Positive employment numbers out of the U.S. have sparked fear in the markets of imminent interest rate rises to curb inflation. So what are the implications for listed equities? Well, to steal an analogy from Warren Buffett, interest rates act on financial valuations in much the same way that gravity acts upon matter. This is because the interest rate on government bonds serve as the risk-free yardstick by which other asset yields are measured; the lower interest rates are, the lower the required rate of return is for alternative asset classes.
It is no secret that an extended period of quantitative easing by central banks has led to record-low interest rates. This has forced traditional income-seeking investors to look to other asset classes for lower-risk, higher-yielding investments. Enter the bond-proxy. Bond-proxies are equities that mimic the characteristics of, you guessed it, bonds. They offer consistent, annuity-style cash flow streams that purportedly carry a low-risk profile. These typically take the form of monopoly infrastructure assets such as airports, utilities and toll roads as well as REITS. These businesses are often protected by regulatory frameworks that ensure they achieve a certain level of return on their assets. Given the stable nature of these cash flows, a significant portion of earnings will generally be distributed to investors in the form of regular dividend payments. For many investors the expectation of consistent and even growing dividends forms the foundation of their investment thesis in these bond-proxies. As such, any change in dividend policy can be expected to draw a significant market reaction.
In the majority of cases the assets these businesses operate are mature, with a negligible growth profile. Earnings growth must then come from new capital expenditure projects or acquisitions. This leaves management between a rock and a hard place; the market expects consistent dividend increases and yet earnings growth requires capital for expansion. This has led many bond-proxies into scenario in which payout ratios exceed one hundred percent of earnings, and even at times consistently exceed free cash flow generation. If cutting dividends is removed from the capital management playbook, managers must look to either the debt or equity markets.
Of these two options, leverage is generally viewed as the more “shareholder friendly” option. Howard Marks offers a simple rule: the more stable the asset, the more leverage it’s safe to use. These assets are inherently stable, which is why it’s so tempting to add leverage to the equation. Adding leverage increases the return on equity, but at the same time also increases the risk of a loss of capital. As leverage ratios continue to rise, these companies start to present the wrong kind of return asymmetry; when things are going well the returns are okay, but when things aren’t running smoothly, there can be severe, permanent losses of capital.
Just a few weeks ago, Macquarie Infrastructure Corporation (MIC: NYSE) offered a rude awakening to the bond-proxy market, selling off 44% after reporting a 4Q results miss and a substantial cut to their dividend. MIC’s trouble stemmed from contract losses in the company’s bulk liquids terminals business, where the residual heavy refined “6 oil” is in structural decline. The downgrade serves as a reminder to those income-seeking investors that even the most predictable of cash flows should not be mistaken for the surety of income provided by a government bond. From 2013 through to 2017, MIC’s leverage ratio expanded from 66.2% to 105.5%, reflecting a c.US$2.8bn increase to net debt. Over the same period, the company distributed over US$2bn to shareholders in the form of dividends, with some of those dividend payments exceeding free cash flow generation. This is clearly unsustainable.
The record of some of the ASX bond-proxies is no better, with many companies expanding leverage ratios to absurd levels in order to sustain dividend growth and fund capital expansion projects. The companies selected below currently sit on an average forward P/E ratio of c.37x, with the highest ratio (TCL.AX) sitting at 51x forward earnings. At these multiples these companies are essentially priced for perfection.
Whilst one might argue that their dividend yields are attractive, there are a couple of issues with this thesis. Firstly, the yield offered is only really attractive on a relative basis to the yield of long-duration treasury bonds. Those treasury bonds themselves, however, only offer a yield of between circa 2.80% to 3.20%, depending on the duration. This is a particularly unappealing rate of return, and not one worth using as a relative benchmark. When interest rates do return to more normalised levels, so too will the dividend yields of these stocks. Secondly, the enormous debt levels offer an outside, but very real, risk of a significant permanent loss of capital. At these leverage ratios, no longer can the debt lever be pulled to fund capex, acquisitions, and subsequently dividend growth.
Taking a closer look at one of these companies – APA Group (APA.AX) – reveals a similar capital management story to MIC. Over the last ten years, APA’s dividend payments have consistently outstripped its free cash flow generation. Since 2007, this cash shortfall has totalled $1.3bn. With total FY18 capex guided at $0.8bn, an increase of more than 100 percent on FY17 levels, the 2H18 cash shortfall is expected to be substantial.
Regardless of whether this capex is for “growth” or “stay-in-business” purposes, it still has to be funded. APA have raised $500m to fund growth projects, a figure eerily similar to the expected FY18 dividend, making this look a little like a case of robbing Peter to pay Paul. Essentially, if you’re an investor and you want dividends to keep rising, expect more raises or more risk in the form of an even scarier balance sheet.