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:
Tax rate | 15% | 30% | 47% |
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.
Whenever you see a strange action incentives or structures are often the culprit – which I figure is what you’re really getting at. To me there’s a huge opportunity in the funds management industry to manage funds on a post tax basis. Seems crazy to me that anyone would do in any other way. Understand there’s a scale issue at play. Perhaps just highlighting to clients how much value is being created by considering tax implications would be helpful? At least it would highlight others don’t…
Dear Steve,
other shareholders have similar concerns and could some combined activity and platform be developed to provide managment with evidence that a significant group are not happy with this policy. I would be happy to defer payment to the ATO until a larger capital gain is made in the future.
Further, what does the dominant shareholder want?
Great article on SSM. As an SSM shareholder I certainly would prefer a buy back. As for the other investor – I thought there was a fair bit of family money in the fund so I am surprised at their decision. However, we all know the mega wealthy are taxed “differently” so maybe they will not be affected by the lack of franking credits. Anyway thanks for your great ideas on managing SSM. I have been a shareholder for a bit over 2 years and after the initial panic it is nice to be making some progress. Hopefully the company can keep up the good work going forward.
Fully agree with your comments. Although am a little surprised that Alex Waislitz (I assume that he’s the mystery shareholder in this), would choose such a dumb way to have money returned. I always regarded him as one of the sharper investing minds on the ASX.
This may indicate that Waislitz is looking to sell Thorney’s stake in the business sometime soon because paying dividends (whether franked or not) will pander to the current market’s reach for yield, and so should result in a better sale price for Thorney.
Put differently, new and continuing shareholders will be forced to hand over some of their wealth to indirectly benefit those shareholders who will choose to sell in the near future (although the Federal Treasury is obviously the direct beneficiary of this dysfunction).
Your last paragraph nails it Matt.
We always try to assess decisions on a post tax basis – like whether to hold a fairly valued stock, that we otherwise intend to sell, for an extra month or two to pass the one year anniversary so the capital gain pass through to investors is discounted. We don’t always hold but we always weigh up the impact. I’d dearly like to think we’d behave that way regardless of our personal incentives, but it does help that our analytical team have much of their personal wealth invested in the two funds, these inefficiencies hit our own pockets too. Perhaps that’s the key thing missing at many other institutions.
It appears to me that considering the tax effects confuses the issue. For example lets a company makes 1m pays 30% tax and pays a 700k fully franked dividend. Shareholders at 30% tax rate pay no additional tax. If the company had losses and paid no tax then shareholders (at 30% would receive the same amount after tax as before even though unfranked. The difference is the tax is in their name rather than the company’s. Same analysis works for other tax rates
The real issue is capital allocation. Whether buying back stock at current prices would be a better results versus paying cash out or reinvesting in the business. In that regard I would still agree that it is a poor decison
Thanks SN. Agree that paying $300k corporate tax and a $700k franked dividend is the same as not paying corporate tax and a $1000k unfranked dividend. But that just demonstrates that the unfranked dividend wastes the value of the corporate tax losses. If we cull the dividend for now, and catch it up later when dividends can be fully franked, then the tax office never gets to tax the $1000k profit from that year. Same with a share buyback done at fair value.
Thanks for the post.
As an insignificant retail investor, receiving unfranked dividends would be frustrating. With Directors and key management holding a small number of shares (13.4m based on page 52 of their FY15 annual report, with a market price of $4.6m based on a 34.5c close), we can take comfort in the fact that value destruction is also hitting them and that we’re not alone.
Interestingly if they suspended the dividend for two years (causing the yield investors to dump the stock and drive down the price) and implemented a share buy-back, this could be materially accretive and benefit the medium term investor.
But a(n unfranked) bird in the hand is worth two in the bush.
Hi Steve, it’s funny looking back on this now with Service Stream at nearly $3. With the (easy in hindsight) early selling of the likes of Service Stream and JIN does the fund reflect on this and was there any indications that you could have held on or so you believe selling was the right decision with the information you had at the time. Can the fund do anything different going forward to hang on to early winners that keep winning long after you may have sold for profits? Thanks Joe