Wednesday, 12 April 2017

Do 'Defensive' stocks with high dividends exist?

As part of my portfolio building exercise I have done some preliminary research on various UK companies looking for a defensive earnings profile and a high dividend yield. 

Unsurprisingly this is not such a simple idea. 

Most of these companies have massive debt loads to manage and also large pension obligations which greatly increase their leverage and pull cash away from what should be ample dividends.

The basic opportunity set of the FTSE 100 is;

Energy: BP & Shell 
Utilities: SSE, Centrica, National Grid, United Utilities Group 
Other: Royal Mail
Telecoms: BT, Vodafone

Dividend Yields by Sector

Other stocks yielding > 5% include:

HSBC which offers a good yield but it is a bank and is cyclical therefore I want to look at that separately. Same for M&S. Similarly companies like Standard Life and L&G being financials are harder to compare to this sample set. Pearson offers a high trailing dividend yield but this looks set to be cut.

So what should I pick to give a defensive, large cap, high yield backbone to the portfolio.
I found objections to all those names but I want to sift out a couple for a deeper look.

Amiable Minotaur: The full data table

Firstly I think BP and Shell probably offer the best metrics and incidentally the highest yields at just under 7%. But this is due to the cyclical downturn in oil which may go on for some time. I think Shell is marginally more attractive than BP because it trades slightly cheaper at 9x against 10x ten year average earnings and has a lower overall debt load because BP is still carrying debt from the Deepwater Horizon issues of yesteryear.

The companies have comparable sized pension scheme liabilities and issues too with Shell’s around 7x average earnings at £94bn but with a large £13bn black hole, they are only paying in £1.3bn. BP has a £49bn gross liability at 8x average earnings with an £8bn deficit and paid in £0.6bn last year. I worry that these companies could have to increase payments to the pension schemes. However I think they can afford it – but the risk is to the dividend.

On an absolute basis RDSA & BP have huge pension schemes - but they have generally better profitability

So Shell makes my shortlist for further research due to (a) Potential for cyclical upturn (b) high dividend yield (c) marginally lower risk than BP. However I suspect dividend cuts for both oil majors in the next 12 months if the macro doesn’t improve – usually any yield much over 5% is a warning sign of a cut.

The Utilities are a trickier bunch:

SSE seems attractive with a reasonable consistency of earnings and a good 6% dividend yield. However the company has a huge debt load of ~£7bn against earnings of ~£400m a year in the last few years. This is a highly-leveraged business. Maybe typical for a utility but they need nearly £1bn for dividends. When you add in gross pension liabilities to the financial leverage with a further £4bn including a £400m shortfall it starts to look a bit scary. 

The dividend has been uncovered by earnings for several years now and looks under threat. I foresee shareholders taking a cut to that dividend in years to come if profitability can’t be improved. It looks pricey on 21x 10 year average earnings. It is a maybe. Because…

Centrica makes you realise it could be worse for SSE. The company has £6bn in borrowings too with much more earnings volatility including two large losses in three years. The icing on the cake is a £9bn gross pension liability with a £1bn funding gap! Centrica being the name of the former British Gas state monopoly unsurprisingly has a massive pension scheme. This is a pension scheme with a gas utility attached. 

The dividend is also under threat given poor profitability but there is cash headroom for now. That dividend is probably the only thing holding together this company’s share price. It looks cheaper than SSE on a 10 year average PE basis at 16.9x but still that is hardly cheap for a utility with a £1bn black hole in the pension scheme. [Also in my experience British Gas have the worst customer service mess I have ever had the displeasure of dealing with. A terribly run business]. So I think Centrica are off the cards.

National Grid offer a lower yield of ~4% and some similarly unattractive metrics like 19x 10 year average PE. Growth has been better at NG in the past 5 years which is a plus and hence the dividend here is generally covered by earnings. But NG has a £29bn debt load! Compared to £2-£2.5bn in annual profits. That is some serious leverage. Now throw in a £30bn gross pension liability with a £2.7bn shortfall! The company is paying £0.5bn a year to make up the shortfall which is 20-25% of earnings. Again being a former state monopoly with a pension scheme to match is a serious issue for investors.

United Utilities are a water group. Growth is meagre and the yield of 4% is not spectacular. At 14x 10 year average earnings the valuation doesn’t seem too stretched. But this company has massive debts of £7bn against average profits of £400m. That is some serious leverage. Throw in a gross pension liability of £3bn and it looks a bit problematic but the scheme does at least run a £250m surplus. 

It seems you either get a huge debt load like UU or SSE or you get a massive pension hole like Centrica or National Grid. I understand utilities need leverage to generate a meaningful return for equity holders but generally these companies have pretty poor economics. Yes they have regulated returns so can manage the debt load but if interest rates rise these stocks become anti defensive as their debt servicing cost increases at the same time as yield hungry investors abandon the stocks driving down prices as they can get their yield elsewhere in cash / bonds. Given I am investing to generate long term value rather than short term income I can generally choose to avoid these. 

Note the extremely high debt levels of the Utilities

My conclusion about the British utilities space is that it is the opposite of defensive.
With huge debt loads, dividends positioned on a knife edge, popular disapproval and regulatory headaches and massive pension liabilities they are poised to deliver sub par returns to investors. 

I think the UK government has really been crafty in privatizing these businesses –as they take huge public pension schemes and debt loads off the public balance sheet and sell the shares to lure yield hungry investors (usually pensioners again!). The only reason to own them is for GBP derived income as few foreign stocks can offer such high yields after tax. The captive audience is probably supporting these valuations.

Note the biggest pension leverage is in the former state monopolies

Which brings me onto Royal Mail being the most recent privatization; It has a 5.5% dividend yield which is attractive. It also has low gross debt of around £400m (net debt £nil) which is not bad either given reasonable profitability. The pension liability of ~£5bn is a worry but the company actually has a net asset of £1.7bn so it is well funded. However note the company is still contributing £400m a year to the scheme. This is 2x what it pays in Dividends to shareholders. 

I note also the company is giving away 1% of its capital as free shares to employees amounting to £150m a year! I suspect Royal Mail Group may be something of an employee centred operation! Still worth a bit more in depth work given the low leverage and funded scheme as compared to the Utilities.

Which leaves Telecoms.

Vodaphone has a nice 5.5% yield and trades around 13.7x 10 year average earnings which seems attractive vis-à-vis the utilities. The pensions scheme is not really a concern at £5bn gross liability (£300m net deficit) against a similar level of average profitability. The debt load however is big. £57.5bn of big. That is >10x average profitability. A heavy load to carry but there is substantial £10.5bn in cash so net debt is £47bn. Also the company has experienced some revenue and earnings growth over the past 10 years and whilst slightly uncovered the dividend may be able to continue. Given the company it keeps this stock should be worth a second look.

BT Group. I think this is a no. Yes it has a reasonable 4.5% yield which is actually covered by earnings. Yes debt is not crazy at £14bn or ~7x average profits. Yes the stock trades at 15x 10 year average earnings so is not too dear. But, BT has a £50.3bn gross pension liability which is 24x the average earnings of the company. On top of that BT has a £6.3bn shortfall! They are paying £1.1bn a year into the scheme of which £880m is to make up the deficit. That is the same as they pay out in dividends a year. Or 1/3 of annual profits. Like National Grid and Centrica these former state monopolies are just pension schemes that throw off a little cash to investors seeking income. Ok yes it has some growth and a decent return on its massive capex but I fear that pension hole will continue to weigh on the shares for the foreseeable future. Vodaphone just looks a bit safer in the telco space. 

On a PE basis Centrica looks cheap as do the energy companies. SSE and NG look particularly expensive.

So my shortlist for a ‘defensive’ high yield payer are:

Royal Dutch Shell (Cyclical upside, cheapest stock on 10 year PE)
Royal Mail Group (Low debt, Pension surplus, Good yield)
Vodaphone (No serious pension problems, decent yield, not BT!)

In depth research to follow.

Disclaimer: I have no interest in any of these shares at present. I may do in the future. These are opinions only, not investment advice. If in doubt read my disclaimer.

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