavan says the first warning sign is a dividend payout ratio in excess of 100 per cent of earnings, leaving nothing to pump back into the business. He suggests comparing earnings per share and dividends per share to see if the company is stretched.

"If it's a capital-intensive business you need to be a little concerned and drill down deeper into the balance sheet," he says, although low debts could be a mitigating factor.

AMP has increased its dividend payout ratio to 85 per cent but borrowing is down and it is generating plenty of cash from its sharemarket-related activities. In other words, it is in a good position to return cash to shareholders. Canavan says interest cover is another good measure of whether a company's finances are stretched. This is the number of times interest payments are covered by earnings.

Canavan argues that although Telstra has been borrowing to pay dividends, it did so deliberately because interest cover was high at 9.5 times and it had the strong cash flow necessary to support more debt. However, if earnings fall further he believes the level of dividends will be more difficult to justify with interest cover now at 6.5 times. Interest cover below five times is regarded as cause for concern.

Canavan points to Ten Network as another company where the share price has been supported by high dividends in the face of falling earnings. "When a cyclical company [such as Ten] goes through tough times there's no room to move if they have an 80-90 per cent payout ratio," he says.

Listed property trusts are popular with investors for their high dividends but they are also one of the worst culprits when it comes to paying out more than they earn. It's worth noting that property and infrastructure trusts feature heavily in both tables below.

Peter Papadakos, an analyst at Property Investment Research, says over the past 12 months the trend has been to reduce payout ratios to below 100 per cent although listed trusts must distribute more than 90 per cent of profits to be exempt from tax at the corporate level.

Papadakos says companies now realise the market will hammer their share price if they pay out more than they earn. The property cycle may also be behind moves to reduce distributions as companies try to build up reserves.

Price argues that Australian companies have failed to educate investors about what constitutes a sensible dividend policy. Too often directors use dividends as a public relations exercise for short-term share price gains. "Directors' business is not to sell themselves to shareholders but to run their business as best they can," says Price.

When sales are not growing Price says directors should say it would be better to lower dividends in the short term because they need to keep cash to build the business. Investors often say they need dividends to live on but Price argues that money is money and wealth grows through a combination of capital gains and dividends. While dividends offer the tax benefits of dividend imputation, capital gains also benefit from the 50 per cent capital gains tax discount for shares held for more than a year.

Price believes investors would be better off selecting quality companies and selling a few shares when they need the cash. "If a share price goes up 15 per cent a year and you only sell 5 per cent of your shares you are still growing in wealth. A company with a 6 per cent dividend yield and no growth is worse than one with a 2 per cent yield and capital growth of 15 per cent," he says. The analysis carried out by Price contained one more surprise.

The high and low debt companies in the lists below were taken from a total of 244 companies with a market capitalisation of more than $500 million. The average 12-month total return for all 244 companies was a remarkable 42.6 per cent, compared with 6.88 per cent for the high-dividend, high-debt group and 15 per cent for the high-dividend, low-debt group.

That is, over the past year, high-dividend-paying companies performed worse on average than low payers. Or as Price puts it, dividends cost you money.


John Price is CEO of Conscious Investing. Email:


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