More To Dividends Than Meets The Eye

Foreword from ShareInvestor

This article “More To Dividends Than Meets The Eye” by Cai Haoxiang was first published in The Business Times on 10 Nov 2014 and is reproduced in this blog in its entirety.

Investors have to pay attention to the payout ratio and associate/joint-venture contributions when assessing stocks

A FEW years ago, I was casually looking through the financial statements of SIA Engineering.

What impressed me then, from that quick glance, was how the Straits Times Index (STI) component stock had negligible debt – just S$2.3 million – and a cash hoard of almost S$400 million.

Its profits were steadily growing. On top of that, the company had paid out a bumper dividend the year before of 30 cents a share. Excluding the 10-cent special dividend, it paid out 20 cents a share.

This worked out to a dividend yield of around 5.3 per cent. Bank deposits were yielding 0.05 per cent – meaning that, a S$10,000 deposit in the bank would have got you S$5 a year, instead of the S$530 a year equivalent that an investment in the company would have earned you.

Moreover, SIA Engineering was trading at about 15-16 times earnings, which didn’t seem too expensive a price to pay at that time.

So, hey, why not?

It was a naive, simplistic way to go about buying a stock, but I went ahead and got myself a couple of lots without thinking too much about it.

I sold off my shares in the company recently, as I was doing some “spring cleaning” on my portfolio.

While I am sure it is still a solid company that will generate wealth for its shareholders, it is my view that SIA Engineering’s fundamentals have deteriorated from the time I first bought it.

I am not an expert on the aircraft maintenance business it is in, so I can only speak of its financials.

Its latest half-year results confirmed a nagging fear of mine that the company’s dividend payouts were becoming unsustainable.

Last week, SIA Engineering announced that it had cut its interim dividend by one cent, from seven cents a share to six, after reporting a 41 per cent drop in net profit for its second quarter ended Sept 30.

To understand why it might have to cut its interim payout, we have to delve into a financial ratio known as the dividend payout ratio.

The premise is straightforward. The dividend payout ratio shows how much of your earnings you are paying out in dividends every year instead of ploughing the money back into the business.

The traditional choice facing managers lucky enough to be generating profits on their company is: do you reward your shareholders, or do you use that money to grow the business further?

If you have too much money at hand, and no use for it, then it makes sense to reward your shareholders. They can then reinvest the money at a higher return, instead of you leaving that money lying around in the bank.

If you do decide to plough the money back into the business, then you better be careful not to waste it. Some managers end up destroying value by investing in loss-making projects or pursuing headline-grabbing acquisitions.

The dividend payout ratio – which is simply dividends divided by net income – is thus a quick way to determine what proportion of earnings the company is giving back to shareholders, and what proportion it is keeping for itself.

In the case of SIA Engineering, it distributed 21 cents a share in dividends for the year ended March 31, 2012, while it earned 24.56 cents a share. Its dividend payout ratio was thus 86 per cent.

(The inverse of the payout ratio is what is known as “dividend cover”. It refers to the number of times the company can afford to pay shareholders dividends out of its earnings.).

The Payout Problem

Now, paying out almost all your earnings may make your shareholders very happy, but the move has risks. For one, it signals that you don’t think you can use your retained earnings to grow your company anymore.

But the key risk is that your earnings could decline. If that happens, you will not be able to pay out an increasing amount of dividends to your shareholders every year.

Worse, you might need to dig into your cash reserves to pay shareholders the dividends they have come to expect.

The worst companies (which is not the case here) will use borrowed money from the financial markets to keep up their dividend payments.

Investors should thus look out for the sustainability of a company’s cash flows, to ensure it can continue paying out a steady stream of cash in the future.

Fast-food restaurant chain McDonald’s is a company that has famously managed to do so. It has increased its dividends every year since it paid out its first dividend in 1976. That works out to 37 years, or roughly the length of a career. Imagine getting an increasing pay cheque every year from your investment, from the time you start work until you retire.

For what it’s worth, McDonald’s has a dividend payout ratio of about 65 per cent. This means it pays out about two-thirds of its earnings and uses the remaining third for its business.

There is no hard-and-fast rule for what makes an optimal dividend payout ratio. A fast-growing company will generally not pay out any dividends. On the other hand, a mature company like telco SingTel could feel confident enough in its cashflow to commit to a dividend payout policy.

SingTel recently increased its dividend payout ratio to between 60 and 75 per cent of its underlying net profit, from between 55 and 70 per cent previously.

Other companies use a “smoothing” policy – holding back some dividends in good years to ensure shareholders still get a stream of income in lean years.

SIA Engineering, meanwhile, does not have a fixed policy. But its dividend payout ratio has risen to precarious levels in recent years, from 86 per cent in 2012 to 90 per cent in 2013, to 105 per cent for its latest financial year ended March 31, 2014.

At 105 per cent, this means the company is paying out more than what it earned. It earned 23.88 cents a share that year. When the year-end results came, it actually cut its final dividend from 15 cents to 13 cents.

On top of the 7 cents dividend it already paid, the company declared a “special” dividend of 5 cents to top up total dividends declared to 25 cents.

Special dividends make me uncomfortable, especially if the company is not making enough money to cover the payments.

The company had 1.116 billion shares then. The company had to pay out an extra 1.12 cents a share, or S$12.5 million, more than what it earned that year. This is small change, considering its cash stood at well over S$530 million.

In the last few months, however, SIA Engineering’s business has taken a sharp turn for the worse. High labour costs persist while customers are delaying maintenance checks to cut costs themselves.

For its latest quarterly earnings, revenue fell about S$9 million to S$285 million, while subcontract costs rose S$18 million. Operating profit was down 44 per cent, from S$28.5 million to S$15.9 million.

When one adds in net profit from SIA Engineering’s other investments like associates and joint ventures (JVs), the group earned S$42.1 million in its second quarter ended Sept 30, 2014 – almost S$30 million less than the S$71 million it earned in the same period the year before.

Assuming these earnings do not rise or drop further, SIA Engineering is on track to earn about S$180 million this year, or around 16 cents a share. It does not make sense to keep paying out the 25 cents a share in dividends that it did last year.

If it did, the company would have to draw down its cash to the tune of about S$100 million. The company has about S$390 million of cash now and can well afford to take the hit. But if the current situation continues for two years, its dividends will not be sustainable.

But if it can pay out only 16 cents a year for the foreseeable future, the stock is quite overvalued. I will buy the stock only if I can get a 5 per cent yield, which I deem attractive for a mature, limited-growth company like this. This means I am looking at a target price of S$3.20.

Subsidiaries, Associates And JVs

The situation is exacerbated because of an item more pertinent at SIA Engineering than at other companies: associate and joint-venture profits, net of tax, fell to S$29.1 million from S$45.6 million a year ago – a 36 per cent drop.

This is a significant drop that impacted SIA Engineering’s earnings; associate and joint-venture profits add up to 69 per cent of SIA Engineering group’s earnings for the quarter. This means that the non-associate and joint-venture part of the business was 31 per cent – less than half.

For the most recent financial year, associate and joint-venture profits made up 61 per cent of group profits.

These associates have come about because the equipment manufacturers SIA Engineering is partnering want to maintain control. The associate structure allows a Singapore Airlines entity to gain access to overseas markets in its key maintenance, repair and overhaul (MRO) segment.

Examine SIA Engineering’s annual report, and you can see a string of mostly Singapore-incorporated companies that the group has stakes in, ranging from 25-49 per cent.

These entities thus have a disproportionate influence on SIA Engineering’s earnings. Yet, there is limited disclosure on the inner workings of most of these companies in SIA Engineering’s statements.

To understand what these entities are, and why they matter, one has to understand how companies account for their investments.

Briefly, there are a few ways in which one company can invest in another, and these will be reflected differently in its accounts. We will cover a few here.

Subsidiaries are usually companies which an investor owns more than 50 per cent of, and they are defined as investments that a company “controls”.

Subsidiaries’ accounts are fully consolidated into the holding company’s financial statements. This means their revenues are added to the parent’s revenues, their costs to the parent’s costs, and so on, for every item in their financial statements.

If other parties own another portion of the subsidiary, the bottom line due to them will be separately accounted for under “minority interests” or some variation, like “non-controlling interests”.

That’s why you usually see two profit lines: profits attributable to owners, and profits attributable to minorities.

Joint ventures, meanwhile, refer to a situation where two parties share control of an entity and can both influence the way its assets are used. Usually, joint ventures are 50-50 partnerships, where each joint venturer owns half of the company that has been set up.

Associates, which the investor company does not control, refer to a lower but still significant level of influence – a stake of 20 per cent and above, but below 50 per cent.

Once a company owns at least 20 per cent of another, significant influence is presumed unless it is clearly demonstrated to be not the case. Conversely, a company that owns less than 20 per cent of another is presumed not to have significant influence unless the influence is clearly demonstrated.

Significant influence means that the investor has the power to take part in financial and operating decisions, but does not control the process.

Deciding whether an investor has significant influence is crucial to figuring out whether a company should be an associate, or just a financial investment where earnings don’t need to be reported.

For example, investors can hold 19 per cent of a loss-making company that it actually has significant influence over. By claiming the company is just a financial investment it does not have influence in, an investor company can avoid having to report those losses.

Equity Accounting

Associates and joint ventures have to be accounted for under a method of accounting called equity accounting.

Under this method, the investor company’s share of its associate or joint-venture company earnings are captured in its income statement under a separate line.

This method is called the “one-line consolidation”.

So if the investor owns 40 per cent of an associate, and the associate reports a net income of S$10 million, the investor will record S$4 million in associate income in its own income statement.

Equity accounting is quite different from consolidation accounting, where everything owned and earned by the company is captured.

Here, the investor will not see the revenues and expenses of the associates, or details on the movement of receivables, payables or debt.

On the balance sheet, associates are usually recorded at “cost plus”: the cost the investor company paid for it, plus the investor’s subsequent share of any income, minus the proportionate share of dividends paid to the investor.

It gets more complicated if the investor and the associate company sell goods to each other. The underlying principle here is that income is recorded only when a sale is “confirmed”. Unrealised profits are taken out of income.

One of the problems with equity accounting is that with a “one-line consolidation”, significant chunks of assets and liabilities are not reflected in the investor company’s balance sheets. This can skew debt ratios.

Associate and joint-venture revenue is also not reported in the income statement. This can overstate profit margins if an investor just lumps profit earned by associates and joint ventures together with what is purely earned by the investor company.

To be fair, SIA Engineering does disclose a number of details in the notes to its annual report.

Basic numbers of a big associate company, Eagle Services Asia (ESA), and a big joint-venture company, Singapore Aero Engine Services (SAESL), are disclosed. Financial information for other associate companies are lumped together. The accounting treatment is similar for other joint ventures.

For ESA, we see summarised information on current and non-current assets, current and non-current liabilities, as well as revenue, profit after tax and total comprehensive income. For SAESL, we see other details like cash, interest income and expenses, and so on.

These disclosures, however, are made only once a year; quarterly information is not available.

With SIA Engineering ‘s multiple associate companies and joint ventures, it is a daunting task for the amateur to have a good idea of the risks the entire group faces, or how it will perform in the future. For example, I counted 16 associate companies, some incorporated in places like Taiwan, Ireland and Indonesia.

According to a CIMB report, SIA Engineering’s most recent results were dismal because SAESL saw a significant reduction in its Rolls-Royce Trent engine repair work due to more reliable engines being used. ESA, on the other hand, was hit by lower repairs for Pratt & Whitney engines.

An investor not aware of the various issues faced by SIA Engineering’s sizeable associate and joint-venture companies will not be able to evaluate how well the group will do, or how badly things will get. And there are no quarterly numbers to pore through.

This is why I said my original investment decision was naive and superficial. I was lucky to get out with a decent return.

Investing is hard work, and one has to look beyond the dividends.