As we touched on in Service Stream Back Online, Service Stream has been an excellent investment for Forager’s Australian Shares Fund. We bought shares in this company, which provides network services for telecommunication companies, at an average of $0.19, and they are now appraised at $0.335 on the stock exchange.
That’s a fantastic result for Service Stream investors. But shareholders are now set to destroy some major value for no reason whatsoever. The culprit? Unfranked dividends.
Let me explain. When we last met with management we congratulated them on doing a superb job turning this business around. At the end of the meeting they requested input from us on the company’s dividend policy given its current tax circumstances.
Due to prior losses, Service Stream has around $33.7m, or 9 cents per share, in tax losses available. This will allow the company to avoid around 2.7 cents per share in company tax over the next couple of years. That’s normally an asset, but Service Stream has now exhausted its franking credit balance and so won’t be able to pay franked dividends until tax payments recommence.
The question put to us was whether Service Stream should pay unfranked dividends. The answer was a pretty easy ‘no’. Unfranked dividends are a tax disaster for shareholders. Effectively, cash which the tax office has no claim over is used to create a taxable event. If an unfranked dividend of $1 is paid to a shareholder on a 30% tax rate, $0.30 is benevolently donated to the tax office. Wherever you read the phrase ‘unfranked dividends’ you can pretty much replace it with the phrase ‘unnecessary tax’.
That’s particularly so with a company like Service Stream that will be paying fully franked dividends again soon. It could simply put the dividend on hold for two years, and then catch up the missed dividends once it resumes paying tax and generating franking credits. If the target payout ratio is 70%, the company should just pay nothing for the next two years and then 100% of profit for a few years after that to distribute the excess cash. Alternatively, Service Stream could substitute dividends for a buyback in the interim period. That way shareholders end up with discounted capital gains rather than fully-taxable dividends.
So it was surprising (or, depressingly, maybe I just wish it was surprising) to hear that Service Stream’s other institutional shareholders unanimously told the company they would prefer the company kept paying unfranked dividend over the next few years. Perhaps they think it is more important to generate a track-record of dividend payments and the tax sacrificed is slight?
Unfortunately that’s not so. Service Stream could produce pre-tax profit of 10 cents per share over the next two years, and comfortably pay 6 cents, or $22.5m, in unfranked dividends before exhausting tax losses.
Here’s the shareholder value sacrificed to the tax office, again completely unnecessarily, for investors on various tax rates:
|Unnecessary tax paid by shareholders||0.9 c||1.8 c||2.8 c|
That’s pretty significant value destroyed compared to the $0.335 share price. And it’s quite ironic that shareholders tipped in $20m in capital in 2013, and are now looking at taking about that much out in unfranked dividends and incurring a tax bill to do so.
Or perhaps our fellow fund managers don’t care given they are assessed on the basis of pre- rather than post-tax returns? Either way, no private company would ever behave in this way. Yet list a company’s shares on a stock exchange and it’s amazing how often the behaviour changes.
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Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.